The Current Market Prices of Each of the Securities - Assignment Example

Question 1

Three stocks A, B and C have just paid their dividend of 17p and have required rates of return of 9% per annum

The dividend growth profiles of each stock is as follows:

Stock A: A growth rate of 2% per annum over the indefinite future.

Stock B: A growth rate of 8% over the next 4 years, followed by a growth rate of 3% indefinitely.

Stock C: A growth rate of zero over the life of the company.

a.Calculate the current market prices of each of the securities? Explain your results.

[5 marks]

The current market price for security A=D1V1÷(r-g)

From the formula, it is the dividend paid divided by the difference between rate of return per annum and the growth rate. This is therefore substituted as shown: 17÷ (9-2) =2.4286. From the figure, there is the expectation of fluctuation in the price of the share in the market. The price is very low and therefore many investors can buy a lot of the shares to gain a large shareholding capacity in the stock market. Having more shares in the market is important because of the ease of transferring the shares and selling them to the other people who would be willing to trade in the market (Finlay, 2012, page 47).

The current market price for security B=D1V1÷(r-g). This therefore equals to 17÷ (9-8) =17. However, this was the market price for the first four years. The growth rate changed to 3% indefinitely and therefore that had an impact in the current market price of the bond after the four years. The future market price therefore will be 17÷ (9-3) =2.833 the current market price for share B in the market is slightly higher than that of A. this could be associated with the ,level of returns that this share has in the stock market. Shares that earn a lot are always priced higher and in many cases they are the ones that are owned and purchased by the lager and well performing businesses that are enjoying the economies of large scale. This therefore allows them to purchase more and increase their investment portfolio in the market thereby earning more profits. This could similarly would have been a new share in the market therefore leading to the high pricing of the share compared to the other two in the similar market (Finlay, 2012, page 54).

The current market price for security C remained constant since there was no rate of growth in the bond. =D1V1÷(r-g). This therefore equals to 17÷ (9-0) =1.889

This is the lowest share current price in the market and this could be attributed by the rate of return that the share is. Similarly, this could be the current price because of the longer duration that the share has been in the market thereby making it to be sold at this price as disposable so to speak. Shares that have taken a lot of time and earn less returns in the market definitely are lowly priced and they are less purchased because they do not perform well too in the stock market (Erick, 2013, page 65).

b.Compute the historic dividend yields of the three stocks. Explain your results.

The historical dividend of the yield is computed by the diving the annual dividend per share by the price per share.

Historical dividend for stock A= annual dividend per share ÷ price per share

17 ÷ 2.4286 = 6.9999 giving 7.000%

Historical dividend for stock B= annual dividend per share ÷ price per share

17 ÷ 2.833 = 6.000705 giving 6.000%

Historical dividend for stock C= annual dividend per share ÷ price per share

17 ÷ 1.889 = 8.99947 giving 9.000%

c. The limitations to the applicability of the dividend discount model in practice.

There are various limitations that that associated with the dividend discounts model’s application. They have therefore been explained as shown below (Randall, 2005, page 71):

• The model may not be related to the earnings.
• There is limited application of the model: the application of this model is only limited and valid only for the multi-corporations that that have proven beyond reasonable doubt historical records of paying their dividends.
• Tax efficiency issues are not evaluated in the model.

The model has several assumptions: there are several assumptions that this model has which are out of the investor’s control and ability. The assumptions such as the rates on interest, taxation rate as well as growth rate are beyond the control of the investors. This model is therefore not reliable from the given parameters. Inn this therefore, there are a ot of assumptions on the calculations involving the dividend discount model. If there is an error in the course of the calculation, it is therefore very easy in determining the stock value that is largely off in regards to the valuation. It can therefore be overvalued or undervalued (David and Kevin, 2012, page 323).

Another disadvantage of the dividend discount model is that it does not take into account the various effect of the stock buybacks. These effects can create a significant impact on the value of the stock making returns to the shareholders. (David and Kevin, 2012, page 174).

Control:- the financial of the large investment companies to make impulse purchases from the corporations tend to show the level of control that the companies have in the corporations. They are therefore the bigger shareholders of for the corporations and therefore the model is not applicable to them (David and Kevin, 2012, page 198).

Another drawback that the dividend discount model is criticized of is on the inability to be used in the evaluation of the stocks that are not remitting dividends. It therefore do not bother even the capital gains that can be realized from investing in the stock. This is because of it inherently assume that the return on the investments that is the offer, it provides on the value of the stock (David and Kevin, 2012, page 213).

The model also does not consider the non-dividend parameters for example the loyalty to the brand, retention of the customer and the ownership of the intangible assets. It is important to highlight that all these factors are contributing to the increment of the value of the company and the model does not consider them (David and Kevin, 2012, page 273).

Question 2

Investment thesis to be used in discussion you’re your colleagues, that lays out potential hedges and portfolio rebalancing measures you might take to help protect your clients’ portfolios.

Abstract

It is important to highlight that this is an investment thesis to be used in discussion you’re your colleagues, that lays out potential hedges and portfolio rebalancing measures you might take to help protect your clients’ portfolios. The company will focus o the various strategies that will be used in the capturing of the hedging factors in the market. Every hedging strategy has an affiliated borrowing strategy and therefore this calls for sensitivity to the adoption on the strategies. Portfolio management is very essential in the stock management as it helps in the avoiding of the various risks that it is exposed to. The withdrawal of the clients is another risk that the portfolio gets exposed to and therefore there is the necessity to rebalance the portfolio as well as come up with very ideal measures for hedging the portfolio in the stock market. All the needed considerations have to be made to avoid the risks in the stock market that for instance can lead to the liquidity of the company. Withdrawal of the clients from the company possess a great risk in the capital base of the company therefore that would make the company to get reduced profits while the rates on dividends on the hand is constant.

Hedging strategy is a tool that most companies tend to implement in offsetting the contingencies that could possibly arise due to the movement of price in the market. There is therefore some negative correlation that the investors tend to get by investing in other collaterals while making another.

Hedging is a risk evasion technique that mist investors use by doing purchases and then hoarding the securities to lower the chancres if the risk that the portfolio could be exposed to. The company therefore will involve itself in the various hedging strategies in a significant ay so limit the risk uncertainties in the market and also the funds that are at risk from the other investors. The risks in the foreign exchange or stock exchange market is a key factor that needs a lot of careful strategizing. The important point is that these risks are not under the control of the company or the investor. The risks associated with the price for instance in the case of this company is a global problem that has been triggered by the price fluctuation in the global market as well as measures that are used by the international monetary fund in the regulating the money supply and overvaluation of the currencies in the global market.

As the portfolio manager at Fitzwilliam Investors and I have been alerted by recent falls in stock markets driven. This has been caused by the fall in the price of commodities. There are also the concerns over impending rate rises by central banks. This has therefore forced quite a number of investment clients in the company that I run to start withdrawing funds over alarm bells prompted by the nature of the firm’s equity-heavy portfolio. The quarter- end is similarly impending. As the company manager therefore, i will engage in the following strategies as potential hedging (David and Kevin, 2012, page 409).:

• Delta hedging: - this is the core strategy that the company will focus on because it is greatly affected by the price fluctuation in the market that is leading to the withdrawal of the other investors from the company. The delta is a panacea for financial risk of an option. The purchasing a derivative using an inverse movement in the price therefore achieves the strategy.
• Risk reversal strategy: - in this, the company will focus on the selling the put options and then buying call option in concurrently. This therefore impacts on a longer stock simulation of the company thereby protecting the portfolio investment of the other investors.
• Back to back hedging (B2B):-the company will also employ the (B2B) whereby they will purchase the commodities that are in the spot market. This therefore leads to the closure of all the open places in the market.

Portfolio rebalancing is very important in the market investment as it help in the keeping of the initial asset allocation of firm. This therefore permeates the execution of investment technique thereby making the investors to follow their investing plans that were laid. Rebalancing portfolio is perceived as the buying and selling of a section of the portfolio. This ensures that the weight for every asset class is established back to its prior state.

In protection of the clients’ portfolios, the following are therefore that the company will put into practice ((Int'l Business Publications, 2014, page 53).

• Keeping records: - the success of every business lies on the track records of the business entity. It is therefore an entrepreneurial role in keeping the records to allow comparison and retrieval of any business information. In rebalancing the portfolio, it is important to highlight that the company will keep all the asset classes, the total cost of each security as at that particular time and the total cost of the portfolio. This will be useful to the company in the making of comparison on the historical and the current asset value and portfolio values. These will be used by the company in checking their performance in the stock market and this will give them the reality in the market behavior thereby making the required adjustments to balance the portfolio to the initial state (Int'l Business Publications, 2014, page 213).

Doing comparison:- making comparison is key in the success of the business. In rebalancing the portfolio, the company should set future dates that they will use in checking the value of the portfolio and the class of the assets. This will therefore enable the company to compute easily the weightings of all the funds in the portfolio. Having obtained the funds in the portfolio, the company should therefore compare that with the previous weightings. The change or no change should therefore be an indicator to the company on the portfolio value. The company should try as much as possible to ensure that the portfolio balances thereby bringing no change in the value of the weightings. This will be a great indicator that the company portfolio should not be liquidated. The effect of the taxes that are levied will also be considered by the company when readjusting the portfolio. The company can at some point take to selling the assets as a way of rebalancing the portfolio. One factor worth highlighting is that the portfolio can at times rebalance automatically to its initial state without incurring additional costs and expenses on the capital gain tax. This therefore shows that it us of no significance paying the extra amounts especially on the overweighed asset classes (Int'l Business Publications, 2014, page 543).

• Adjustments: - from the above rebalancing techniques that should be adopted by the company, it is important to highlight that adjustments are usually conducted in rebalancing the portfolio when the weightings of an asset class have got changes in the exposure of the portfolio to risks. In trying to balance the portfolio, the company should get the product of the each percentage weighting by the current total value. This will be very important, since it will give the amount that needs to be invested in each asset. Investing this in each asset will therefore be of benefit to the company since it will be able to achieve sustainability in the initial asset allocation.

Every company tries tie remain competitive is the stock market but the behavior of the company portfolio matters to its success. It is therefore very important for the company managers to adopt various hedging strategies to assist the company clients in incurring heavy losses. The stock market is quite dynamics and is affected by several factors in the market. These factors are covered by the various hedging strategies and therefore the companies need to come up and evaluate all the models and strategies that they remain with a good and balanced portfolio in the market .

Good portfolio management t boosts the confidence of the client’s to invest in the company and therefore this will enable the company to keep topping up the portfolio value thereby earning more from the stock market. The profit levels of the company in the stock market depends on the ways the company plays in the stock market through rebalancing the portfolio.

Just like any business, the customer focus is the key. This therefore makes it important that as that as the company manager, there will be a lot done in safekeeping and rebalancing the portfolio through all the possible ways to retain the customers and keep them. Their withdrawal from the firm for instance can lower the capital gain tax and the company can as well be charged a lot of taxes but the income that it get out of the portfolio value is very little. This therefore calls for the effective, measures to be adopted in the management of the portfolio.

As the manager, there is the need to regularly conduct economic analysis in the market. This will enable the company to have all the market information on the forces of the market in the share capital and the techniques that the other stock market are using to as well as the investors in maintaining their portfolio. Benchmarking in business is key and this help in the coming up with better strategies for managing the portfolio without incurring losses attributed by the market factors.

The interest on the share capital in the market is also a matter that is worth considering as an investor in the stock market. A market that has low returns is definitely not profitable and therefore, that is not profit oriented to invest. In. in business, there is the need to be a profiteer, you should invest using money to get money as opposed to the case when the losses become more than the profits (Frank, 2004, page 43). A good market to invest in the stock exchange is the one therefore that yield more profits and is stable. The stability of the market is determined by the policies that are laid down in the market structure. This should help in limiting the freedom of entry and exotic into the market. When there are stock market policies implemented effectively, the portfolio value for instance will always be maintained at the required level that it was during the beginning of the business operation. Investment portfolio is very important to maintain ton keep the returns high as expected.

There should also be minimum membership that is not exceeded and no maximum. In setting the minimum membership, it is important to consider the best portfolio value that will give more returns. This will help in the sense even when the others withdraw from the company and takes away their portfolio, the limit of returns for the remaining investors is not tampered with. This will always ensure that the portfolio is balanced and its value is maintained.

Question 3

Shanti Mining Corporation, a miner with exposure to gold prices decides that in the falling market environment for commodities that it would be beneficial to hedge some of their production for the next year. They approach their main banker for advice and are given the following information for potential 1y hedges:

Current Gold Spot = 1080 usd/oz

Potential Hedges:

1y Gold Forward = 1100 usd/oz

1y 1300 call = 22 usd/oz

1y 1200 call = 53 usd/oz

1y 1150 call = 75 usd/oz

1y 1050 put = 68 usd/oz

1y 1000 put = 45 usd/oz

1y 900 put = 18 usd/oz

The three hedging that have been chosen are the

Illustrate three separate payoff diagrams for one put, one call and the forward.

Current gold spot

1080/usd

Break even point

current gold spot 1080/usd

1y forward 1100usd

current gold spot 1080/usd

1y 900 put=18usd/oz

Current gold spot 1080/usd

As financial advisor to the board the best potential hedging solution that the firm can adopt is the put option. This option is very important as the company can sell the commodity or the assets of the company by the expiry date or maturity date which is the predetermined date set in the market by the owner. It is therefore not an obligation to the company but out of the will.

Question 4

% Returns

MonthShare AShare BMarket

110%11%11%

216%6%10%

35%8%5%

46%7%8%

5-5%0%-2%

6-8%9%-2%

7-22%5%-4%

825%16%15%

912%-5%7%

10-1%14%13%

1112%10%2%

1225%5%11%

(i)The average returns for share A, share B, and the market.

From the values, the average returns for share A is calculated as the sum of all the returns divided by the number of the return.

Sum of returns for share A= (10+16+5+6+-5+-8+-22+25+12+-1+12+25)% this therefore gives 75% which is then divided by 12=6.25% average return on shares.

Sum of returns of shares of B= (11+6+8+7+0+9+5+16+-5+14+10+5) % =86%. The sum is then divided by 12 giving the average of 7.167%.

Sum of returns of market=(11+10+5+8+-2+-2+-4+15+7+13+2+11)%= 74%. The sum is then divided by the total number, 12 giving 6.167%.

(ii)The volatility of each asset

It is important to highlight that the volatility of the assets can be computed through the calculation the standard deviation. The values of share A are as shown in the table:

THE ASSET VOLATILITY OF A

To compute the standard deviation, the variance is first calculated and then the square root of the variance which is the standard deviation gives the asset volatility. This is therefore calculated as shown below:

14.0625+351.5625+27.5625+52.5625+33.0625+351.5625+798.0625+203.0625+126.5625+0.0625+1.5625+95.0625= 2054.75

The sum is thereby divided by the number of the returns to get the variance: 2054.75 ÷12 =171.229

The square root therefore gives the standard deviation which is the asset value for share A.: √171.299=13.085%

THE ASSET VOLATILITY OF B

To compute the standard deviation, the variance is first calculated and then the square root of the variance which is the standard deviation gives the asset volatility. This is therefore calculated as shown below:

14.69+1.3619+0.6939+0.0228+51.3656+3.36+4.696+78.0219+148.0359+46.69+8.0256+4.696= 361.6596

The sum is thereby divided by the number of the returns to get the variance: 361.6596 ÷12 =30.1383

The square root therefore gives the standard deviation which is the asset value for share A.: √30.1383=5.49%

THE ASSET VOLATILITY OF MARKET

To compute the standard deviation, the variance is first calculated and then the square root of the variance which is the standard deviation gives the asset volatility. This is therefore calculated as shown below:

23.3579+21.8089+46.69+78.0289+78.0289+103.3679+66.70+66.70+3.3599+1.3619+14.6919+23.3579= 527.4541

The sum is thereby divided by the number of the returns to get the variance: 527.4541 ÷12 =43.95

The square root therefore gives the standard deviation which is the asset value for share A.: √43.95=6.63%

(iii)The correlation matrix for all three assets using the format below –

ABMarket

1357

A13

B5

Market 7

The correlation matrix can therefore be computed as shown below:

([13x13]+[13x5]+[13x7]-([5x13]+[5x5]+[5x7])-([7x13]+[7x5]+[x7])

=325-125-179 this therefore gives a correlation matrix of 21.

(iv)The Betas of both share A and B

To calculate the beta of the shares, it is important to first determine the

The covariance of AB=[ 1/(12-1)]∑(10-6.25)+(16-6.25)+(5-6.25)+(6-6.25)+(-5-6.25)+(-8-6.25)+(-22-6.25)+(25-6.25)+(12-6.25)+(-1-6.25)+(12-6.25)+(25-6.25)))(((11-7.17)+(6-7.17)+(8-7.17)+(7-7.17)+(0-7.17)+(9-7.17)+(5-7.17)+(16-7.17)+(-5-7.17)+(14-7.17)+(10-7.17)+(5-7.17)))

=0.091(3) (2) this therefore becomes 0.091 x 6 =0.546

To determine the beta if A and B, the covariance is therefore divided by the variance of the market. This is as show:

0.546÷43.95=0.012

(v)The Return and Risk of an equally weighted portfolio of Share A+B (50% A and 50% B)

For this portfolio, the formula that is applicable is:

E[RP]=50(3.125)+(1-50)(3.5835)= 156.25 +-175.5915 =-1.3415% this therefore how the rate of return from the portfolio will fall and therefore, there is the possibility of incurring losses by getting less returns from the company. A business is worth investing in if the rate of returns are on the positive. The value of the positive return value is very important for the success. It may be very insignificant but it gives the business owners and other investors’ confidence and the drive to invest a lot in the portfolio for their return to increase more thereby safeguarding the interest in return (Int'l Business Publications, 2014, page 543).

b.An undiversified investor has the option to invest in a combination of A+B shares in portfolios with the following weights – 100%/0%, 50%/50%, 0%/100%. (A and B respectively)

Given the data above, explain how we could evaluate the performance of these possible combinations over the past year and comment on them. Explain how these options are different for a diversified investor?

Question 5

An emerging market has a number of bonds in issuance as described in the table below. (Where ‘Yield’ is Yield-to-Maturity) Assume annual coupons, and that all bonds are ex-coupon.

BondMaturity (Years)CouponYieldPrice

A203.00%17.00%--------------

B1010.00%----------88.69955

C515.00%7.00%------------

• Calculate the missing pieces to complete the table

The general equation is yield =coupon ÷price

From this, the various elements can be substituted to get the values. In bond A, the price= coupon ÷ yield; this substituted is, 3÷17=0.1765 this is therefore the price of bond A.

The yield of bond B however is computed directly from the formula by simply dividing the coupon and the price. This is 10÷88.69955=0.1127%. The yield of bond B is therefore 0.1127%.

The price of bond B will follow the same suit just as it was done in A. coupon is divided by the yield. This is 15÷7=2.1429. This is therefore the price of bond C.

ii.Calculate the duration and modified duration of all 3 bonds. [5 marks]

Bond duration is a technique that is used by the investors in determining the fluctuation in the interest rates. High volatile bond has a higher duration while a lower duration in the bond therefore shows how less the bond is sensitive to change.

iii.These bonds have an unusually steep yield curve, explain why this would be the case and how could the historical coupon rates help infer what has happened to this country’s ability to raise credit over time.

It is important to highlight that the steepness in the yield bond is an indication of the economic growth in the activities facilitating the development of the country. There are certain factors that lead to the steep yield curve.

• Increased circulation of money in the economy: the increase in the circulation of the money in the economy is another crucial factor that could have led to the steep yield curve in the country. The central bank in the country could have released money into the economy while buying the securities and shares. The circulation of money in the economy has a very negative effect on the price of the shares and bonds. This is because the central banks tend to buy them at a higher price and therefore the other commodities in the market as at that time get their prices increased. This therefore leads to inflation in the whole economy thereby leading to the effect on the curve declining very steep.
• Expected inflation:-successful businesses and even in the stock markets hoard their products or shares anticipating an inflation. This is because for the expectation of better market prices doing the time that they expect this to happen. Inflation is cyclical and therefore this is a trend that the market players tend to involve themselves in while expecting better profits. This could therefore have been the likely situation that occurred I the country (Frank, 2004, page 143).
• Another possible cause for the steep yield curve in the country is the increased gap between the short term and the long term bonds. The difference in the term of bond maturity is another cause for the steepness of the curve. There are bonds that mature after a very long time while others mature after a very short time. This is therefore a very important factor that is worth noting in the shape of the curve (Frank, 2004, page 233).

It is worth highlighting that the confidence of the clients in the firm or the market that they are investing in is very vital. The investment company that they are investing in should have good managerial skills so that the funds that they have involved in the firm is not misused. The company that they invest should as well have a wider portfolio base so that they can withstand the forces in the stock market that can lead to the withdrawal of the firms from the firm. These are the real customers for the firm and therefore their funds must be cared for by the company of investment (David and Kevin, 2012, page 413).

The companies in the stock market should also be very sensitive to the price factor in the market so that they adopt relevant hedging strategies that they can use in the establishing of a stable portfolio in the market. The stable the portfolio the more investment the company is likely to get from the other investors and consequently high rates if return earned by the company. A higher portfolio in the market of shares attracts a higher profit return therefore there is the need to attract more investors into the firm to increase the portfolio base (Frank, 2004, page 243).

Successful investors in the stock exchange market are very sensitive to the changing world stock market prices and follow the performance of the transactions to the latter. This is to ensure that they do not incur losses by the low portfolio volume that they have in stock. They similarly involve themselves in the follow up of the performance for ascertaining the right hedging strategies that they can adopt while in the market and thereby evade these losses. This can help in the loses for instance in diversifying their portfolio into other forms of business would enhance a safer way of averting the possible risks. The clients for such companies can as well see the creativity of the company in portfolio diversification for the good of the customers and this would therefore bring in more customers who had had losses before as a result of impending quarter (Int'l Business Publications, 2014, page 543).