International Financial Markets - Term Paper Example

International Financial Markets Introduction Investment management has been very helpful for investors of all types and risk categories. It is known to everybody that risk and return are inversely related and therefore every investor tries to increase their return by investing in risky securities. However, this need not always be good as there can be chances of unforeseen events in the market that can lessen the chance of increasing return even for high risk projects. The subject of investment management has evolved many theories and concepts to facilitate identification of healthy investment opportunities and allow investors to analyse different investment avenues so as to increase their return. Many of the investment management theories were found worthless in an investment climate which is characterized by innumerable number of investment opportunities with differing categories of risk. This has led the investors to think about collective investment to set off the risk from one investment with the return from another investment. This was formally called portfolio and many theories have been developed thereafter to facilitate portfolio management. This paper discusses some of the important concepts of modern portfolio management. The paper takes a descriptive approach where all the concepts are described in such a way how they are useful for investors. Portfolio Theory Investors always seek for an optimal investment portfolio where the returns are more and risk is less. This can be met through Portfolio Theory. The Theory helps in developing an optimal portfolio that will enable an investor to optimize market risk and generate more return from the business. Thus Portfolio theory is an approach to manage risk and return. The Theory has got much relevance in of financial management literature as many investors found them effective means of increasing the return at a given risk level. The theory is basically applied to the stock market and is based on the idea that there are basically two kinds of risk: (a) diversifiable or relevant risk (risk associated with events occurring in individual companies such as strikes, new marketing programs, lawsuits and new inventions (b) non diversifiable or market risk (risk associated with factors that affect all companies such as inflation, war and recession (Elton, 1999). The careful construction of portfolio of securities helps investors to reduce the diversifiable risk to zero and optimize the market risk. However the market risk cannot be eliminated as it is uncontrollable one. And to the investment managers it helps to meet the current financial goals of their company. Portfolio Theory also states that every project of a company should be appraised for risk involved and return expected, so that it can help the company to accept a project where the success rate and returns are higher (Gruber, 1987). Diversification: Diversification is considered to be the core principle of Portfolio Theory. It is a portfolio strategy or a technique that enables an investor to reduce portfolio risk (relevant risk and market risk) by investing in combination of instruments such as stock, mutual funds, cash, bonds and real estate which are moving in different direction. In other words it can be told as the strategy that reduces the exposure of investors to individual asset risk by holding a diversified portfolio of assets. It can be well summed up with the phrase “Don’t put all of your eggs in one basket” (Glink, p. 78, 2001). Take examples suppose an investment is made by the investor only in the stock issued by the single company. Unfortunately a serious downturn happens to the stock issued by single company then the portfolio of the investor will decline ultimately. So the better way for an investor is to split his investments of stocks in two different companies so that the investor can reduce the potential risk of his portfolio. The other way to reduce risk is to include cash, bond and stock in the portfolio that is to develop an asset allocation strategy for the portfolio. Thus the ultimate goal of diversification is to reduce the risk in a portfolio. Correlation: The actual process for establishing an optimal portfolio (series of assets) there is a need for statistical measures namely correlation also known as correlation coefficients for each asset to be used in the portfolio. Asset allocation is the process through which funds are allocated to each asset class. Each asset class will have different levels of risk and return and at the same they behave differently, to say one asset is increasing in value, and the another asset may be decreasing or, at least, not increasing in value as much and vice versa. In such case there is a need for the measure correlation coefficient. Correlation coefficient is a measure of degree to which two assets or investments move in a same direction. As it is known that value of correlation coefficient ranges from -1 to +1. Thus when assets have a correlation coefficient of -1, it indicates that they are negatively correlated or their values move in opposite direction and magnitude; when assets have a correlation coefficient of +1, it is said that they are positively correlated or their values move in same direction and magnitude and when correlation coefficient is 0, then there is no relationship between them at all. Mostly the assets have positive correlation, although it may be very low. Efficient Frontier Set and Standard Deviation An efficient frontier is a combination of portfolios that represent the maximum return for an accepted level of risk or reduce the risk for an accepted level of return. An accompanying appraisal of market risk and credit risk is provided by building an efficient apparent frontier, which is a three-dimensional price apery the set of efficient portfolios (Satyanarayan, 1994). The three magnitudes are: accepted return, accepted animation and accepted default. The admittance of a third dimension may represent an access of economic good as continued as there is a credit risk premium. It is clear that entire premium for credit return curves is affected to be due to credit risk. In this case, the added return from credit should be greater than that compensate the credit risk. Market portfolio The stock market portfolio is that set of stocks and securities that you own. A stock market portfolio is put together, or is declared to be put together, to reflect and facilitate your objectives as an investor. It may also characterize a snapshot of who the investor is as a person. For instance, if one investor is awful environmentally conscious, he/she may invest only in companies that he/she feels are "green" , which id enough to offer return to his/her money (Brealey, 2007). This first thing that one must understand about stock market portfolio is the own risk tolerance. Now-a-days there are many financial advisors, who advice investors appraise their risk tolerance, will sometimes say that this is too heavily emphasized. They are acceptable right, but claimed risk appraisal is still important, because there is no point in advance if you are likely to incur loss of sleep, top stress, and other adverse effects from consistently annoying that you may lose or about to lose handsome amount of money. In the stock market, the greater the risk, the greater the abeyant reward. That is, if a companys stock price fluctuates a lot and fluctuates greatly, you may lose a lot of money by purchasing it...but you as well accept the abeyant of acumen huge gains. On the other hand, stocks that are efficient-bodied accepted and efficient-bodied established, and captivated by a abundant abounding humans and institutional investors, accept actual little adventitious of plummeting...but they as well accept little adventitious of authoritative huge advancement swings, at atomic in the abbreviate term. Humans are not apperception a abundant accord about these companies so the accord about what anyone should pay for their shares is established. And if something bad happens to them, humans are assured that they will affected it, because they consistently accept before. Capital Market Line (CML) and the relevance with the investor A technique that represent one used in the Capital Asset Pricing Model to exhibit the amount of benefits to portfolios depending on the risk free amount of return and the rate of return (beta) for a certain portfolio (Maginn,, 2007). A blueprint acquired from the Capital Asset Pricing Model that shows the amount of return for an efficient portfolio in affiliation to the rate of risk (the market portfolios beta). The blueprint forms a positive, beeline accord bidding in the equation, According to Maginn, CML line may be computed as below: Expected return = risk-free rate + portfolio beta (the difference between the expected return on the market as a whole and the risk-free rate Advantage and disadvantage The CML is acquired by drawing a departure line on the ambush point on the efficient frontier area the accepted return equals the certain amount of return. The CML is advised to be above to the efficient frontier it takes into risk asset in the portfolio. The basic asset valuation archetypal (CAPM) demonstrates that the market portfolio is about the efficient frontier. This is accomplished visually through security market line (SML). Capital Asset Pricing Model Marginal utility, not consumption, is the basic measurement of how you feel. Most of the approach of asset valuation is about how to move from marginal utility to considerable indicators. If utilisation is low and marginal utility is high, so consumption may be a advantageous indicator. Consumption is as well low and marginal utility is top if the investor’s assets performed poorly; thus, it is accepted that prices are low for assets that co-vary absolutely with an ample based basis such as the market portfolio. This is the Capital Asset Pricing Model (CAPM) [Franke, 2003]. It was one of the ancient asset pricing models. It states that accepted asset allotment are accustomed by a linear function of assets’ betas, which are their regression of coefficients adjoin the market portfolio. The axiological question is to access at the accepted return for an accurate security so as to price that security. The CAPM, which is a calm model, arrives at this application market basis utilizing the abstraction of mean-variance efficiency. Assumptions in CAPM model are, The market is fabricated of risk-averse investors who calculate risk in agreement of the variance of portfolio returns. All investors follow a common time frame Similar expectations i.e., all investors are likely to have the same expectations about approaching stock allocation and their risks. Markets are perfect. CAPM and Portfolio theory Asset valuation approach analyzes the prices or values of claims to ambiguous payments. One can as well anticipate of the approach as answer why some assets pay higher return than others. To price an asset, it is necessary to calculate the delay in payment and the likely risk of its payments. It is not too difficult to plan out the aftereffect of time. However, corrections for risk are abundant added important determinants of abounding asset’s values. Uncertainty or corrections for risk accomplish the approach of asset valuation absorbing and challenging. There are a lot of important botheration of the financial market is the altitude of the accommodation amid risk and accepted return. It is accepted that chancy investments such as stock instruments market crop high return than investment in certain assets. A investor have to adjudge how abundant to consume, and what portfolio of assets to hold. The basal valuation blueprint comes from first-order action for that decision. The marginal utility risk of arresting a little beneath today and affairs a little added of an asset should according the marginal utility accretion of arresting a little added of the asset’s adjustment in the future. If the amount and adjustment do not amuse this relation, the investor should buy added or beneath of the asset. Beta Beta (b) is usually declared as a benchmark of volatility, the level to which a stock price fluctuates in affiliation to the all-embracing market. It compares the allotment change in the price of a security to the allotment change in the price of the market, based on a market index, taken over a length of time. Beta as a Measure of Risk Every portfolio has two types of risks anchored in it: Diversifiable Risk or Non-Systematic Risk, which is peculiar to a firm Non-Diversifiable Risk or Analytical Risk, which is market-related or economy-related Everyone is acquainted that risk is associated with a reward; high the risk, greater the return. As far as an investment portfolio is concerned, as the risk is torn into diversifiable and non-diversifiable portions, the market will not accolade an investor for captivation diversifiable risk. This is so because a acute investor is accepted to alter them, by increasing more securities to his portfolio. However, increasing more securities to the portfolio cannot abate analytical risk as it refers to the market-wide or economy-wide risk. Beta is the measurement of analytical risk. Security market line SML The line that exhibits systematic, or market, risk versus return of the entire market during a specific period of time and shows all risky marketable securities. The SML takes a graph from the capital asset pricing model (CAPM) formula. The X-axis represents the accident (beta), and the Y-axis represents the accepted return. The bazaar accident exceptional is bent from the abruptness of the SML (Benninga, 2000). Advantage and disadvantage It is an advantageous technique if an asset getting advised for a portfolio that offers a reasonable accepted return for risk. Individual stocks are advised on the SML graph. If the securitys risk against accepted return is advised aloft the SML, it is undervalued back the investor can apprehend a greater return for the inherent risk. And a security advised beneath the SML is overvalued back the investor would be accepting beneath return for the bulk of risk assumed. Difference between CML and SML Capital market line measures risk by accepted deviation, or absolute risk Security market line measures risk by beta to acquisition the security’s risk in addition to portfolio CML shows and defines efficient portfolios SML exhibits both efficient and non-efficient portfolios CML eliminates diversified efficient risk for portfolios SML includes all portfolios that lie on or beneath the CML, but alone as a allotment of M, and the accordant risk is the stock’s addition to market’s risk Firm specific risk is extraneous to each, but for altered reasons Conclusion Any investor who wants to advance in the security market can do so by investing in any of the basis stocks. Further, the abstraction as well actually shows that alternate funds do not beat equal investment methods such as investment in the basis stocks. In fact, this abstraction proves that advance in a risky portfolio of stocks generates increased return if compared to the allotment generated by advance in the equity-oriented alternate armamentarium schemes. To generalize this conclusion, it can be said that acquiescent advance in index-based stocks would yield return comparable, if not higher, to the allotment provided by alternate funds. Hence, investors do not pay exceptional for these funds in the anatomy of paying access amount and other charges. References Benninga, Simon and Benjamin Czaczkes (2000), Financial modeling, 2nd Edition, MIT Press Brealey, A. Richard (2007), Principles of corporate finance, Tata McGraw-Hill Elton, J. Edwin and Martin Jay Gruber (1999), Investments: Portfolio theory and asset pricing, MIT Press Franke, Günter and Herbert Hax (2003), Finanzwirtschaft des Unternehmens und Kapitalmarkt, 5th Edition, Springer Glink, R Ilyce (2001), 50 simple things you can do to improve your personal finances: how to spend less, save more, and make the most of what you have, Three Rivers Press Gruber, Jay Martin (1987), Modern portfolio theory and investment analysis, 3rd Edition, Wiley Maginn, L. John (2007), Managing investment portfolios: a dynamic process, 3rd Edition, John Wiley and Sons Satyanarayan, Sudhakar and Panayotis N. Varangis (1994), An efficient frontier for international portfolios with commodity assets, World Bank, International Economics Department, International Trade Division Read More