Finance Risk in a Portfolio Context - Admission/Application Essay Example

? Heading: In finance, risk is best judged in a portfolio context In finance, risk is best judged in a portfolio context Risk if a feature that is common in any business venture. The general definition of risk is the possibility that a chosen course of action will not end up as expected (i. e.) it might lead to a loss. Whenever one invests in a certain project, in most cases it is not certain what the outcome will be. It might lead to a gain or to a loss. Therefore, one risks to lose the money invested. For one to reduce the level of risks, it is advised that they invest in numerous projects. In such a case, if one project fails, the amount lost will be partially covered by the other project that succeeds. That way, one avoids losing all his or her money in one project. Investing in several projects to reduce the level of risk is referred to as spreading portfolio. Therefore, the term portfolio can be defined as a collection of investments that are held by an individual or by a company (Brealey, Myers & Allen, 2011). It is not easy to judge risk from a single investment. One investment may fail or it may succeed. There are a number of factors that contribute to the failure or success of a project such as the prevailing economic conditions, the type of project one has invested in, the geographical area where the project is established among others. Therefore, for one to correctly judge the risk in a certain area it is important to judge from a portfolio. This is especially applicable in the stock market. This essay gives a discussion in support of the statement “In finance, risk is best judged in a portfolio context”. Risk and return Every investor is usually concerned with the return associated with the project they invest in. Return is not realized immediately after investing, one has to wait for some time. Hence return is a future function (Brealey, Myers & Allen, 2011). The future is not always clear. No one knows what will happen in the future. It is uncertain. Therefore, it follows that there is always a risk that is attached to the future since it is uncertain. The investor is never sure about the returns he or she will get in the future from an investment activity. It is therefore important for an investor to do his assignment carefully to determine the magnitude of risk associated with the investment so as to make a good decision to avoid huge losses. The main aim of an investor is to try and reduce the chances of risk as much as possible. It is a general rule that the when the chances of risk are high, the rate of return is usually high. However, there are some exceptions to this rule. Different projects have different levels of risk and hence different rates of return. Therefore, in order to correctly assess the risk one should consider portfolio (Chandra, 2011). Portfolio Theory The theory is also referred to as the modern portfolio theory and was developed and introduced by Harry Markowitz in the year 1952. Under this theory, it is assumed that the returns from an investment activity are spread over the period of time being analysed. The objective of this theory is to maximize the expected return of a portfolio for a certain level of portfolio risk. In other words, it attempts to minimize the level of risk associated with a certain level of expected return. They concept that guides this theory is that when calculating the risk level, an investment should not be considered alone. It is important for the investor to evaluate several investments varies in prices in comparison with other investments in the portfolio varies in prices (Brealey, Myers & Allen, 2011). When making an investment, one trade- off between a risk and a return and therefore the investor should always try to choose the investment that will give him the highest returns possible. The C.A.P.M In order to determine the theoretical rate of return that is appropriate for an investment, Capital Asset Pricing Model (CAPM) is used (Brealey, Myers & Allen, 2011). Assets that are evaluated using this model can be included in an existing diversified portfolio if their non- diversifiable risk is known. In doing the calculation, the sensitivity of the investment to systematic risk is taken into consideration. This risk is represented by the symbol ?. The projected market return and the projected theoretical return of the risk free investment are also determined. The formula for CAPM used to determine the expected rate of return is as follows; The measure of systematic risk used in CAPM is important since the investors can compare it with that of other investments in the market. They can therefore go ahead and select the best investment. In addition, they are able to improve their portfolio and reduce the chances of risk. Managers can also use the model to determine the required rate of returns for investment (Chandra, 2008). Long Term Financing In a business, there are those investments whose returns are expected for a long period of time usually over one year. These are usually investments in long term assets such as machinery and buildings. The money needed to finance these investments should be available for a long time (Brealey, Myers & Allen, 2011). The time required to pay back the finance should exceed one year. A company should have a good mix of long term financing (capital structure). This will help reduce the cost of capital as well as the risk involved. The investor should have a good business plan so as to make a good investment portfolio that reduces risks. The company will get a long term debt depending on the collateral available. The manager should be able to select between the short term and the long term financing. To do this, they should consider the risk-return trade off. It is important to note that long time financing is less risky as compared to the short term financing (Droms & Wright, 2010). Capital Structure (Irrelevance) The mix of the company’s finances is referred to as the Capital Structure. In fact, the liabilities of a company are made up of the capital structure. The combination of the different finance should be in such a way that it reduces the risk involved. The Modigliani-Miller theorem is used to evaluate the capital structure of a company. It states that the value of a company is not relevant to its financing in a perfect market (Baker & Martin, 2011). Two propositions were developed. First, the capital structure does not affect the value of the company. Second, the cost of equity for both leveraged and unleveraged firms are equal. If the effects of taxes and risky debts are included, this analysis becomes irrelevant. Capital Structure (and Market Imperfections) In the real world, it is not easy to have a perfect world. Therefore, it is not possible to have an optimal capital structure that can maximize the firm’s value. The capital structure is not relevant is in the real world since there are many imperfections. The imperfections that affect the capital structure are; information asymmetry, taxes, financial distress as well as bankruptcy (Baker & Powell, 2005). The weighted average cost of capital (W.A.C.C.) For a company to satisfy its financial providers there is a minimum rate of return that it should earn on an investment portfolio. This minimum rate of return is the weighted average cost of capital (W.A.C.C.). When calculating the WACC, all the components of the capital structure must be considered. WACC is very important in determining the worthwhileness of an investment. Therefore, if all the components of a capital structure have to be considered in this calculation, then it means the best way to judge a risk is in a portfolio since WACC calculates the risk and involves different components of capital structure (Pratt & Grabowski, 2011). Dividend Policy The shareholders of a company expect a share of the company’s profit in form of shares at the end of every financial year. The company needs to come up with a plan on how it will be paying dividends. This plan is the divided policy. The company can decide to pay dividends at present or to pay large amounts in the future. In addition, dividends can be paid in different forms (i.e.) cash or stocks. Dividends can affect the price of shares. Investors view future capital gains and present dividends differently. This makes dividends policy an important management decision (Baker, 2009). Options (Financial) The owner of an asset has the right to make a decision on whether to buy or sell a certain asset at a given price on a given date. Financial options are usually for a short period of time (less than a year). The variable that drives the financial option is usually the price of the asset. Pricing of financial options is not affected by the market effects (Higham, 2004). Options (Real) This is an analysis that applies option valuation techniques to help in making capital budgeting decisions. A real option is a right to an investor to engage in a given investment activity. Real options are not traded as securities. Real option analysis helps the managers to make decisions under uncertainty. Therefore, they help managers to reduce the chances of risk in an investment (Higham, 2004). Reference List Baker, H. K, 2009, Dividends and Dividend Policy: Epub Edition. John Wiley & Sons Inc . Baker, H. K., & Martin, G. S. 2011, Capital structure & corporate financing decisions: Theory, evidence, and practice, John Wiley & Sons, Hoboken, N.J. Baker, H. K., & Powell, G. E. 2005, Understanding Financial Management: A Practical Guide. Blackwell Pub, Oxford. Brealey, R. A., Myers, S. C., & Allen, F. 2011, Principles of corporate finance, McGraw-Hill/Irwin, New York Chandra, P. 2011, Financial management: Theory and practice, Tata McGraw-Hill Education, New Delhi. Droms, W. G., & Wright, J. O. 2010, Finance and Accounting for Nonfinancial Managers: All the Basics You Need to Know, Perseus Books Group, New York. Francis, J. C., & Kim, D. 2013, Modern portfolio theory: Foundations, analysis, and new developments + website Wiley, Hoboken, N.J. Higham, D. J. 2004, An introduction to financial option valuation: Mathematics, stochastics, and computation, Cambridge University Press, New York. Magni, C, A., 2008, CAPM-based capital budgeting and non-additively, Journal of Property Investment & Finance, Vol. 26 Iss: 5, pp.388 – 398 Pratt, S. P., & Grabowski, R. J. 2011, Cost of capital in litigation: Applications and examples, Wiley, Hoboken, N.J. Read More