Investment and Portfolio Analysis - Essay Example

? Investment and portfolio analysis The five different measures of risk adjusted Portfolio Performance; the and how each of these measures defines the risk that investors face. The five of the different measures of risk adjusted portfolio performance include; Treynor ratio, Sharpe ratio, Information ratio, Jensen alpha and Sortino ratio. Treynor ratio refers to a measure of excess returns that can be obtained from a given investment operating under a risk free rate. Treynor ratio utilizes beta rather than standard deviation when determining portfolio returns. Therefore, Treynor ratio assumes that relevant risk is systematic whereby; the inherent risk can not be diversified through portfolio management (Anric, 2013). On the contrary, Sharpe ratio refers to a measure of risk adjustment measure that utilizes standard deviation when computing portfolio returns and inherent risk associated with a particular portfolio (Ctaff, 2012). Empirical research asserts that if Sharpe ratio is higher it implies returns are better. Therefore, by utilizing standard deviation, Sharp ratio assumes that the relevant risk is total risk unlike Treynor ratio which assumes that the relevant risk is systematic (Ctaff, 2012). Both Treyon and Sharpe ratios are similar; however, the two measures differ in terms of how they determine of risk volatility. Whereby, Treyon ration utilizes beta while Sharp ratio tend to utilize standard deviation (Anric, 2013). Information ratio measures the ability of corporate managers to utilize skills/ luck to generate excess returns beyond the established benchmark. This ratio utilizes alpha elements as well as standard deviation to measure volatilities associated with a particular portfolio (Reilly and Brown, 2012). Therefore, information ratio assumes that the relevant risk is total where both systematic and unsystematic risks are combined (Harkins, 2012). Jensen alpha refers to a measure of portfolio returns predicted using capital asset pricing model. In addition, Jensen’s alpha assumes that relevant risk is systematic (Bacon, 2013). On the other hand, Sortino ratio refers to a ratio that helps to determine the difference between good and bad risk in sharp ratio. This ratio tends to be similar with Sharp ratio. However, it utilizes downward deviation making it slight different from sharp ratio. This ratio measures return that can be derived during volatility whereby, standard deviation may be utilized. Therefore, Sortino ratio assumes that relevant risk it total (Feibel and Vincent, 2011). 2. Discuss whether the present value of cash flow approach and the relative valuation approach to security valuation can be considered to be competitive or complementary. The present value approach may utilize discount rate to discount cash flows generated by a particular project to determine their value. Additionally, the present value approach may be utilized in making valuations of different assets such as shares, real estate properties and even bonds (Feibel & Vincent, 2011). Whereby, a negative net present value indicates that a project may not be profitable. In addition, a positive net present value implies that a project may be profitable and therefore, such project should not be undertaken because it will expose the company at a greater risk. On the other hand, relative valuation approach focuses at valuing company stocks with those of company own historical method of valuation. In addition, relative valuation tends to compare company’s stocks with the market value of other similar assets to determine whether they can be suitable for investments (Feibel and Vincent, 2011). This means that similar stocks of a particular company should be compared with those stocks of companies operating in the same market. However, relative valuation approaches have some limitations. For example, all companies may not utilize the same corporate strategies and hence, great discrepancies may exist between companies (Feibel and Vincent, 2011). Connectively, relative approach asserts that the value of an asset equals to what the market is willing to pay depending on the product characteristics. This implies that customer might be willing to pay higher amount on a product with desirable characteristics (Damodaran, 2012). In addition, relative approach asserts that the value of an asset may not be determined by valuation, unlike the present value approach which asserts that the value of an asset may be determined via valuation. Therefore, it can be scrutinized that the two approaches are competitive rather than complimentary because they are based on different principle as discussed (Damodaran, 2012). 3. Although the Capital asset pricing model (CAPM) is widely used to analyse securities and aid in portfolio management, it is often criticised as providing a too simplistic view of risk. Discuss. Capital asset pricing model faces numerous criticisms. Among the criticism of CAPM include; CAPM is a single period model and hence, it can not fully determining portfolio expected returns. Additionally, the model may cause great variations between portfolio returns and return from risk free rate (Ku?rschner, 2008). Connectively, the model is based on the assumptions that a well diversified portfolio may be affected by systematic risk alone which may not always be the case because some portfolios might be affected by investment risk. In addition, CAPM is based on the assumption that markets are efficient. This may not be the case because in an efficient market stocks are correctly price. Therefore, it may not be easy to separate between risk and portfolio returns when using CAPM (Ku?rschner, 2008). Connectively, the model is based on some unrealistic assumptions. For instance, the model is based on the assumption of forward looking data where the data on expected beta and expected returns is utilized (Ku?rschner, 2008). The validity of capital asset pricing model may not be easily ascertained due to lack of data on anticipated price data to test the outcomes. For instance, empirical research indicates that the relationship between beta and returns may not be ascertained (Ku?rschner, 2008). Additionally, utilization of beta in CAPM model may cause the outcomes of portfolio expected return to be invalid because beta keeps fluctuating and this may cause adverse effect on the outcomes. The model asserts that all investors have homogeneous anticipation which may not be true because investors are different. Whereby, some tend to be risk takers, risk neutral and risk takers (Rogers and Securato, 2009). 4. Why might an investor choose to invest in the common stock of a company rather than its corporate bonds? Though common stocks are riskier as compared to corporate bonds, they provide investors with numerous benefits as compared to corporate bonds as indicated in the graphs below. The graphs below indicate the return patterns of common stocks and corporate bonds. Source: Author Source: Author It can be scrutinized that the returns of common stocks increased significantly through out the periods,while on the contrary, the returns of corporate bond increased within the first three years and later displayed a decline in the consequent years (Sandilands and Media, 2013). Connectively, common stock holders may obtain both capital gains and dividends at any time when the owners perceives the need to sell them unlike corporate bonds where owners must wait till maturity date. In addition, common stocks may be easily utilized to finance a business by issuing them through the stock exchange market unlike bonds where investors must wait for the expiry period. This means that common stocks tend to be more flexible than corporate bonds because common stock holders can issue their stocks at any time unlike corporate bond holders (Sandilands and Media, 2013). The owners of corporate bonds tend to be more secure than common stocks holders. For example, corporate bond holders are guaranteed with total refund of the amount invested while common stock holders are highly exposed to market risk. However; common stock holders may obtain more returns than corporate bond holders. This is because corporate bond holders are entitled to fixed interest payments till maturity while on the other hand; common stock holders can obtain higher dividends payments especially if economic conditions are favourable (Sandilands and Media, 2013). Additionally, common stock holders may obtain higher capital gains in the long-run than corporate bond holders. Therefore, it can be scrutinized that the benefits of investing in common stocks outweighs the benefits of investing in corporate bonds hence, investors may choose to invest in common stock rather than corporate bonds(Sandilands and Media, 2013). 5. Empirical work that produces results which challenge the semi strong form of the efficient market hypothesis. Semi-strong form of market efficiency entails a situation where the stock price reflects the past and present information. According to empirical work based on random walk stock series of 1970 puzzle, it was observed that investors can not “beat the market” (they can not earn super normal returns) using the past and present information. This is because semi strong form efficiency contains information that is already available to the public and has already been reflected in the stock prices. Additionally, the case of Pakistan’s stock market challenged the semi strong form of efficiency. Whereby, seasonality effects such as; day effect, weekly effect, monthly and yearly effect challenged the efficiency of semi-strong form efficiency (Ali and Mustafa, 2001). Garfield and Cowles conducted event studies to determine whether technical analyst could help to earn more returns than the normal returns. The studies found that returns earned as a result of recommendations made by technical analyst were lower than those earned by investors who selected their portfolio at a random. This means that timing and selection made by technical analysts could not help investors to earn higher returns. This is because in a semi strong form of efficiency, all investors have the same information concerning the stock prices (Burghardt, 2011). Connectively, Fama, Fisher, Jensen and Roll (FFJR) conducted an investigation between to determine whether stock splits have an impact on share prices. Whereby, 940 splits that occurred between 1956 to 1960 were taken, it was observed that stocks splits diluted the value of stocks causing a decline in the amount of dividends paid(Burghardt, 2011). However, the events study indicates that the split were inconsistent with the assertions made by FFJR. This means that semi strong form of efficiency may not help to earn higher returns than the normal market returns (Burghardt, 2011). Reference List Ali.S.S. and Mustafa.K. (2001).Testing Semi-Strong for Efficiency of Stock Market. The Pakistan Development Review. Retrieved :< http://www.pide.org.pk/pdr/index.php/pdr/arti cle/view File/1841/1814>on 13th May 2013. Anric. (2013).What is Treynor Ratio. Global Funds Exchange. Retrieved :< http://www.globa lfundexchange.com/faqs/86-glossary/307-what-is-the-treynor-ratio->.on 11th May 2013. Bacon, C. R. (2013). Practical risk-adjusted performance measurement. Hoboken, N.J., Wiley. http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=490420. Burghardt, M. (2011). Retail investor sentiment and behavior an empirical analysis. Wiesbaden, Gabler. http://site.ebrary.com/id/10455831. Ctaff.C.I. (2012). Interpreting Sharp Ratio. American Association of Individual Investors. Retrieved :< http://www.aaii.com/computerizedinvesting/article/interpreting-the-sharpe-ratio> on 11th May 2013. Damodaran, A. (2012). Investment valuation: tools and techniques for determining the value of any asset. Hoboken, N.J., Wiley. Feibel, B. J., and Vincent, K. D. (2011). Compley with global investment performance standards (GIPS). Hoboken, N.J., Wiley. Harkins. M. (2012). Managing risk and information security: protect to enable. [S.l.], Apress. Ku?rschner, M. (2008). Limitations of the Capital Asset Pricing Model (CAPM) Criticism and New Developments. Mu?nchen, GRIN Verlag GmbH. http://nbn-resolving.de/urn:nbn :de: 101:1-2010082913342. Sandilands.T. and Media.T. (2013). Are Corporate Bonds Riskier than Common or Preferred Stoks.Hearst Communication, Inc.Retrieved :< http://smallbusiness.chron.com/corporate-bonds-riskier-common-preferred-stock-38641.html>on13th May 2013. Reilly, F. K., and Brown, K. C. (2012). Investment analysis and portfolio management. Mason, Ohio, South-Western Cengage Learning. Rogers, P, and Securato, J 2009, 'Estudo Comparativo no Mercado Brasileiro do Capital Asset Pricing Model (CAPM), Modelo 3-Fatores de Fama e French e Reward Beta Approach. (Portuguese)', RAC - Eletronica, 3, 1, pp. 159-179, Academic Search Premier, EBSCOhost, viewed 14 May 2013. Schneider, C. (2010). How useful is the information ratio to evaluate the performance of portfolio managers? Hamburg, Diplomica-Verl. Read More