Investment Analysis and Strategy - Assignment Example

Investment Analysis and Strategy Investment in a particular project by an individual or by a firm is done through the analysis of risk-return trade-off associated with the investment project. Before investing in any asset, investors need to be very aware of the relationship between the risk and the return of that asset. It is generally known that for a financial asset a positive relationship between the risk and the return strongly holds. This kind of positive relationship simple implies that if an investor takes more risk, then he would definitely expect a higher return, or in other words, if an investor wants to get higher return from his investments then he has to be prepared to take on higher risk. Modern Portfolio theory elaborately discusses the relationship between the risk and the return. (Lintner, 1965; Brealey and Myers, 2003) Goldman Sachs, one of the largest banks, is the firm, which will be studied in this paper. Before calculating the rate of return that is expected on the investment in the shares of this company employing CAPM, it is required to briefly discuss this model for the betterment of the understanding. Whether an individual will be interested in investing his money in the shares of a particular firm depends on the exposure of the firm to the market risks as well as those risks, which are mainly specific to this firm. Now portfolio theory suggests that instead of making investment in one particular share, it would be wiser for an individual to invest in a diversified portfolio. An appropriate diversification reduces total level of risks. (Brealey and Myers, 2003; Markowitz, 1991; Bernstein, 2001) To estimate expected return on an investment in a particular stock, Capital Asset Pricing Model is used. This model specifies a formula, which is generally applied by the firms to determine market return on the shares of that firm. CAPM takes into account only those risks, which are non-diversifiable. These risks are commonly known as systematic or market risk and they are often expressed by the term beta (β). (Markowitz, 1991; Bernstein, 2001; Tobin, 1958 ) The CAPM formula for measuring expected return on a stock is as follows: E(Ri) = Rf + β (E(RM) - Rf); where E(Ri) is expected return on the ith capital asset, Rf is the return on the risk free asset, β represents sensitivity of the return on the stock to the market return, and E(RM) stands for the expected return on the market portfolio. (Markowitz, 1991; Bernstein, 2001) Before moving into further analysis it is necessary to understand what risk free and risky assets stand for. The classification of assets, particularly of financial assets, into risky and risk-free types is difficult to be done on an absolute term. The classification of financial assets into risk and risk free assets are mainly done on relative term. It is, however, very difficult to find a financial asset, which is completely risk-free. Risk-free assets can be defined as those assets which contain within themselves the lowest level of risk among all assets that are available in the market. Therefore, a risk free asset has a relatively lower level of risk compared to other assets. Generally short term government Treasury bill is considered to be a risk free asset. For example, in U.S. a U.S. Treasury security is generally considered to be a risk free asset by the investment analysts. The reason behind treating a U.S. treasury security as a risk free asset is that practically there doest not exist any chance that the U.S. Government will file bankruptcy at any point of time since it posses a power of imposing tax for raising required money to pay the interests and redeeming the securities in due times. There, however, exists great debate on which Treasury security should be used as a risk free asset. In most of the cases 3-Months Treasury bill is considered to be a risk free asset for analytical purposes. The reason is that it is the shortest Treasury bill and it is least sensitive to interest rate and inflation compared to others. The rate of return that is obtained by investing in risk-free asset is called the risk-free rate. To any investor this risk-free rate is of great importance as investors use this risk-free rate as a benchmark while measuring return on other financial risky assets. Risk-free return is actually the lowest level of return that an investor can gain from his investment. (Cooper and Channon, 1998; Markowitz, 1991) To calculate the expected return on the stocks of the selected company, Goldman Sachs, it is first necessary to find out the values of risk free rate, beta of the firm and expected market return. Beta of the company stands at the level of 1.42. Now risk free rate is around 4.3 percent in U.S., while market risk premium on U.S. securities is 6.8 percent (for 2008). Given these values, expected return on the stocks of Goldman Sachs is as follows: Expected return on Goldman Sachs’ stock = 4.3 % + 1.42(6.8 %) = 13.96 %  2. When a firm plans to invest in different types of project with varied risks, to set appropriate discount rate for each of the project it is very necessary to take into account the risks associated with the project as expected return depends on the level of risk as explained in the previous section. As mentioned in the earlier section of this paper CAPM also takes into account the sensitivity of a firm’s asset to the market risk which is also known as the systematic risk associated with the investment projects. While setting discount rates, it is very essential for the firm’s decision makers to adequately and appropriately take into account systematic risk factors associated with different projects with different level of risks. This section tries to analyze systematic risk management strategies applied by Goldman Sachs. Like any other firm, Goldman Sachs also aims at investing in a well diversified portfolio so that total risk reduces. (Black and Litterman, 1991) For taking decision regarding where to invest, every firm needs to judge future potentials of the projects. Whether a project will be worth undertaking by a firm depends on its discounted value of projected cash flows in the coming years. If the discounted cash flows exceed current value of investment in that project, then the investment would seem to be profitable. Now to estimate discounted cash flows, it is necessary to use appropriate discount rate. Same discount rate can not be applied for projects with different levels of risks. Discount rates have to be adjusted with the degree of risks. Now assuming that the firm is capable of making a well diversified portfolio, it is only the systematic risks associated with the projects that it needs to take into account. Goldman Sachs has devised an innovative risk management strategy to take right investment decision. This strategy is well known as the Goldman Sachs’ ‘Hot-Spot’ technique of risk management. An analysis of this strategy will reveal how this gigantic firm in the international banking sector accounts for systematic risks associated with different investment projects. (Litterman, 1996) To set appropriate discount rates corresponding to different degrees of risks, the first thing is to measure the level of systematic risks. Specified risks are generally not taken into account assuming that by constructing a well diversified portfolio these risks will automatically be eliminated. Now in Goldman Sachs, risk managers follow various risk measuring approaches. However, among different approaches they mainly rely on “the daily volatility and the daily once-per-year VaR” (Litterman, 1996, 10). It uses daily volatility as a measure of risks as it takes into account a typical event which makes it easier for a risk manager to confirm the level of risks by observing a small set of events. On the other hand VaR has the advantage to quantify the level of gain and loss associated with particular level of risk measured through volatility. (Litterman, 1996; Litterman and Winkelmann, 1996) Now for taking into account systematic risk factors for financial accounting, Goldman Sachs applies it’s Hot Spot Technique. The term ‘Hot Spot’ actually refers to its portfolio. The main objective underlying this technique is to decompose the portfolio into different asset classes. Assets can be classified in terms of country specific stocks as the levels of systematic risks vary from one country to another. In a Hot Spots report, the company usually provides two numbers corresponding to each asset class in its portfolio. The first number corresponding to a particular asset class represents the marginal contribution of the position of that particular asset class in total portfolio risk in percentage term, while the second number estimates the size of the position of that asset class. A Hot Spots report of the company reflects which risk classes should get more attention from the risk managers to control for risks. These positions in the Hot Spots report of the company are regarded as the Hot Spots. While calculating discount rate for a particular investment project, the company finds out which particular asset class the proposed project belongs to. Once the project’s asset class in detected, the level of systematic risks associated with that project is found out from the hot spots report of the company. The systematic risks corresponding to a particular project is nothing but the marginal contribution of the asset class that the project belongs to into total market risk of the portfolio. It is therefore clear that for projects belonging to different asset category, the level of systematic risks associated with the investments in those projects will be different, hence discount rate also differs from one to another. Discount rate for projects belonging to a particular asset group, however, however, changes over time as risk managers adjust for the level of risks corresponding to different asset classes by altering their position sizes in the portfolio. (Litterman, 1996; Litterman and Winkelmann, 1996) It is now important to investigate into how Goldman Sachs calculates discount rates by taking into account the level of systematic risks corresponding to a particular asset class, say an asset class corresponding to a particular nation. For calculating discount rate for estimating present value of a proposed investment in the assets, say, stocks of a particular country, the company use the traditional technique, i.e. it applies the basic assumptions of the famous and widely used model of CAPM where the rate of discount for an investment in a particular stock is considered to be equal to the risk-free rate plus the risk premium on that equity. Since at the time of calculating risks for country specific asset classes, only country or region specific risks have been taken into account as the measures of systematic or market risk factors, the discount rate (R) for a country specific asset group is defined by the company as the sum of risk free rate represented as Rf and an equity risk premium represented as REQ in the following equation: (Sharpe, 1964; Gray, 1999) R = Rf + REQ …………………………………(1), where REQ is equal to the value of market spread multiplied by the level of country specific systematic or market risks associated with the particular asset class. Goldman Sachs has also devised a very interesting methodology of calculating discount rates for the emerging markets. For calculating discount rates for the stocks of the emerging markets, it has redefined Rf. For the emerging markets, it calculates Rf by adding up the risk-free in the United states stock market represented as Ru to a country risk spread represented as Rs. Here Ru is nothing but return on the 30 year US treasury bond, while Rs is defined as the difference between the return on the 30 year US treasury bond and an emerging market bond (dollar denominated) having similar maturity period. The following equation summarizes this relationship- Rf = Ru + Rs …………………………………(2). (Mariscal and Hargis, 1999) Now risk premium for an emerging market stock is redefined by the bank as the equity risk premium for an US security multiplied by the ratio of the stock market index volatility in the emerging country represented as Sb to the US stock market index volatility represented as Su. The following equation represents this relationship: REQEmerging = (Sb / Su) REQUS…………………………………..(3) (Mariscal and Hargis, 1999) Here an interesting observation about the methodology applied by Goldman Sachs for calculating discount rates for emerging market stocks can be employed. Equation 3 shows that instead of using beta of the stocks of the emerging market as a measure of systematic risks, to account for systematic risks for the emerging market stocks the bank employed the above mentioned ratio of standard deviations. The company does so by assuming that volatility of stock returns in local market plays a much bigger role in the determination of risk of a world market portfolio than betas do. According to the risk managers of this international bank, measures of volatility in terms of standard deviations are more efficient in distinguishing between high and low yield markets compared to betas. The following equation represents the formula that the bank adopts to calculate country specific discount rate: R = (Ru + Rs) + (Sb / Su) REQUS…………………………………..(4) (Mariscal and Hargis, 1999; Mariscal and Lee, 1993) This equation has further been modified to calculate stock specific discount rate. It has represented the stock specific rate as Rβ. The adjustment has been made in the expression for the equity risk premium. The adjusted expression includes the beta of the stock. The adjusted expression for stock-specific-discount rate can therefore be represented as follows: R = (Ru + Rs) + β(Sb / Su) REQUS…………………………………..(4) (Mariscal and Hargis, 1999) The model applied by Goldman Sachs for calculating discounting rates for investment opportunities with different risks has some flaws. Among all its flaws, the most crucial one is inherent in its structure itself. In the traditional formulation of CAPM, the equity risk premium and the risk free rate represent two different types of risks which are independent of one another. But the problem with the model applied by the bank is that in this formulation these two risks are likely to overlap one another. This overlapping may lead to a serious problem of double-counting of systematic risks associated with a particular stock. This double counting would simply exaggerate the actual level of risk and would also overestimate the discount rate. A possible solution to this problem is to adjust the equity risk premium by subtracting from the earlier expression of equity risk premium the value of correlation coefficient between the yields on the stock market and risk free bond. The adjusted equity risk premium can be represented as follows: REQad= [(Sb / Su) (1- corr(T, B)] REQUS, where T stands for dollar denominated stocks and B represents risk free bond. (Ades and Frederico, 1997; Gray, 1999) This procedure may provide the following advantages: first, this formulation can help in decomposing the discount rate into stock market factors and bond market factors. Second, it also allows the optimization of the analytical resources in the firm’s possession. (Gray, 1999) References: 1. Goldman Sachs Group Inc. msn money. 2009. available at http://moneycentral.msn.com/detail/stock_quote?Symbol=GS [accessed on 14th June, 2009]. 2. Ades, A. and Frederico, K. 1997. A measure of current account sustainability for developing countries. Emerging Market Economic Research. Goldman Sachs. 3. Bernstein, W. J. 2001. The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize. London:McGraw-Hill Professional. 4. Black, F. and Litterman, R. 1991. Global Asset Allocation With Equities, Bonds, and Currencies. Fixed Income Research. Goldman, Sachs. 5. Brealey, R. A. and Myers, S. C. 2003. Principles of Corporate Finance. London: McGraw Hill. 6. Cooper, C. L. and Channon, D.F. 1998. The concise Blackwell encyclopedia of management, London: Wiley-Blackwell. 7. Gray, D. F. 1999. Assessment of corporate sector value and vulnerability: links to exchange rate and financial crises. Washington: World Bank Publication. 8. J. Tobin. 1958. Liquidity preference as behavior towards risk. The Review of Economic Studies, 25: 65–86.  Available at: http://cowles.econ.yale.edu/P/cp/p01a/p0118.pdf (accessed on April 4, 2009). 9. Lintner, J. 1965. The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. The Review of Economics and Statistics, 47 (1): 13–39. 10. Litterman, R. 1996. Hot SpotsTM and Hedges. Journal of Portfolio Management. Special Issue: 52–75. 11. Litterman, R. and Winkelmann, K. 1996. Managing Market Exposure. Risk Management Series. Goldman, Sachs. 12. Mariscal, J. O. and Hargis, K. 1999. Emerging markets discount rates: A consistent market based methodology for Asia, EMEA and Latin America. Portfolio strategy. Goldman Sachs. 13. Mariscal, J. O. and Lee, R. M. 1993. The Valuation of Mexican stocks: An extension of the Capital Asset Pricing Model to Emerging Markets. Investment Research. Goldman Sachs. 14. Markowitz. H. M. 1991. Portfolio Selection. London: Wiley-Blackwell. 15. Sharpe, W. F. 1964. Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk, Journal of Finance, 19(3): 425–442. Read More