Portfolio Theory and Investment Analysis - Term Paper Example

?The market capitalization was 30 million pounds As given, the return on the three-asset portfolio that consists of equities, bonds and cash are given below as follows; Instrument Upto 2007 2007-now Equities 60% 40% Bonds 30% 40% Cash (treasuries) 10% 20% Where: a=equity b=bonds c = cash (treasuries) I. The benefit of the strategy adopted from 2007 onwards. The return on the three asset portfolio: rp = wara + wbrb + wc rc Whereby rp is the return. ra is the return and wa is the weight on asset a. rb is the return and wb is the weight on asset b. rc is the return and wc is the weight on asset c. wa + wb + wc = 1. E(rp) = waE(ra) + wbE(rb) + wcE(rc ) 0.6(-0.2) + 0.3(0.1) + 0.1(0.04) = -0.086 Hence the strategy before the 2007 economic crisis would have realised an expected return of -8.6% on investment. The strategy adopted from 2007 onwards in the light of the crisis would realise: E(rp) = waE(ra) + wbE(rb) + wcE(rc ) 0.4(-0.2) + 0.4(0.1) + 0.2 (0.04) = -0.032 The strategy adopted after 2007 would realise an expected return of -3.2% on investment. As a result, the benefit of the strategy adopted from 2007 would be a reduced lose of 5.4% II. Advisability of investing more funds in UK equities. With the managers of the funds thinking of investing more funds into equity in the market, it is important for the managers to analyse the UK equities in a risk-return relationship. Hence when analysing the risk premium of the equity with the rest of the asset class, the return differential will be attributed to the difference in the risk associated with equity as opposed to bonds. The equity line will be normally "shakier" than the bond line. As evident from the data provided, Wealth invested in equity for the past 20 years has been more volatile than wealth invested in bonds (the UK equity having a risk of 16% as compared to 5% for bonds and cash for 0.3% in derivatives). Despite the higher return, the risks were higher as well. The fund’s managers should care about the riskiness of any investment especially in a volatile market. As a result, they should also be willing to trade a lower rate of investment return for "insurance" that their principal will be secure. This is called risk-aversion -- and all things being equal, most investors would prefer less risk to more. At the same time, when analysing the Standard Deviation as a measure of risk, the UK equity returns are riskier and more volatile. Even with the future projections of 8% returns per annum, the projected risk is projected to be at 18% for UK equity and 19% for overseas equity respectively and at the same time, their correlation is very high at 0.8% between the UK and overseas equity making diversification not an option since it will not create any positive benefits of diversification. Due to the fact that the fund’s managers will be holding different portfolios, it would be important for them to use other statistical and non statistical data to be able to make informed decisions like the beta in respect to the market, fundamental ratios such as Book to Market Ratio and Earnings Price Ratio. III. Advantage of investing in the funds in international equities rather than UK equities. Due to the fact that stock market investing is risky, in the wake of the financial crisis, it is recommended for the fund’s managers to hold a well-diversified portfolio (including international diversification) to reduce risk as supported by the Capital Asset Pricing Model (CAPM) and the Modern Portfolio Theory (MPT). The fund’s manager, after analysing international market correlations in relation to the returns of various national markets due to difference in levels of economic growth and timings of business cycles, would allocate investments among these markets as a means of rebalancing their portfolios and reducing risks in favor of foreign equities (Rezayat and Yavas 440-458). In analysing the data provided, international equity portfolio diversification would be recommended based on the existence of low correlations among national stock markets and identification of diversification opportunities for the investors with the aim of lowering the investment risk. The data provided indicates that during the period of the past 20 years, annual returns in overseas equity has been at 5% per annum, a figure that is lower than 7% for the UK equity but the projected future earnings will be at 10% per annum, a figure that is higher than 8% for the UK equity and the same time higher than the cash and bond market in the UK (2% and 7% respectively). At the same time, in analysing both auto and cross-correlations to find out if they are significant (of which the results would imply diminished diversification benefits for investors if there is a close correlation among the markets) or insignificant (not significantly different from zero whereby the investors can benefit from international diversification). Looking at correlations between the UK and the overseas equity markets, it can be noted that the correlations are significantly different from zero, a finding that implies that the co-movement (or interdependence) of the two markets which increased to 0.9 and is projected to be at 0.8 for the future. Therefore, from the perspective of the international investor, these results imply that the benefits of international portfolio diversification across the UK equity and overseas equity are possibly less significant. In conclusion, international diversification will result in risk reduction for a given return as long as the correlation coefficient between the domestic and the foreign market is less than one (i.e., less than 100 percent) and at the same time being insignificant. Lower future correlation will provide deeper risk reduction. Based on the results provided, the fund’s managers having a portfolio of overseas equity and UK equity will experience a small diversification benefit (risk reduction) since the cross correlation coefficients with the overseas derivative market are rather large. On the other hand, the same funds manager will have better diversification benefit by investing in a combination of UK equity and bonds market and the UK bond and overseas equity market. IV. Use of derivatives within the potential new equity strategy. Brealey and Myers (397) attested that derivatives can be used as financial instruments to reduce risk while offering the potential for a high return (at increased risk) to another. The managers would take advantage of the huge range of derivatives contracts available in the financial market, and invest in futures, forwards, options and swaps that are traded in the market. This derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index). Their performance can determine both the amount and the timing of the payoffs. The fund managers may purchase derivatives for the following factors: Insurance and hedging: The managers may use derivatives as a tool to transfer risk by taking an equal but opposite position in the futures market against the underlying commodity. For example, the managers would buy/sell futures contracts on financial assets from/to a speculator as a means of minimizes risk from price fluctuations. Speculation and arbitrage: This is due to the fact that in most financial derivatives markets, the value of speculative trading is greater than the value of true hedge trading. In dealing with derivatives, the managers may look for arbitrage opportunities between different derivatives on identical or closely related underlying securities. Derivatives would eventually offer increasing possible reward for betting on whether the price of an underlying asset will go up or down. However, derivatives have been criticized for the following reasons: The use of derivatives may result in massive losses due to the use of leverage especially if the price of the underlying assets moves against them significantly. Derivatives (especially swaps) expose investors to counterparty risk. Especially if market that are variable change due to economic changes. As a result, fund managers may have to do credit checks as a practice of performing due diligence and risk analysis. Derivatives pose unsuitably high amounts of risk for small or inexperienced investors due to speculation hence its investment would requiring increased amount of experience and market knowledge. Derivatives typically have a large notional value. They control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator. However, the benefits of derivatives includes its ability to facilitate the buying and selling of risk, and thus have a positive impact on the economic system. In analysing the different financial derivatives in the market, the fund managers may consider purchasing options and future contracts. Options Options are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security. For example, the fund managers would buy a call option that would provide them the right to buy a specified quantity of a security at a set strike price at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wrote, the option must fulfill the terms of the contract. The fund managers would also use futures contract which are defined as standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. A futures contract would give the fund managers the obligation to buy or sell (Elton et al 611). This option would give the managers the ability to hedge against future economic risks by enabling them the option of exercising the contract at the end or prior to the settlement date, the holder of a futures position has to offset his position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations. The objective of the fund’s manager should be to create a portfolio that is able to take advantage of 'forecasted' market movements, up or down. As a result, the fund’s manager would strategies their asset allocation policy by buying calls (puts) or buying (selling) futures on a market if they expect the market to go up (down). Sources Brealey, Richard, and Stewart Myers. Capital investment and valuation. New York: McGraw-Hill, 2003. Elton, Edwin, Martin Gruber, Stephen Brown, and William Goetzmann. Modern Portfolio Theory and Investment Analysis. New York: John Wiley and Sons, 2009. Rezayat, Fahimeh and Burhan Yavas. “International Portfolio Diversification: A Study of Linkages among the U.S., European and Japanese Equity Markets,” Journal of Multinational Financial Management 16 (2006/10): 440-458. 9 December 2011 . Read More