Risk Is Best Judged in a Portfolio Context - Essay Example

? “In finance, risk is best judged in a portfolio context." Is this true? Why? Table of Contents Table of Contents 2 Introduction 3 Risk and Return 3Portfolio Theory 4 Capital Asset Pricing Model 4 Dividend Policy 5 Long Term Financing 5 Capital Structure (Irrelevance) 6  Capital Structure (in market perfection) 6 WACC Capital 6 Option (Financial and Real) 7 Empirical Evidence of Risk in Portfolio Context 7 Reference 8 Introduction In present corporate scenario, the market investors adopt the policy of undertaking diversified investments thereby resorting to a portfolio of investments. The investors take diversified investment strategy, where they invest their money in national as well as international investment instruments. Here the researcher tends to analyse the key mechanism of international investment diversification. The diversification process in their investments consist of different types of activities viz. investment in diversified portfolio like equity, bond, preference share, different securities etc in domestic as well as international stock market. A number of companies are attached with this investment process where the finance managers and the fund managers of the investment companies are responsible for the whole process of investment by taking into consideration the associated risk factor (Kimmel, 2008 p.145). Risk and Return In case of investment, risk is associated with the financial operation and transaction of securities and stocks (Correia, 2007 p.111). So, the risk of the financial operation is determined by calculating the difference between the expected return and the actual return of the stocks. On the other hand the return on the investment designates the total earnings of the investment. Here the return of the investment may be positive or negative. Rate of return is the fundamental expectation of the investors. If the portfolio manager decides to invest in the euro denominated bonds, the return on investment would be around 11.5%, whereas, the US denominated bonds would provide a return of around 9.9%. Thus there would be a difference in return when comparing these two bonds. Therefore, the portfolio manager should aim at maximizing the portfolio returns (wealth maximisation) by making the entire foreign bond allocation in euro denominated bonds, to fetch more returns for his investment. Frequent changes in the economic condition and currency value of US affects the US bonds. So, euro bonds hold a strong position than US bonds. Portfolio managers should also take into consideration that higher returns are associated with higher risks. However, the European currency in comparison to the US currency is quite stable in nature. Therefore, the euro-denominated bonds do not get much affected by the volatility in the market (Kieso, 2010 p.169). Portfolio Theory The main theme of the portfolio theory is to minimise the risk by allocating the financial securities into different portfolio i.e. by diversifying the portfolio. This theory is introduced by Harry Markowitz in 1952 to maximise the wealth of the investor by mitigating the risk. Hedging strategy is a part of portfolio theory and it involves with the reduction of risk of the investments domestically as well as international markets. But companies can invest in appropriate proportions in different stocks by framing proper hedging strategy. Mainly, there are two types of hedging strategies followed by the corporate sectors like financial hedging and operational heading. The financial heading strategy is mainly applied in the derivative instruments, foreign currency borrowings and loan related matters. However, operational hedging is applicable in the cases where investment is diversified internationally. Most of the investment companies invest in different countries to control the foreign exchange market and to maximise the return from investment. This is also a part of the portfolio strategy. Thus investing in a portfolio reduces the risk of investment as compared to the risk involved in 100% investment on a certain stock. Thus risk could be best judged in a portfolio as the proportion of investments are decided after considering percentages of individual and the portfolio (Jain, 2007 p.125). Capital Asset Pricing Model The international CAPM when compared with the domestic model shows little difference. The main aim is to lower the risk of the investment and maximise the benefit of investment in the foreign markets (Harrison and Freeman, 2005 p.158). Since the transaction cost in CAPM is zero, the market risk premium is smaller. The market risk premium is calculated as a difference between the expected rate of return on market portfolio and risk free rate. In both the models, the risk involved is uniform for the investors. In international scenario the assets are global which have greater risks involved and thus involve hedging techniques. The currency hedging is present in international CAPM model which is not there in domestic CAPM model (Kurschner, 2008, p. 3). Hence the risk is more and chances of failure are more in the international venture. The model ignores the unsystematic risk and takes the systematic risk which is balanced with reality. Since the investors have invested in the diversified portfolio they always expect the systematic risk. The capital asset pricing model portray the bond between the rate of return and the systematic risk associated with the return which is essential from the point of view of investors as a part of their investments decisions (Shim and Siegel, 2008 p.147).. Dividend Policy Dividend Policy plays an important role at the point of investment for each and every organization. Dividend policy is the proper distribution of Company’s earnings among the share holder. Company’s share holders are the more important sources of capital supply. The purpose of the company behind financial decision making is ‘Maximizing the share holders’ wealth’. Dividend policy is the most important strategy which a company utilizes to handover the dividends (сash) to the shareholders (Garone, 2008 p.87) The investors get an idea of the business risk looking at the trend of net income of the company and its dividend policy. This information is taken into consideration to calculate risk and return of the portfolio. Thus risk is the best judge in a portfolio as it gives an idea of the return as well. Long Term Financing Long term financing is essential to expand the business operation looking at the long term growth prospects. The sources of long term finance to a company may be in the form of equity share capital or debt capital. There are number of business activities that depend on this type of financing i.e. modernisation, diversification, business expansion, opening of new operation unit along with smooth flow of working capital. The management of the companies use the capital funds raised through equity or debt financing for the purpose of the maintaining the existing growth rate as well as trying to enhance it in the competitive market scenario (Puxty, 2010 p.241). Capital Structure (Irrelevance) There are some assumptions or irrelevance in the capital structure theory which have been discussed as follows: The capital structure ignores the different types of tax effect. It is assumes that the debt capital within the capital structure does not effect on the profit before interest and tax. If the concerned organisation falls into bankruptcy, the cost of bankruptcy is not included with in the capital structure theory. The cost of transaction is also ignored in the capital structure theory. It is assumed that the all the information related to the capital structure are basically symmetry in nature.  Capital Structure (in market perfection) In a perfect market situation, the fund managers try to convince the investors to invest in securities. Many studies have shown that managers generally announce the issue of shares when there has been large increase in the value of stocks and are unwilling to issue shares when they think that the value of stocks is too less. In both the cases managers believe that they can evaluate the value of stocks better than anyone else. It can be correct to a certain extent as there might have the inside information which outsiders does not know. However, the managers think that they can predict the situation, market perfection concept of capital structure better than the investors irrespective of their perception (Kimmel, 2008, p.245). WACC Capital Weighted Average Cost of Capital is mainly used to determine the cost of capital of the business and indicates the proportion of capital in the capital structure of the company. Option (Financial and Real) The option is basically a written contract between buyer (option writer) and seller (option holder). This is financial instrument which is used in the foreign exchange. Empirical Evidence of Risk in Portfolio Context From the above discussion the researcher summarizes that CAPM is a technique which is used as a bridge of systematic risk and rate of return of the portfolio. The literature review highlights that the well diversified stock is less risky than less diversified portfolio. For the purpose of establishing the relationship, probability theory could be considered here. Here the researcher presents an example of how probability theory is applicable in CAPM model. Suppose a coined is tossed once. If a head occurs, then investors win ?10000 and if a tail occurs, then the investors need to pay ?6000. The expected return can be calculated as 0.5(?10000) + 0.5(-?6000) = ?2000. So, here it is proved that high risk is involved with the return, because the investors have to bear a high risk of losing ?6000 in case a tail occurs. There is a good probability in this case that the investors score about 50% of the heads and 50% of the tails and gain an amount of ?2000. In this case the portfolio is less risky because of well diversified portfolio. So, where holding portfolio of stock is taken as matter rather than a single stock, the theory of diversification is used more. Therefore, investors can be reminded that risk associated with investment cannot be eliminated through the international diversification but can be reduced to a large extent in parity with the expected return on investment (Jain, 2007 P.345). Reference Correia, C., 2007. Fundamentals of Financial Management. 5th Edition. Harper Press: Liverpool. Garone, S.J., 2008. The Link Between Corporate Citizenship and Financial Performance, The Conference Board Report, 63: 174-179. Harrison, J. S. and Freeman, R.E., 2005. Stakeholders, Social Responsibility, and Performance: Empirical Evidence and Theoretical Perspectives, The Academy of Management Journal, 8. Jain, K., 2007. Financial Management. 4th Edition. Harper Sport: South Kieso, D.W., 2010. Global Financial, Study Guide. 8th Edition. David Fulton: London. Kimmel, P.D., 2008. Financial: Tools for Business Decision Making. 7th Edition. Fourth Estate: Leeds. Kurschner, M., 2008. Limitations of the Capital Asset Pricing Model. GRIN Verlag. 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