The Global Financial Market - Assignment Example

Question 1

• Average expected holding period return, variance and standard deviation of each stock

Average expected return = (PS * RS) + (PN * RN) + (PW * RW) + (PR * RR)

Where S – Strong growth

N – Normal growth

W – Weak growth

R - Recession

Stock A

Average expected return = (0.10*27%) + (0.20*20%) + (0.50*11%) + (0.20*-10%)

= 10.2%

Stock B

Average expected return = (0.10*12%) + (0.20*10%) + (0.50*10%) + (0.20*6%)

= 9.4%

Stock C

Average expected return = (0.10*16%) + (0.20*14%) + (0.50*8%) + (0.20*2%)

= 8.8%

Variance of holding period return

Stock A

Variance = 0.10*(27% - 10.2%)2 + 0.20*(20% - 10.2%)2 + 0.50*(11% - 10.2%)2 + 0.20*(-10% - 10.2%)2

= 1.294%

Stock B

Variance = 0.10*(12% - 9.4%)2 + 0.20*(10% - 9.4%)2 + 0.50*(10% - 9.4%)2 + 0.20*(6% - 9.4%)2

= 0.032%

Stock C

Variance = 0.10*(16% - 8.8%)2 + 0.20*(14% - 8.8%)2 + 0.50*(8% - 8.8%)2 + 0.20*(2% - 8.8%)2

= 0.202%

Standard deviation of each stock =

Stock A

Standard deviation =

= 11.38%

Stock B

Standard deviation =

= 1.79%

Stock C

Standard deviation =

= 4.49%

• Estimated return and expected variance for the three portfolios

Portfolio 1

Stock

Return

SD

Weights

Expected return

Variance

A

10.2%

11.38%

0.50

9.80%

0.00413

B

9.4%

1.79%

0.50

ρ(AB)

0.8

Portfolio 2

Stock

Return

SD

Weights

Expected return

Variance

A

10.2%

11.38%

0.20

9.08%

0.00263

C

8.8%

4.49%

0.80

ρ(AB)

0.5

Portfolio 3

Stock

Return

SD

Weights

Expected return

Variance

B

9.4%

1.79%

0.60

9.16%

0.00071

C

8.8%

4.49%

0.40

ρ(AB)

0.7

Investing in a single stock tends to have a higher risk compared to when assets are combined together and hence the importance of portfolio analysis for the purpose of risk diversification. Portfolio analysis refers to the combination of different stocks held by an investor. Portfolio theory is very important for an investor since it helps in determining how to combine different stocks so as to maximize expected returns and minimize the risk associated with an asset. The market portfolio is regarded as the well diversified portfolio and most investors hold stocks trying to imitate the market portfolio. The risks associated with the stocks are divided into systematic and unsystematic risk; systematic risk also known as non-diversifiable risk is the risk which is exists even in a well-diversified efficient portfolio, this implies that the investor do not have control over this risk. Unsystematic risk or diversifiable risk is the risk that can be eliminated by an investor by holding an efficient portfolio (McCabe, 2010).

Some investors hold stocks in portfolio with an aim of obtaining higher returns at a given level of risk, such investors are known as risk takers. However, most investors are risk-averse which means that they tend to invest in those stocks with low risks at a given level of returns. These types of investors try as much as possible to hold a portfolio with the lowest risk levels (Rey, 2015). It should be noted that increasing stocks in a portfolio reduces risks but up to a point M after which any additional stock have no effect on the risk reduction of the portfolio. From the three portfolios calculated above, I would recommend portfolio 3 which is a combination of stock B and stock C, this is because, compared to portfolio 1 and 2, portfolio 3 has the lowest degree of risk (variance) of 0.00071 with expected return of 9.16%. Holding stock B and C in isolation, we can observe that stock B has a risk of 0.032% while stock C has a risk of 0.202% which is higher compared to when both are held together in a portfolio. A risk averse investor faces the risk of relatively low returns from the investment with low returns and therefore he should add other stocks such as the risk free assets which have zero risk and the returns are certain and predictable. Risk-free rate includes government Treasury bills and bonds which are only affected by inflation rates.

• Gordon dividend discounting model

Stock A

Stock price (Po)

19.6078

Expected dividend (5 year)

$2

Growth rate (g)

0%

Required rate of return R

10.20%

Stock B

Stock price (Po)

208.333

Expected dividend (5 year)

$5

Growth rate (g)

7%

Required rate of return R

9.40%

Stock C

Stock price (Po)

105.263

Expected dividend (5 year)

$4

Growth rate (g)

5%

Required rate of return R

8.80%

Limitations of Gordon dividend discounting model;

Gordon dividend discounting model also referred to as the dividend discount model is a financial management tool for determining stock prices using the net present value of its expected dividends. The formula used in calculating the stock price using this model is;

Po = Do * (1+g)/(R-g) = D1/(R - g)

Where;

Po – current stock price of a company

g – constant growth rate

R – required rate of return (obtained using CAPM formula)

Do – current dividend

D1 – expected dividend which is obtained as Do*(1+g)

Despite the fact that the model provide an easy method of calculating stock price, there are some limitations too and they include; the model is based on the assumption that expected future dividend grows at a constant growth rate without taking into consideration the fact that some industries experience rapid growth with unpredictable dividend patterns. Gordon model is a purely quantitative model and thus it ignores qualitative factors such as market trends, management trends and brand loyalty.

Question 2

• Price of a 10% US Treasury bond (2036)

Number of days to maturity = (2036 – 2016)*360

= 7,200 days

Yield = 2.2%

Price = 100 - (7,200 * 2.2) / 360

= 100 – 44

= $56.00

• Price of a 3% US Treasury bond (2018)

Number of days to maturity = (2018 – 2016)*360

= 720 days

Yield = 0.8%

Price = 100 - (720 * 0.8) / 360

= 100 – 1.6

= $98.40

• Yield on a 3-month US Treasury bill (using 360-days)

Face value = $100,000

Maturity = 67 days

Market price = $91,000

Yield = (face value – market price)/face value * (360/maturity)

= ($100,000 - $91,000)/$100,000 * (360/91)

= 0.09 * 3.96

= 35.64%

• For a risk-averse investor, I would recommend both the 10% US Treasury bond 2036 and a 3-month US Treasury bill since they have higher yields. Treasury bills are low risk securities since they payment of interest is fixed. A risk averse investor tends to hold a portfolio with lower risks at a given yield and thus the appropriateness of the two securities in a diversified portfolio since the inventors are guaranteed of a stable payment of income at well-known intervals.

Question 3

It has always been the advice given to investors to invest in different markets internationally and domestically for the purposes of increasing their diversification and at the same time increase the total return of their portfolio. However, as is with many other markets, the financial market is overly dynamic and each change brings along its benefits and challenges. Today, the global financial market presents a number of challenges to investors that in one way or another hinders their operations and cuts the profits that they expect from their investments. In the global financial market of today, opportunities and challenges that face investors are more complex than ever before (Bengtsson, 2013). In my opinion, the greatest challenges that investors face in the global financial market revolve around uncertainty of the market and their lack of predictability, which translates to risks that these investors have to face if they are to carry out their investment projects. The aspect of uncertainty presents investors with a horde of risks that causes a good number of them to be hesitant to continue with their investment projects both domestically and abroad.

One of the greatest challenges that investors face in the global market is the challenge of transaction costs. Carrying out investment projects on a global scale exposes one to costs that regard transactions. These costs increase as the course for international investment is furthered. Although it may be thought that we live in a relatively globalized world whose connections are as definite as those of villages, making the world a global interconnected village, costs attached to transactions vary depending on the foreign market that an investor sets to invest in (Kohn, 2008). Usually, stock broker business’ commissions, in the international market are always higher when compared to rates in domestic environments Crotty, 2009). In addition to the commissions charged in stock brokers businesses, there are other charges that are frequently charged which are piled on top of the brokerage commissions. However, this is specific to the local market in which the investor decides to carry out his/her investment project. These additional charges may include levies, stamp duties, taxes, and exchange fees as well as exchange fees. Additionally, if an investor decides to invest through a fund or professional manager, they are likely to be presented with a higher fee structure (Horowitz, 2014). Further to acquire knowledge on foreign markets in order to make informed investment decisions and to a point where good returns can be realized, one has to go through a process that essentially involves research and analysis which is also done using significant amounts of money and time. To carry out an exhaustive research, one would be required to spend additional funds on hiring researchers and market analysts that are familiar with the expertise involved in foreign financial statements, data collection and are familiar with the specific market of interest as well as other administrative services. For foreign investors, the above transactions and fees for professional services, more often than not, end up featuring in the management expense ratio Crotty, 2009).

One risk that poses as a challenge to this community of investors in the global financial market is the risk associated with currency. Currency risks are primarily a bother for retail investors and majorly lie in the area of currency volatility (Horowitz, 2014). When investing in a foreign market, for instance in a country in Asia, it is required that one exchanges their domestic currency into a foreign currency at the then currency exchange rate in order to be able to carry out investment activities such as buying stock. In case of stock exchange, if an investor buys foreign stock and holds it for a year then decides to sell it a year later, they will have to covert they foreign currency into their domestic currency at the prevailing rates of exchange. It is at this point that uncertainty features Crotty, 2009). The investor and the entirety of the market is uncertain of what the exchange rates in the future would be. For the fear of the exchange rate being lower than what they would be ready to lose, investors become hesitant in engaging in the investment activities.

Additionally, the global financial market further engages markets in developing countries and their markets such as those in Africa. African equity markets are distributed across a grid that features nascent markets and markets that are well established. When investors view this African markets’ space, they run into prospective challenges that exceed the mere lack of adequate liquidity (Gregory, 2012). This brings us to another risk that investors face when engaging in investment projects outside their domestic confines, the liquidity risk. Essentially, liquidity risk is the risk of being unable to sell stock fast as possible once an order of sale has been entered (Shin, 2014). In African equity markets, it has been observed that the sturdiness of broker-dealers and the fee structures that they profess present one other concern that prevent liquidity. Investors retreat from markets where stock cannot be sold quickly enough when a sale order is issued (Shin, 2014).

One other challenge that investors face in the global financial market is the fact that most investors lack the knowledge and skill to maneuver through international markets without facing significant losses. In this light, the investors that experience such situations, more often than not, fail to get the appropriate financial advice that should in all cases accompany investment advice Crotty, 2009). This financial advice include advice on issues such as strategizing tax and estate planning in conjunction with investments. One other issue that would do with financial advice is that of how to allocate their investment projects and activities among other accounts of retirement with their taxable accounts. However, there are those that see their lack of knowledge of the market and affiliated aspects and thus take to hiring analysts and investment professionals. On the down side, although it is possible for them to achieve more in the financial market than those that do not seek professional services, they incur fees and charges for the services they receive (Crotty, 2009).

In addition, the investment scene today has changed significantly from the last four decades or so. Today, most personal investors profess very unrealistic expectations of the market and what returns can be achieved. Forty years ago, the global market experienced a long period where high inflation was the order of the day (Frieden, 1991). As a result, during this time, large nominal returns could be earned with ease even though in real times, the returns could not be considered as gains at all. Today, eyeing the former years, many investors are seen to expect high nominal increases in the prices of assets even with the low inflation that most of the world experiences (Gilpin, R. and Gilpin, J., 2000). Additionally, in the periods that saw high returns alongside high inflation, interest rates and bond yields were also significantly high. As such, if investors disliked the prospects professed by the then equity market, they could get attractive return rates on money they deposited in banks and bonds. This is however not possible in the current global financial market, not with the low rates of inflation (Bengtsson, 2013). This is presented as a challenge to investors who, like gamblers, still believe that it is possible by skill or luck to enjoy descent returns (Horowitz, 2014). They are even over-confident that through the right card, they could land descent returns, an aspect that is overly rare in today’s global market.

In summary, the greatest challenges that investors face in the today’s global financial market primarily revolve around uncertainty of the market and their lack of predictability and lack of knowledge regarding overseas markets. These factors translate to risks that these investors have to face if they are to carry out their investment projects. However, carrying out investment projects in the international market is a proven way of diversifying one’s portfolio and getting higher returns, albeit potentially (Horowitz, 2014). As proven, it is difficult for the average investor to navigate the international market and an attempt of such can be met with numerous challenges that may include losses (Khanna and Palepu, 2013). However, by understanding the main risks and challenges in the global financial market, an investor can put himself in a good position to minimize the identified risks and challenges.

Reference List

Bengtsson, E., 2013. Shadow banking and financial stability: European money market funds in the global financial crisis. Journal of International Money and Finance, 32, pp.579-594.

Crotty, J., 2009. Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’. Cambridge Journal of Economics, 33(4), pp.563-580.

Frieden, J.A., 1991. Invested interests: the politics of national economic policies in a world of global finance. International Organization, 45(04), pp.425-451.

Gilpin, R. and Gilpin, J.M., 2000. The challenge of global capitalism: The world economy in the 21st century (Vol. 5). Princeton, NJ: Princeton University Press.

Gregory, J., 2012. Counterparty credit risk and credit value adjustment: A continuing challenge for global financial markets. John Wiley & Sons.

Horowitz, N., 2014. Art of the deal: Contemporary art in a global financial market. Princeton University Press.

Khanna, T. and Palepu, K., 2013. Winning in emerging markets: A road map for strategy and execution. Harvard Business Press.

Kohn, D., 2008. Money markets and financial stability. Speech May, 29.

McCabe, P.E., 2010. The cross section of money market fund risks and financial crises.

Rey, H., 2015. Dilemma not trilemma: the global financial cycle and monetary policy independence (No. w21162). National Bureau of Economic Research.

Shin, H.S., 2014. The second phase of global liquidity and its impact on emerging economies. In Volatile Capital Flows in Korea (pp. 247-257). Palgrave Macmillan US.