Financial Management - Essay Example

Financial Management Question a) Explain, with examples, how you would measure the risk of a single asset. An investment has the following characteristics: - return, risk, safety and liquidity. An investor generally prefers liquidity for his investment along with safety of his funds, a good return with minimum risk. Risk: Risk is an uncertainty that a loss or losses will occur (Christoffersen, 2003). It is inherent in any investment. This risk relates to loss of capital, delay in repayment of capital, non - payment of returns or variability of returns. The risk of an investment depends on the following factors : The longer the maturity period, the larger is the risk. The lower the credit worthiness of the borrower, the higher is the risk. The risk varies with the nature of investment. Return: All investments are characterized by the expectation of a return. In fact, investments are made with the primary objective of deriving a return. The return may be received in the form of yield plus capital appreciation. The return from an investment depends upon the nature of the investment, the maturity period and a host of other factors. In a nutshell, risk and return of an investment are related to one another. Normally, higher the risk, the higher is the return and vice-versa. Single Asset: Any item of economic value owned by an individual or corporation, especially that which could be converted to cash. (Ishaq, 2004) Examples are cash, securities, accounts receivable, inventory, office equipment, real estate, a car, and other property. On a balance sheet, assets are equal to the sum of liabilities, common stock, preferred stock, and retained earnings. Risk and return for a single asset : The rate of return on an asset for a given period (usually a period of one year) is defined as follows : Rate of return = Annual income + Ending price - beginning price Beginning price When you invest in a stock you know that the rate of return from it can take various possible values further the likelihood of these possible returns can vary. Hence you should think in terms of probability distributions. The probability of an event represents the likelihood of its occurrence. Based on the probability distribution of the rate of return, you can compute two key parameters, the expected rate of return and the standard deviation of rate of return. This in fact is the measure of risk for a single asset. State Probability Return on Stock A Return on Stock B 1 20% 5% 50% 2 30% 10% 30% 3 30% 15% 10% 4 20% 20% -10% Given a probability distribution of returns, the expected return can be calculated using the following equation: Where, E [R] is the expected return on the stock; N = no: of states; pi is the probability of state i and Ri is return on the stock in state i. So we see that Stock B offers a higher expected return than Stock A. However, that is only part of the story; we haven't yet considered risk. Given an assets expected return, its variance can be calculated using the following equation and the standard deviation is calculated as the positive square root of the variance. Although Stock B offers a higher expected return than Stock A, it also is riskier since its variance and standard deviation are greater than Stock A's. Advantages of Risk and Return: It enables investors and entrepreneurs in taking capital budgeting decisions. In case of risk chances of future losses can be foreseen. Disadvantages of Risk and Return: Uncertainty lies in decisions taken based on these. Calculations might be difficult at times. (b) Explain, with examples, how you would measure the risk of a portfolio. Most investors invest in a portfolio of assets, as they do not want to pout all their eggs in one basket. Hence what really matters to them is not the risk and return of stocks in isolation, but the risk and return of the portfolio as a whole. Expected return of a portfolio: The expected return of a portfolio is simply the weighted average of the expected returns on the assets comprising the portfolio. For eg : when a portfolio consists of two securities then the expected return is - Rp = x1R1 + ( 1 - x1) R2 where Rp is the expected return on the portfolio,R1 and R2 are the expected return on securities and ( 1 - x1) is the proportion of portfolio invested in security.(Shim, 2000) Portfolio Risk: Portfolio risk is the risk associated with the portfolio. The risk associated with the portfolio can be categorized as market risk and unique risk. Total Risk = Unique risk + Market risk Consider the following two stock portfolios and their respective returns (in per cent) over the last six months. Both portfolios end up increasing in value from $1,000 to $1,058. However, they clearly differ in volatility. Portfolio A's monthly returns range from -1.5% to 3% whereas Portfolio B's range from -9% to 12%. The standard deviation of the returns is a better measure of volatility than the range because it takes all the values into account. The standard deviation of the six returns for Portfolio A is *1.52; for Portfolio B it is *7.24. A VALUE RETURN (%) FINAL VALUE 1,000 0.75 1,008 1,008 1.00 1,018 1,018 3.00 1,048 1,048 -1.50 1,032 1,032 0.50 1,038 1,038 2.00 1,058 B VALUE RETURN (%) FINAL VALUE 1,000 1.50 1,015 1,015 5.00 1,066 1,066 12.00 1,194 1,194 -9.00 1,086 1,086 -4.00 1,043 1,043 1.50 1,058 * Calculation of S.D : A Derive Variance : 2.875 [(075+1.00+3.00+-1.50+0.50+2.00)/6] is the Mean of the returns (0.75 -2.875)+(1.00-2.875)+(3.00-2.875)+(-1.50-2.875)+(.50-2.875)+ (2.00 - 2.875) 6 = 2.314 SD = sqrt 2.314 = 1.52 Calculation of S.D : B Derive Variance : 8 [(1.50+5.00+12.00+-9.00+-4.00+1.50)/6] is the Mean of the returns (1.50-8)+(5.00 - 8)+(12.00-8)+(-9.00 - 8)+(-4.00 - 8)+ (1.50- 8) 6 = 52.41 SD = sqrt 52.41 = 7.24 Advantages of Portfolio: Investment risk can be diversified by spreading investment across a number of assets. It helps in forecasting exceptional inputs. Disadvantages of Portfolio: Measuring portfolio performance is a highly difficult task. REFERENCES: -> A A Gropelli & Ehsan Nikbakht, 2000 : Finance -> Jae K Shim, 2000 : Financial Management -> Peters Christoffersen, 2003 : Elements of Financial Risk Management -> M. Ishaq, 2004: Understanding Financial Management. Read More