Risk Management and Investment - Bonds and Security Investments - Coursework Example

RISK MANAGEMENT AND INVESTMENT Table of Contents Table of Contents 2 Executive Summary 3 1 Past Performance of the Bonds investment 4 1.2 Past performance of the Security investments 5 1.3 Efficient Market Hypothesis in action 5 2.0 Identification and measurement of the risks which the fund faces in the current climate 6 2.1 Credit risks 7 2.1.1 Measurement of Credit risk 7 2.2 Interest rate risk 8 2.2.1 Impact and measurement of Interest rate risk 9 2.3 Other types risks the asset portfolio is exposed to 9 3.0 The Key Recommendations for changes to the current portfolio and the major investment theories 10 3.1 Modern Portfolio Theory 10 3.1.1 Assumptions made under MPT in this portfolio 11 3.2 Use of external borrowing 12 3.3 Use of Split capital investment trusts 13 3.4 Efficient Market Hypothesis Selection 14 3.5 Fundamental Analysis 15 3.6 Hedging using derivatives 15 4.0 Written communication and use of information sources 16 4.1 Books 16 4.2 Financial websites and periodicals 16 Executive Summary The investment in the bond market has seen the guilt trust fund investing in only two bonds which include the 8% Treasury stock 2015 and the 4% Treasury Gilt 2022 which are all government bonds characterized by its reduced risks. This paper analyzes the past performance of the portfolio with major focus on the potential increase in the interest rates of United Kingdom and the share price trend in the selected portfolio of assets. The theory of EMH is introduced to provide an emphasis that past performance cannot be used to determine the future performance to information asymmetry. The risks identified in the portfolio include majorly the credit risks and the interest rate risks. These risks have been noted to have a possible measure through the derivation of the variance and standard deviation from the portfolio. The credit risks majorly affect the financial service market where the HSBC, Prudential and provident Fund Group are involved. Other risks noted in the portfolio include the regulatory related risks, which influence assets such as Tesco and BP as well the financial service assets. Various recommendations in the discussion include use of the modern portfolio theory whose demerits have been highlighted. The main idea behind this theory is the assumption made by the risk adverse investor and the possible returns. Borrowing to invest split capital investment and the fundamental analysis strategies have also been proposed to give an overview of the available options available for the investors who wishes to minimize on the risks and maximize on the returns. However, the derivatives strategies have not be advised due to complication involved in the management of the financial derivatives. Lastly, the communication and use of financial information have been presented to provide a glimpse of how the sources of information for investment can be obtained. Risk Management and Investment Project description 1.0 Analysis of the past performance of the portfolio 1.1 Past Performance of the Bonds investment Analysis of past performance does necessary mean this will be used as a guide for future performance. However, analysis of past performance can be used to predict future performance. The past performance of the asset portfolio can be tracked back when the Treasury bond markets rallied in January, which benefitted from the search by investors for safe investment between flaws in the world equities especially the emerging markets. This came amid worries that the Federal Reserve had an opportunity to proceed in tapering its quantitative moderation programme. This was in spite of the erratic weakness in some world fiscal data, 10 year gilt yields, which went down to 2.7% by approximately 0.3% (Koponen, 2003; p. 551). The long-term gilts had performed better than the short term dated gilts with predictable issues meeting ahead of the index connected gilts in the same month. The plunge in the yields on treasury bonds highly reflects the world as opposed to local impact, with UK economic news remaining robust within the month. The rate of unemployment went down to 7.1% from 7.4% within a fraction of the 7.0% verge below which the previous guide by the Bank of England showed that an increase in the formal rates of interest would be under scrutiny (Chandra, 2003; p. 99). Even though valid information from the housing industry indicated that, the increasing prices would proceed to strengthen the consumer action and house associated job conception. The governor of Bank of England assumed the prediction of a superior near-term bank rate proposing that the recovery required more time to gain force. The case of the bank was also supported by the information that the consumer price index went down to 2.0% in the month of December from 2.1% experienced in November. This was the first time the rate of inflation had an influenced the Treasury bond market which rallied in January in a period of just four years. The drop was mostly because of the sluggish increase in the food price, while at the same time discounting from some retailers in the loom of the Christmas, which experienced the impact. 1.2 Past performance of the Security investments The portfolio of assets invested in the Trust fund did not have a smooth sailing. In the last three years, the trust fund had a volatility of 5% with relative volatility rate of 0.92%. The correlation to Benchmark was about 91% while the correlation to the FTSE all share Index was approximately -29%. The top performing funds in the portfolio include; AstraZeneca shares with a share value of £ 3757, Diageo securities with a share price of £ 1906.8 but with a net dividend yield of 2.60%, Prudent Financial Group with a share price of £ 1893 and a net dividend yield of 4.3%, close Brothers Group has a share price of £ 1326 and Prudential Company has a share price of £ 1287. However, in terms of net dividend yield, Tesco securities which has the lowest share price seems to be producing the best net dividend yield which might be due to its constant trading and high demand at the London Stock Exchange (Lintner,1965; p. 38). Tesco’s shares produce a higher net dividend yield of about 5.20%. 1.3 Efficient Market Hypothesis in action Taking into consideration the efficient market hypothesis it is not possible for the investors to use past performance of the various shares or the historic share price to predict the future value of the shares under the weak form market efficiency. The share value of the various assets in the portfolio assume the random walk theory where the investors cannot easily predict the share value of the shares since the shares are unpredictable (Kent, David and Avanidhar, 2001; p. 923). Besides, the investors cannot easily use the historic and the publicly available information to predict the share value of the assets given that under the semi-strong form market hypothesis, the past and publicly available information about the company are easily and quickly incorporated in the share value hence difficulty in predicting the future share value. For example, the rumors about the possible takeover of BP can easily be integrated in the share price such that the investors have no chance to use the information to drive the share value up and arbitrage from the deal. Moreover, the strong form market efficiency where both the insider information, publicly available information and the historic share performance are easily and quickly integrated in the share price, it leaves no room for investors to arbitrage from such information. In addition, with the advent of technology, information in various locations of the United Kingdom is easily incorporated in the share price regardless of the time and place where the trading is taking place. This implies that the theory of efficient market hypothesis and random walk hypothesis applies with the past performance and the current performance of the share value in the portfolio. 2.0 Identification and measurement of the risks which the fund faces in the current climate The GILT trust fund is exposed to various risks in the current UK market based on the individual investments in the portfolio. However, most of the risk causing losses is offset by other returns acquired from other high performing assets. The objective or target by the fund managers is to maximize on the shareholder’s wealth through proper use of the assets and capital employed to get returns. The investments in the financial institutions and chain stores expects to realize returns for the asset portfolio where the managers make it possible to increase the income such that the interest paid on borrowings and deposits exceed the costs of operation. In the course of doing this the various institutions encounter various risks which include; liquidity risks, interest rate risks, credit risks, foreign exchange risks, technological risks, operational risks, regulatory risks, competitive risks and product innovation risks (Merton,1972; p. 1867). 2.1 Credit risks Majority of these risks can be grouped into systematic risks and unsystematic risks. Systematic risks cannot be eliminated by diversification while the unsystematic risks can be minimized through diversification. In the asset portfolio, the major risk that can be noted in the current climate is the credit risk and liquidity risk, which have affected most asset portfolios in the United Kingdom. Credit risk comes about due to non-performance of the debtors. This might emerge from either the inability or unwillingness of the debtors to act within the agreed contract. Therefore very many people are affected which range from lender or the institution that made the contract to other lenders to the creditor and the shareholders of the debtor. Credit risk can be grouped under unsystematic risk which can be hedged through diversification even though it cannot be perfectly hedged (Brodie, Giannone and Loris, 2009; p. 106). Credit risks affect nearly all the assets in the portfolio but especially the HSBC asset, Provident Fund Group and the Prudential Company’s assets. 2.1.1 Measurement of Credit risk Credit risks that affect the assets in the portfolio can be measured by a statistical variable known as standard deviation. Nevertheless, taking into account the asset price of the entire portfolio, the standard deviation is approximately £ 1056.04. Comparing to the mean share price of the entire portfolio of £ 1273.90 this is a huge risk given that the deviation from mean is very large. Therefore, the management has to devise appropriate methods of controlling or managing the risks to minimize their impact on the portfolio. Besides, the credit risks can be measured in terms of the number of debtors and their potential default depending on the performance of their respective business. The credit worthiness of the respective debtors is a good measure of the potential credit risk of the portfolio of assets (Merton, 1972; p. 1867). 2.2 Interest rate risk The interest rate risk is another risk that can be noted from portfolio. The interest rate affects the bond market and the acquisition of loans. The United Kingdom has unemployment rate of about 7.1%, which then suggests that the interest’s rates are likely to rise from the current 0.5%. However, even though the treasury bonds are considered as being risk free bonds, there is some of market risk, which affects the investment in the bonds. It should be noted that not all the risks stated in this discussion are significant risks; the major vital risks of much focus in this section are the interest’s rates risk and the credit risks. This is because challenges in this section normally result into crisis of liquidity and failures of the banking institutions. As a result, in case the institution or the asset happens to experience an increase in the rates of interests on its long term and short term liabilities and at the same time it does not increase the rates of interest imposed on the liabilities to the customers because of competition, then it is said that the asset can become concession (Chamberlain, 1983; p. 200). 2.2.1 Impact and measurement of Interest rate risk In addition, institutions such as HSBC in the portfolio are prone to unrecoverable loans, which then threaten its viability. Other assets vulnerable to interest rate risks include Provident financial Fund and the prudential fund given that they all fall under the financial institution industry. However, the rest of the risks do not often cause a fatal threat. Consequently, majority of the risks would need to be merged in order to create a crisis. Since risk is assumed to entail elements like a feel of power and knowledge, it is known that perception of risk is influenced by the social-cultural elements such as trust and justice. The main cause of the credit risk and the interest rate risks can be traced way back during the outbreak of world financial crisis in 2007/2008 which came about as a result of some financial and investment institutions taking over some risks (Bhalla, 2010; p. 590). Moreover, due to the financial crisis, banks especially those in countries such as Greece which is still struggling with the aftermath of the crisis have become indisposed in lending to other banking institutions since they are not ready and willing to face any form risk in the market. Besides, the government has come up with various laws that are set to ensure that the crisis will not occur again. This include adopting various financial regulations which are to be observed by all institutions and management trust funds to reduce the possibility of experiencing interest rate risks and the credit risks (Bhalla, 2010; p. 591). 2.3 Other types risks the asset portfolio is exposed to Other risks that have been noted even on smaller margins from this portfolio include counterparty risks, operational risks, legal risks, currency risks and capital risks. For example, the legal risks affect assets such as Tesco and BP in terms of the various environmental regulations that are supposed to be adhered to. British Petroleum has to encounter extra costs in ensuring that these risks are minimized to the least level. This type of risk cannot be diversified. What’s’ more, the counterparty risks experienced by some companies in this portfolio are because of its scope of trading. Tesco, BP, HSBC and Diageo are some of the assets which are global hence if the partners are not performing because of political risks. Operational risks are risks related to the challenges of precisely processing, recording, taking, settling and creating delivery in exchange for money. Some of the potential problems that may be experienced include; the technical errors made by the distributors and supply chain managers in processing the orders on time to the designated areas and customers. However, there is relief to this type of risk due to advent of technology, which might have fewer errors. This risk might also arise in the process keeping records, making computation of precise payments, failures in the processing system and compliance to the different regulations. In most case these type of errors have proven to be costly whose origin might stem from the personal problems which would end up hurting the company (Mandelbrot and Hudson, 2004; p. 11). It is the responsibility of the risk manager to identify these types of risks and their magnitude on the portfolio and take appropriate recommendations or course of action to minimize their influence. 3.0 The Key Recommendations for changes to the current portfolio and the major investment theories 3.1 Modern Portfolio Theory The investor can make use of the modern Portfolio theory in an effort of maximizing the expected return for the quantity of the portfolio risk or similarly minimizing the risk for the selected level of expected return by cautiously selecting the different assets in the portfolio. The current portfolio offers an expected return of about 4%. In this case, the investor would combine about seven assets in the portfolio (Owen, 1983; p. 747). These assets include BP assets, HSBC, CAN, AZN, DGE, TSCO, and NG. and CBG. The basis for this selection is on the annual income acquired by the investor. This would mean the 20000 shares owned in Prudential and the 10,000 shares in Provident fund Group would be distributed to high earning assets such as Tesco and AZN assets. The rest of the assets would remain the same but the expected return would increase as shown in sheet 1 of the excel spreadsheet. The expected return increases by approximately 0.11% from 4% to 4.11%. 3.1.1 Assumptions made under MPT in this portfolio The investors use the normal distribution to formulate their returns and that they investor will neglect the transaction fees and the taxes. The investors are more concerned in the optimization of their returns, which means maximizing the mean for a selected variance of the portfolio. For these investors to apply optimization of the mean and variance there is presumption that the joint merger of returns and utility creates the utility problem optimization to be same as mean-variance optimization. Furthermore, the investors assume that the returns are combined using the normal distribution by random variables. In reality, it is noted that the returns in the assets and other investments are not distributed normally (Sharpe, 1964; p. 432). The investors also assume that the correlation between the equities is constant and fixed at all times. This assumption would apply perfectly in the event of financial crisis since all equities become positively correlated given that they move together. This theory is appropriate for investors who wish to minimize on the risk from the portfolio. The investors also target to maximize on the economic benefit where the efficient market hypothesis applies mostly. The investors using this model are risk averse and rational about risks in the portfolio. This is also an assumption that applies mostly in the efficient market hypothesis (Sharpe, 1964; p. 433). Moreover, the investors access data and news at the same time hence there is no investor who will get information faster than another will. In fact, the real equity market has information asymmetry, which means that all information is acquired by all investors at the same time. Another assumption in this model is that the investors in the portfolio are price takers, which imply that their activity does not affect the price of the equities, and that the volatility of the equity is well known in advance, even though inn normal markets the risk is normally mispriced by the investors (Edwin and Martin, 1997; p. 1749). 3.2 Use of external borrowing There is a huge difference between the unit trusts and investment trust where under the investment trust one can borrow to invest in a given portfolio. This potential is referred to as gearing ability, which has been noted to have a theatrical effect on the value of investments. This portfolio being an investment trust can make use of the loan to venture into various equities and other securities in the market. It is to be known that the gearing is very vital when the markets are emerging as it enlarges the benefits made. Nonetheless, whenever the security market tends to fall down, gearing has a tendency to increase the amount of losses. This strategy will be most appropriate for investors who are risk takers, the investors who are not afraid of taking risks (Markowitz, 1959; p. 91). An investment with a high degree of gearing must fall more under this situation compared to investment trust with a low gearing level. This implies that the investor with a high level of borrowing on the investment posses a higher level of capital risk but the probability of higher returns is also very high. The joint effect of discount and gearing implies that the investment trusts have the probability of being more volatile compared to a similar unit trust. As a result, if the investor puts more money in investment trust he or she must anticipate huge benefits or huge losses, which might not be on a smooth sailing (Hubbard, 2007; p. 23). 3.3 Use of Split capital investment trusts Modern investment trusts have a tendency to issue simply one type of share. These provide an income via dividends and an opportunity to grow on the capital of the investor. Therefore, if this investor makes use of the split capital investment trust, the institution is guaranteed to have an opportunity to invest in more than one type of security. Besides, this type of investment, the investor has a chance to experience the benefits of winding up dates. In theory, investing in more than one type of shares using the split capital trust means that the investor can have more differing needs satisfied. This applies to investors who interested in having their wealth level grow exponentially as opposed to investors who would wish to have regular income payments from the investment (Tobin, 1958; p. 77). The good news are that since the 2001/2002 scandal the split capital trust is more regulated hence the risk of losing one’s investment is very low. The split capital trust, which offers more different kinds of equities, is common in the market. One of the split capital investments that are popular is the zero dividend preference stock. This type of split capital trust pays no income even though it provides a predetermined return rate upon the winding up of the trust. Therefore, this type of investment can be applied by the investor in this portfolio for some proportion of the investments if the investor wishes to have a certain sum of money at a predetermined time in the future. This type of investment is guaranteed to give the investor good returns due to its heavy regulation in the market. The investor will also have the chance to be paid first before any other investor is paid out upon the winding up of the investment. Therefore, this means that the investment is more relevant for risk averse investors due to the lower risk attached to the shares in the split capital trust (Markowitz, 1952; p. 90). 3.4 Efficient Market Hypothesis Selection As mentioned before the efficient market hypothesis selection is vital in the selection of a portfolio for investment. Under this theory, the market is assumed good processors of information and past data and that, the equities and securities replicate the information that is accessible at any given period. Therefore, any efforts by investors to estimate or predict any additional information will prove to be less significant since all the data and news is already incorporated in the share prices. This means that in case the investor selects a given portfolio of assets and obtains strong or huge returns, he or she does it out of sheer luck. The supporters of the Efficient market hypothesis provides this piece of information to the investors; select the types of assets you would wish to have in the portfolio on the basis of the extent of risk the investor wishes to hold, the desire for tax situation and cash flow. The EMH strategy does not rely on the information from speculators and analysts even though it is the actions of the analysts and speculators that create the efficient market. Using this information the best recommendation for the investor in this situation would be to keep the current assets in the portfolio and perhaps the risks exposed to might eventually result into more returns for the investor. However, caution must be taken especially when the individual assets seem to be showing signs of collapsing. The investor in this scenario must not merely assume that the assets will eventually lead to more returns. As a result, the stocks that show a long-term trend of poor performance must be done away with in the portfolio and its income invested in other productive assets (Andrei, 2000; p. 17). 3.5 Fundamental Analysis Moreover, looking at the economic of the various assets as shown in sheet three of the excel the spreadsheet; the investor must doing away with the BP shares due to its economic trend. The shares are reportedly losing its value gradually. The information in this sheet 3 shows the trend of monthly share prices for the past twelve months since March 2013. Using the fundamental analysis the trading of the stock market is found on the economic pattern and profitability of individual company. Therefore, an ideal asset portfolio in this case would have assets whose possible benefits are high compared to the present market prices. This form of analysis begins with a research on the elements that influence the entire market. Therefore, BP in this case has experienced very many speculations of a possible sell and with the constant risks related to the oil prices, it will be prudent to dispose off these assets on the asset portfolio. Thus, the elements that influence the individual industry might be put into consideration such as the extent of budget deficit, which might affect the interest rate. Therefore effective market research on each individual firm will be put into account to establish whether the share price is under valued or overvalued (Chandra and Shadel, 2007; p. 363). 3.6 Hedging using derivatives Hedging process-using derivatives has been avoided due to the fact that some risks cannot be hedged such as systematic risks. It will then be less useful in the use of options and futures to hedge the potential risks. However, some of the assets can be hedged depending on the management strategies in managing the risks in the portfolio. Some form of hedging might also present some types of risks, which presents plenty of work to the risk management department on how to deal with such risks. It is therefore the choice of the investor to decide whether to use the hedging process by use of the financial derivatives. 4.0 Written communication and use of information sources 4.1 Books As a beginning point, the investors must consider using the following sources of information for individual companies. These sources will help in investigation and learning in connection the performance of the companies and its state of management. Books such Investment management by Bhalla offers rich information about various modes of investment and their returns. The book review by Tobin James and the Wall Street Journals provides a good introduction of the financial information on various companies and their potential trend of share prices. The investors might also consider reviewing some other latest editions of book reviews, which have information on the assets in the portfolios as well other asset portfolio to establish the trend in the performance and the management style employed in the companies. The rest of the books have been included in the reference lists, which can be reviewed by the investor for rich source of information. Caution must be exercised especially with the credibility of the authors in the investment sector to ensure authenticity of the information acquired. 4.2 Financial websites and periodicals Financial websites such as MSN money, CNN money.com and morning star offers education news on investment in securities and bond market as well as in the mutual funds. The sites offer current news on the management of different assets in the portfolio hence giving the investor an opportunity to choose the right type of investment. The newspapers and periodicals can also be of big help to the investor. Publications made by the Dow Jones offers an insightful facts about the rating of some companies and their potential flaws which gives the investor a chance to adequately review where to invest their funds. Therefore, before deicing to invest the money the investors have an obligation to analyze these sources to find the best investment portfolio or assets in their portfolio. Bibliography Andrei Shleifer: (2000) Inefficient Markets: An Introduction to Behavioral Finance. Clarendon Lectures in Economics. Bhalla, V. K. (2010). Investment Management. New Delhi: S. Chand & Co. Ltd. pp. 587–93. Brodie, De Mol, Daubechies, Giannone and Loris (2009). Sparse and Stable Markowitz Portfolio. Proceedings of the National Academy of Sciences 106 (30). 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Commodities in action: measuring embeddedness and imposing values. The Sociological Review. Volume 50 Issue 4, Pages 543 – 569 Lintner, John (1965). The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. The Review of Economics and Statistics (The MIT Press) 47 (1): 13–39. Mandelbrot, B., and Hudson, R. L. (2004). The (Mis) Behavior of Markets: A Fractal View of Risk, Ruin, and Reward. London: Profile Books. Markowitz, H.M. (1952). Portfolio Selection. The Journal of Finance 7 (1): 77–91 Markowitz, H.M. (1959). Portfolio Selection: Efficient Diversification of Investment. New York: John Wiley & Sons. Merton, Robert. (1972). An analytic derivation of the efficient portfolio frontier, Journal of financial and quantitative analysis. 1851-1872. Owen, J.; Rabinovitch, R. (1983). "On the class of elliptical distributions and their applications to the theory of portfolio choice". Journal of Finance 38: 745–752. Sharpe, William F. (1964). 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