Mei-Ting Huang Ph. D. Student,Graduate School of Management Accounting Doctoral Program, National Yunlin University of Science and Technology, Taiwan E-Mail

Mei-Ting HuangPh. D. Student,Graduate School of Management

－ Accounting Doctoral Program,National Yunlin University of Science and Technology, Taiwan

E-Mail ： [email protected]

Measurement and Application of Investment Portfolio Risk：

Application of D&D(2002) Model

American Accounting Association (AAA)

Annual Meeting 2009

Contents of this paper

Section I. Introduction

Section II. Methodology

Section III. Empirical Results

Section IV. Controlling Procedure

Section V. Conclusion

Content



I. Introduction(1/2)

Our Background

In previous research (McNichols 2002; Francis et al. 2005) that follow the Dechow and Dichev (2002) suggest a new measure of one aspect of the quality of working capital accruals and earnings.

Our Research Problem

When investors estimate the proxy variable of Earnings Quality by the D&D model to assess the information risk of their investment subjects, they lack a relative risk reference standard with which to serve as a benchmark for their decision-making.


I. Introduction(2/2)

Our Purpose

To resolve the problem,we develop an Earnings Quality Capability Index by

incorporating a Process Capability Index concept, used in industrial engineering, into the D&D model.

Further, investors may assess a relative risk degree of single investment object or investment portfolio.


II. Methodology(1/6)

Earnings quality

(D&D model)

Earnings quality

capability index

Investment risk

Step 1

Step 2

Step 3

Measurement model of portfolio Empirical model

we exploit the D&D model to estimate Earning Quality in step 1.

Then, we establish a measurement benchmarkand terms it as Earning Quality Capability Index in step 2.

Further, we will convert the measurement of investment risk in step 3.



Measurement of Earnings Quality (D&D model)

The D&D model regresses as following equation (1).

The standard deviation of these residuals is a firm-level measure of accrual quality.



Earnings Quality Capability Index (1/2)

We exploit the Process Capability Index, proposed by Juran (1974) and Kane (1986), to establish a measurement benchmark as following equation (2).

(2)



Modified Earnings Quality Capability Index (2/2)

Further, We establish the two-tail biased Process Capability as following equation (3).

(3)



Investment Risk

Finally, we derive investment risk as following equations (5 to 7).



Empirical Data in Table 1 is as follows.


III. Empirical Results(1/2)Regression Result of Earning Quality in Table 3


III. Empirical Results(2/3)

Regression Analysis of Table 3

Based on D&D model, Panel A of Table 3 displays the regression results.

Model explanatory power, adjusted R2, is 29.1%. This means that the remaining 70% variance is unexplained by the cash flow from operation.

Panel B reports a zero mean residual term,consistent with the basic assumption of linear regression model. Standard deviation of residual

term is 0.088 and is used to surrogate the Earnings Quality of potential investment subjects.


III. Empirical Results(3/3)We assume investor chooses the investment subjects

with residual terms within (or outside) 90% tolerable upper bound and lower bound to form his (or her) investment portfolio A (or B) of Table 5.

Results of Table 5 .The standard deviation of residuals in investment portfolio A is less than that in investment portfolio B. This implies that Earnings Quality Capability Index of investment portfolio A is higher than that of investment portfolio B and thus investment risk of investment portfolio A is lower than that of investment portfolio B.


III. Empirical Results(3/3)Results of Investment Portfolio A&B in Table 5


IV. Controlling procedure of investment decision-making system

Earning quality (D&D model)

Potential investment subjects

Earnings quality

capability index

Investment risk

Acceptance of portfolio

YES

NO

Measurement model of portfolio

Step 1

Step 2

Step 3

Portfolio

Tolerable range of Pi

If investment risk still falls out of his (or her) acceptable range :

The investor checks components of the portfolio and identifies the investment subjects with inferior Earnings Quality.

Then investor proposes control project to improve the risk to make the risk fall within acceptable range.

or investor may choose new

investment subjects with which to apply our measurement model of investment risk.

Such an investment decision procedure repeats until the risk fall within acceptable range.


V. ConclusionFirst, we introduced the Process Capability Index

concept used in industrial engineering into the D&D Earning Quality model. Moreover, We develops a measurement model of investment risk in terms of market participants.

Second, we establish portfolios within the risk tolerable bound of investor and form a controlling procedure of investment decision-making system. Investor may control risk effectively and achieve his (or her) optimal portfolio.

Finally, Research results indicated that the higher the Earnings Quality, the lower the indicator of investment risk and thus the lower the investment risk of the portfolio.

Thank you for Your Attention!Questions?


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Mei-Ting Huang Ph. D. Student,Graduate School of Management Accounting Doctoral Program, National Yunlin University of Science and Technology, Taiwan E-Mail