BSM002: Finance Theory Assignment sample

BSM002: Finance Theory Assignment sample

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Task 1

1. a

Portfolio Theory: The theory that includes the Investing decision of a person correlated by risk and return depending on the market conditions and expectations. In other words, it can be said that ways in which one individual can maximize profit by investing in a diversified portfolio.

There are many portfolio theories such as Modern portfolio theory, Traditional Approach, and Random Walk Theory based on market Hypothesis which aim at maximizing return but with reasonable risk. Such as modern portfolio theory also states that variance and covariance with a good investing decision is a must before investing in financial securities. One should maximize return by attaining the minimum risk by selecting the best portfolio available with us. Such as depending on the situation such as minimum risk with greater return and maximum risk with greater return. The portfolio should be in such a way that there is minimal risk associated with stock of different securities, so these theories help us in deciding which stock to choose

Risk and Return: It is the amount of profit that is earned over some time by taking possible risks with one's capacity. Risk is the amount of unpredictable loss or unforeseen situations that are hard to remove but can be minimized to some extent by selecting the best option available to us. So it can be said that there is a positive relation not an adverse one with each other. So financial securities must be taken into consideration taking this into account with the utmost priority (Kelly et al., 2019).

Generally to start with the portfolio theory is directly related to risk and return and the older concept of portfolio allocation, one thought that return could be minimized but risk should be lower and now in this era, it has completely changed an investor thinks that his/her portfolio should be diversified with maximum return. It is said that the higher the risk greater the return and the lower the risk lower the return. Time frame also plays a vital role in determining the risk and return because, in the long run, we can assume and predict more return. By this, he means to take more risk to gain more return which is opposite to the previous concept.  Variance and Co variance both play a vital role in determining one's risk and return and hence deciding the ultimatum portfolio risk. One of the major contributions of portfolio theory is that it suggests measures of how to diversify the various assets minimize risk to a large extent and earn a quantifiable amount (Kelly et al., 2019).

Financial Securities: It is a wide term that is used to describe bonds, securities, and stocks that tend to earn a maximum profit under a given set of conditions with maximum future benefits. It is a financial instrument that states that investing is done in these forms. Traditionally these were in physical forms but nowadays they are in electronic form (Begley & Purnanandam, 2017).

Major characteristics of Financial Securities in understanding risk and return are as follows:

• One must not invest money in a single asset but should have sufficient knowledge of various financial securities so that he has a diversified portfolio leaving him with maximum return.
• Market risk is one of the major components that should be kept in mind while allocating different financial securities in the portfolio (Begley & Purnanandam, 2017).
• Determining the portfolio of financial securities another component that should be kept in mind is the market risk through which expected return is hampered sometimes.
• Investing can be done in many ways in financial assets or financial securities to attain the maximum expected return.
• Financial Securities are issued at a specific date
• Financial Securities are tradable financial assets.
• Financial Securities have a specific Monetary Value.
• It can be in Long-term form or short-term form (Begley & Purnanandam, 2017).
• Financial securities are redeemable which means they can be redeemed anytime shortly, which is the utmost feature of the financial securities.
• It is fully in the negotiable form
• Financial Securities a legal proof of the ownership
• Financial Securities are convertible (Mutende et al., 2017).
• There is no specific return in investing in Financial Securities, so analyzing the scenario is a must.

So, while deciding diversified portfolio with different financial securities to maximise return and minimise return market return should be kept in mind. It also depends on the market situations and economic fluctuations. The market scenario is sometimes positive and sometimes negative which will determine the expected return shortly and also the risk associated with it (Mutende et al., 2017).  The contributions of Portfolio theory is therefore must in analysing the market conditions and picking up the best stocks that are expected to earn good returns. Risk can also be high in case of adverse economic conditions and can be minimal in case of good economic conditions. Likewise, it is always said that there should be favorable economic conditions with more growth, and more GDP so that there is a maximum expected return shortly with the diversified portfolio. 

1. b

Maximizing return in a portfolio can be done by choosing the best alternatively by finding low-cost ways for investing and by diversifying the portfolio and thinking about the near future what a good portfolio should have to maximize the return. It can be considered as an investment tool to maximize the return and try to minimize the risk.

An optimal Portfolio is one in which risk in minimized to an extent at a given level of return that is they both are correlated, and one cannot be taken individually. In other terms, it can be said that higher risk is taken to gain higher profits shortly. It can also be said that it is the efficient frontier at which one gains the maximum return. Generally, it can be related to the demand and supply where they both meet. The point at which they meet is called the optimal level. It depends upon the investor's preference concerning risk and return. In respect of that one should optimize its financial securities by expecting the highest return.

Reference Source: https://www.motilaloswal.com/article-details/what-do-we-understand-by-an-optimal-portfolio-/1924

Market Portfolio: It is a combination of different types of investments that include different stocks and bonds having market value with expected returns. It also measures the weighted average of the beta coefficient of different individual stocks in a portfolio. In other words, it can also be said that it is a portfolio that consists of all different securities where the proportion invested in each one corresponds to their relative market value. Investors hold a certain positive amount of every risky security. It is a cluster of investments that includes every possible investment that is good for one's portfolio (Fjesme, 2020). 

A Capital Market Line is a line that depicts portfolios that usually combine risk and return. It shows various points of combinations and one can select the optimal level, where risk is less and return is more. Generally, it is straight because it is a tangent drawn between the two assets which are positively correlated.  It is a theoretical concept that links risk and return (Fjesme, 2020).

In the first case, where we have two stocks, with the expected return of stock X of 10% and of stock Y of 15% and deviation from the mean of 13% of stock X and 17% of stock Y. The correlation in this case is higher than 90% which is the second case. Here we are considering the first scenario where correlation is higher which means that the expected return should be maximized in this case, and it is in the first case where sock Y is completely favorable and there is no role of stock x. Here it depends on the individual whether he wants to optimize maximum return with minimal risk or whether he wants to have less return with neutral risk.

For example, if an individual opts for maximum return he can go for stock Y and if one wants lesser risk then he can go for solely stock X. At one point there is a reasonable amount of risk with return which is investing 60% in stock X and 40% in stock Y. After this point the return keeps on decreasing with increasing risk. So, ultimately one is responsible for the options available (Arslanalp & Tsuda, 2015). 

In this condition which is the second most, there is an expected return of 10% in stock X and of 13% in stock Y and a standard deviation of 13% of stock X and 17 % of stock Y. Here the correlation is less than 10% which is to be considered in the second case. Here, it is the case with a minimum return that is in the case with the option in which one invests fully in stock X with a 10% return and more risk. Here the expected return is minimum i.e. 10% when compared to other options. Now talking about optimal level which is reasonable risk with return is preferred over other cases. At some point, the risk is higher with more return and gradually the risk keeps on decreasing at one point the risk is reduced to a larger extent which is preferred. Mostly it is not taken into account as by taking 13% of risk one can earn only 10% of profit and there are many good options available other than this. Therefore, one should be sharp while analyzing which option to go for (Arslanalp & Tsuda, 2015).

Now looking at the market capital line first it increases and at reaching one point which is the maximum it decreases to .1%. It depends on the market conditions and economic fluctuations which hampers the decision of an individual which option to choose. This clearly shows that the x-axis shows the risk and the y-axis the expected return. Hence the portfolio opted should be in that manner that one gains maximum return with minimal amount of risk in the scenario. So, the market conditions should be carefully studied and depicted.

Looking at past data we can again see that the WG Group has lesser return when compared with the other one.

Task 2 

Interest Rates:

It is defined as the amount that is due for the amount lended for a period which generally varies from time to time. Interest rates are generally decided by the head institution in the country which other follows for the time being till it is not changed periodically. The highest authority determines the interest rates also keep on changing because the highest interest rates over some time may lead to inflation and then it will hamper the economic conditions of the country so there should be constant improvising the interest rates so that inflation does not occur in the country which hampers the purchasing decision of the people and also the standard of living is also hampered over some time (Saymeh & Orabi, 2013).

Inflation Rates:

Inflation is generally described as a hike in the price level in which the value of the particular country's currency keeps on declining which can be positively sloped or negatively sloped. These rates should be minimised up to some extent so that inflation does not persist over a long period hampering the country's status in the world. The inflation rates are generally determined by the economic conditions of the country and directly impact the purchasing power of individuals (Saymeh & Orabi, 2013).

Future Economic Activity:

The prediction as to how things will work shortly with past and present records and some assumptions for the future. The economic conditions of a country such as GDP, Growth Rate, Inflation rates, and Interest Rates all are considered to be economic activities. If we look at the present scenario that is of COVID-19, the growth rate has subsequently declined over the past few months.

The yield curve is a line that shows the idea of future interest rates and the current yield curve is represented above and is somewhat neutral when compared with previous years, generally, it depicts a fair picture of long-term and short-term interest rates. The current Yield Curve is a curve that depicts the current picture of the country.  Inflation rates also play a vital role in which the yield curve is plotted.

We can also see that during the last years, there was a gradual rise which indicates that there is growth, and when related to interest rates it has an inverse relationship with growth prospects. That means the higher the interest rates lesser the growth prospect and vice versa.  In the graph depicted above also we can see that in the last month, there was a huge rise and during the last 6 months there were ups and downs in the yield curve which meant that there was no stability in the interest rates and growth profile.

This yield curve is of India and states that there was a major fluctuation in this time frame which was somehow due to the interest and market conditions. 

Task 3 

Market anomalies generally mean the factors that are responsible for the changes in the price level. It also states these are those factors that contradict our expectations about the future market growth and future value of our stocks and bonds in the portfolio. It can also be said that the abnormal or irregular conditions in the market will hamper our expected return.

Some of them that are so common are the Holiday Effect, Monday Effect, Value Effect, Momentum Effect, January Effect, and Turn-of-the-month Effect, etc. These are some which have a higher impact on the prices of the stocks.  Likewise, here it is seen that the market anomalies have played a vital role in determining the prices of the shares. The UK Stock market has shown a great variation during this period. Here we can see the previous data that is the prices of the last year. We can see that market situations have a great impact which is visible like in January we had a higher price and as soon as we had Corona news in the market it had a huge impact on the price (Degutis & Novickyt?, 2014). The price had reduced to a larger extent by approximately Rs1000. This lockdown had an impact on the economic conditions of the country which stated that no one was investing money to a larger extent than before. Somehow there were negligible changes too. Again the prices were about to increase as there was some news in the market about the coronavirus Vaccine which led to the increase in the prices of the share. Besides the market anomalies, more situations affect the prices and in other words, it can be said that the efficient market hypothesis is solely represented by the share prices which is somewhat true in the cases. Market Hypothesis could be Strong, Semi-Strong, and weak which means sometimes there can be variation in the hypothesis and the prices in the current scenario. The efficient market hypothesis should be a reflection of all the share prices over a period and should be optimized. And we can see that is the case here also. The total average change is negative which means that there is a huge change in the prices. It also shows when the investors will be gaining the maximum profit and what is the right time to go for the purchasing decision. And this crucial decision should be taken considering all the factors which are right for investment (Degutis & Novickyt? 2014).

Reference:

Arslanalp, S., & Tsuda, T. 2015. Emerging market portfolio flows: The role of benchmark-driven investors.

Begley, T. A., & Purnanandam, A. 2017. Design of financial securities: Empirical evidence from private-label RMBS deals. The Review of Financial Studies, 30(1), pp.120-161.

Degutis, A., & Novickyt?, L. 2014. The efficient market hypothesis: A critical review of literature and methodology. Ekonomika, 93, pp.7-23.

Fjesme, S. L. 2020. Foreign market portfolio concentration and performance. Financial Management, 49(1), pp.161-177.

FTSE 100 Historical Rates - Investing.com India. (2020, December 11). Retrieved December 13, 2020, from Investing.com India website: https://in.investing.com/indices/uk-100-historical-data

‌Kelly, B. T., Pruitt, S., & Su, Y. 2019. Characteristics are covariances: A unified model of risk and return. Journal of Financial Economics, 134(3), pp.501-524.

Mutende, E. A., Mwangi, M., Njihia, J. M., & Ochieng, D. E. 2017. The moderating role of firm characteristics on the relationship between free cash flows and financial performance of firms listed at the Nairobi securities exchange. Journal of Finance and Investment Analysis, 6(4), pp.1-3.

Saymeh, A. A. F., & Orabi, M. M. A. 2013. The effect of interest rate, inflation rate, and GDP, on real economic growth rate in Jordan. Asian Economic and Financial Review, 3(3), pp.341.

World Government Bonds. 2020. India Government Bonds - Yields Curve. Retrieved December 13, 2020, from World Government Bonds website: http://www.worldgovernmentbonds.com/country/india/