Whether in Finance, the Risk Is Best Judged in a Portfolio Context - Essay Example

? “In finance, risk is best judged in a portfolio context" Is this true? Why? Table of Contents Introduction 3 Risk and Return 3 Portfolio Theory 4 The CAPM (Capital Asset Prising Model) 5 Dividend Policy 5 Long Term Financing 6 Capital Structure (Irrelevance) 6 Capital Structure (and Market Perfection) 7 The weighted average cost of capital (W.A.C.C.)  7 Option (Financial) 7 Option (Real) 7 Risk in Portfolio Context 8 References 10 Introduction The investment market is inextricably linked to the securities market of the country; and the understanding of the stock markets is a must for the successful management of the portfolios. The investment decisions are taken having regard to all of the various investment instruments in the market and the analysis of the return generating capacity of the same. The portfolios are investments in a variety of these investment instruments which have a combined impact on the overall return generating power of the total investments in the portfolio concerned. The giant players of this sector, the business are generated by management of the funds of the High Net-worth Individuals [HNI] clients and the big Corporate Houses. The services are obviously for a pre-determined fee which is generally structured on the basis of the returns generated by the investment bankers. In most common cases, there is a fixed portion of fee as well irrespective of the return generated by the fund managers (View, 2007 p.144). In this essay the researcher will analysis different aspects of portfolio. The theoretical background of portfolio especially risks and return is the integral part of portfolio discussion. So, here the researcher discusses this part at the first part of the essay. After that the researcher will discusses different aspects related with the portfolio i.e. CAPM Model, Long term financing, capital structure, WACC model, dividend policy and option. After discussing these aspects the researcher will summarise the whole topic and find out risk is the best judge in the portfolio context or not. Risk and Return In the terms of Investment, risk is the probability of difference between the expected returns and the actual return of investment. Since, the risk indicates the possibilities of reducing the part of initial or original investment or all amount of original investment. The risk is calculated through the standard deviation of the average or historical return of the particular investment. Presently, the market is too much volatile. So, most of the Companies are spending a large portion of time and money to develop the risk management strategies for the purpose of manages the risks attached with the business operation. On the other side, the return is the reward of taking the risk in investment. So, return indicates the loss or gain in the securities with in a particular timeframe. Portfolio Theory This is mathematical formulation which derived from the diversification concept. According to this theorem more than one investing assets are selected to minimise the risk of the each assets. There are two primary aspects of portfolio theory i.e. tries to minimise the portfolio risk at a certain level of expected return or to attempt to maximise the expected return of the investor at certain level of portfolio risk. Harry Markowitz was the person who introduced the idea of diversification in the year 1952. The concept of equity diversification in the international market is aimed at reducing risk, thereby maximizing the value of the portfolio. In the current market scenario, there are two views in the market that are quite competitive in nature. One of the views accept that diversification in the international equity markets have the capacity of eliminating the factor of risk involved in an investment, whereas the second view accepts that if the disturbances in an economy is specific to a country, then the diversification benefits can be achieved as a result of correlation between the markets remaining at a lower level. But in case the correlation existing between the markets remains at a higher level, then the whole rationale behind international diversification stands out be unjustified (Shim and Siegel, 2008 p.57). The CAPM (Capital Asset Prising Model) Determination of the rate of return of the investors is the primary aim of the CAPM model. The key assumption of this model is compound growing of the dividend is happened due to the fixed rate of interest. This model is used weighted average cost of debt and cost of equity for the purpose of calculating the cost of capital of an asset. The primary base of an asset is totally depending on the relative amount of debt as well as relative amount of equity. The CAPM by this proposition and reached a conclusion that the average returns on stocks of small firms , that means who are having low market values with equity were higher than the average stocks of the firms which are large (with high equity market values). This result is called the size effect. This finding has been expanded by the examination of different sets of factor\s that might influence the risk-return relation. To be more specific, the yield from the earnings, the leverage, and the ratio of the book value of equity of a firm to its value in the market has all been used to test the validity of CAPM (Correia, 2007 p.87). Dividend Policy Stakeholders are the essential sources of finance for any type of company. So, the foremost importance of dividend policy is ‘Wealth Maximization’ of the share holders for the continuous supply of finance. Dividend policy is also important to maintain the balance between the probable dividend pay and retain earning. The other needs of dividend policies are discussed below: Dividend policy is important to maintain proper equilibrium between different stages of life cycle and the dividend pay. For example, any company in growth stage with fewer projects will try to pay large amount of dividend to their stakeholders. Dividend decision is one of the necessary decisions in financial management. Dividend policy solves so many financial management problems in an organization like amount of dividends should pay to the stakeholders, Company should employ new share issue strategy or bonus share issue strategy. The dividend decision interlinked with the amount of tax, paid by the stakeholder of the concern company. The policy helps the company in planning and decision making process about NAV (Net Asset Value). The essential ratios are calculating in dividend policy i.e. dividend payout ratio, price earnings ratio, and dividend yield which helps to make important strategy. The ratios also indicate the current financial position of the company (Garone, 2008 p.167). Long Term Financing The long term finance is required for the purpose of expansion, diversification, modernisation, purchasing huge quantities and irreversible decision. The primary sources of long term financing are equity share capital and debt capital. On the other side, the debenture, term loan and preference share capital also supply long term finance to overall growth of the company (Jain, 2007 p.301). Capital Structure (Irrelevance) The irrelevances of the capital structure are discussed as follows: There is no tax compliance in this structure. The transaction and bankruptcy cost are involved in this structure. The model stressed on equivalence in borrowings for investors and both companies. Here it is assume that the market information is symmetry in nature. Finally, there are no effect of PBIT (profit before interest and taxes) on the debt of the company. Capital Structure (and Market Perfection) In 1950, Modigliani and Miller analysed the capital structure theory and developed the irrelevance proposition of the capital structure. The research mainly hypothesized the perfect market where they ignored the financial operation in the capital structure. The main theme of this theorem is to determine the market value of the firm which can be calculated by the risk of underlying assets and power (Kieso, 2010 p.163). The weighted average cost of capital (W.A.C.C.)  This is valuation model of calculating the cost of capital of the firm. Here it has seen each category of capital in the capital structure is proportionally weighted. In this model, different sources of capital i.e. common stock, bond, preference stock and other long term debt are calculated. This model enhances the rate of return and beta of the equity increases, as well as increases the WACC notes which decreases the higher risk and valuation. Option (Financial) Option is a financial derivative which indicates that there is a contract between two parties i.e. option holder and option writer. By this derivative, a legal right is provided to the buyer. It is not an obligation to buy or sell the financial assets and security at the strike price. Option (Real) The real option is also right provide to the option holders. But this option is not applicable for few business initiatives like expanding, abandoning, deferring, staging or contracting in capital investment project (Kimmel, 2008 p. 241). Risk in Portfolio Context Generally, in the portfolio the risks are calculated through the beta coefficient. As the market goes up and down, the tendency of a stock to fluctuate is measured by a coefficient is called Beta. Beta is an important element of CAPM. A stock with an average risk can be defined as that fluctuates up and down with relation to the up and downs of the market and with respect to an established stock exchange. This stock exchange can be Dow Jones Industrials, the S&P 500, or the New York Stock exchange index. This type of stocks will be assigned a beta coefficient of 1.0, which means that if the market goes up by 10%, the stock will also rise by 10%, and if it falls to 10%, the stock price will be reduced by 10%. These stocks will fluctuate with respect to that of the broad market averages, and the risk coefficients will be similar between the stocks and the broad market averages. The graph below (fig.1) shows the volatility of three types of the stocks. This shows three types of stock, H, A and L respectively representing the High, Low and the Average stocks. With respect to an average stock, Beta measures a stock’s volatility (Harrison and Freeman, 2005 p.119). By plotting these lines, the beta coefficient can be calculated. (Source: Puxty, 2010, p.98) References Correia, C. 2007. Fundamentals of Financial Management. 5th Edition. Harper Press: Liverpool. Garone, S. J. 2008. The Link Between Corporate Citizenship and Financial Performance, The Conference Board Report, 63: 174-179. Harrison, J. S. and R. E. Freeman. 2005. Stakeholders, Social Responsibility, and Performance: Empirical Evidence and Theoretical Perspectives, The Academy of Management Journal, 8 Jain, K. 2007. Financial Management. 4th Edition. Harper Sport: South Kieso, D, W. 2010. Global Financial, Study Guide. 8th Edition. David Fulton: London. Kimmel, P., D. 2008. Financial: Tools for Business Decision Making. 7th Edition. Fourth Estate: Leeds. Puxty, A. 2010. Investmenet Management: method and meaning. 7th Edition. Element: Oxford. Shim, J., and Siegel. J. 2008. Investment Management. 6th Edition. Frank Cass: Dundee. View, F. 2007. Financial Management. 8th Edition. David Fulton: London. Read More