Introduction to Financial Accounting - Assignment Example

Introduction to Financial Accounting  Question 1 1(a) 1(b) Short selling involves an investor who sells out borrowed stocks today in the anticipation of lower prices in future and promises to return the borrowed stocks to the broker (Reilly and Brown, 2003, p. 126). Hence, if the prices fall, the investor buys back the stocks from the market at lower price and makes a profit however, if the prices rise, the investor will have to buy back the stocks from the market and incur loss. Since the stocks are not owned by the investor, he holds no claims on dividends; therefore broker gets the dividends paid during the time the investor had borrowed them for. Investors adopt this trading strategy because they would want to make big profits in as less time as possible, particularly when the perceive stocks being overpriced. To short sell, an investor must have a margin account with the broker, for which the investor has to meet the initial margin requirement which is a proportion of the total investment that has to be paid in cash. For e.g. if an initial margin requirement is 50% on the total investment of £10, 000 then an investor has to pay £5000 in cash which is initial margin deposit, and can borrow the rest of the amount. 1( c) Assets Liabilities and Net worth Sales proceed Market value of short stock 10,000 x 21.655= £ 216500 10,000 x 21.655= £ 2, 16550 Initial margin deposit: 216550 x 0.43= £ 93,116.5 Total assets Net worth £216550 + 93116.5= £309666.5 309666.5 – 216550 = £ 93,116.5 1(d) Selling price (1+ initial margin)/ (1+ maintenance margin) (Reilly & Brown, 2003, p.130) {21.655 (1.43)}/ 1.35 =30.9738/1.35 Therefore, I will get a margin call when the closing price would go above 22.943£, hence the first margin call would come on the 1st of April 2010, because the closing price would be 23.01£. 1(e) Assets Liabilities and Net worth Sales proceed Market value of short stock 10,000 x 21.655= £216500 10,000 x 20.255= £2, 02550 Initial margin deposit 216550 x 0.43= £93,116.5 Total assets Net worth 216550 + 93116.5= £309666.5 309666.5 – 202550 = £107116.5 1(f) Margin trading is purchasing stocks by borrowing money from the broker. For margin trading, an investor would need a margin account which has a specific initial and maintenance margin requirement (Reilly and Brown, 2003, p. 128). Investors opt for margin trading because it provides them with financial leverage or in other words increases their buying power. If the margin in account falls below the maintenance margin, the broker calls the investor to put in more cash in the account so that the margin can be maintained. This is known as a margin call (Reilly and Brown, 2003, p. 128) 1(g) The maintenance margin ranges for the new transaction of 23000 shares at 21.655£ per share can be calculated as follows: If the value of maintenance margin remains below £184652.9, I will not get a margin call. Maintenance margin at 20.55 is 465865 x 0.35 = £163052.75 Therefore the range of maintenance margin values within which I will not get a margin call is values lesser than £184652.9 and equal to or greater than £163052.75 during the entire investment period. Question 2 2(a) RSS BLT FTSE100 Expected rate of return 4.42% 3.13% 0.29% Standard deviation 13.09% 10.37% 4.45% Correlation coefficient RSS and BLT 0.363765338 Correlation coefficient RSS and FTSE 0.183641311 Correlation coefficient BLT and FTSE 0.71201878 2 (b) Minimum variance Weight of RSS = 0.4419 = 44.2% Weight of BLT = 55.8% This proportion of both the share will create a minimum variance portfolio Expected return = 3.7% Standard deviation of portfolio = 5.036% Optimal Risk Portfolio Weights of RSS= 40.3% Weight of BLT= 59.6% Expected return = 3.65% Standard deviation of portfolio =8.37% 2 (c) 2 (d) In order to find out if diversification would reduce the risk of portfolio, the correlation of assets must be studied (Reilly and Brown, 2003, p. 245). The greater the number of negatively correlated assets in a portfolio, the lesser will be the risk. RSS and BLT correlation coefficient is 0.3637 which shows that the two stocks are moderately correlated, that might not help much in diversifying the risk of portfolio. In a case when the when both shares have same weights, standard deviation and expected return along with perfect positive correlation, the diversification of risk will be minimal. 2 (e) Systematic risk is an unavoidable risk whereas unsystematic is a diversifiable risk. Systematic risk occurs because of factors which are beyond the influence of an investor or a company (Reilly and Brown, 2003, p. 20). The portfolio containing RSS and BLT stocks face both systematic and unsystematic risk like business risk, financial risk, liquidity risk. To achieve a residual level of unsystematic risk, more negatively correlated assets should be added in the portfolio however, systematic risk cannot be influenced. 2 (f) The combination of risk and return of risky and risk free assets in a portfolio is graphically represented by a line known as capital allocation line (Bodie et.al., 2008, p. 142). The slope of this line represents the compensation given to an investor for bearing risk and is known as Share Ratio. In other words, Sharpe ratio gives the price of risk which the investor bears. The higher the ratio is the better the risk adjusted performance of portfolio is. 2 (g) Regression equation: Return of asset = α + β Return on FTSE100 + standard error (Reilly & Brown, 2003, p. 252) 0.0442= -0.4267+ 0.5306*0.0029 + 0.129 (regression equation for RSS) 0.0313= -0.0264 + 1.66* 0.0029 + 0.073 (regression equation for BLT) Calculated beta with the formula Beta RSS 0.531496 Beta BLT 1.632438084 Question 3 Efficient market hypothesis assumes that the share price reflects all the public and private information available in the market (Reilly and Brown, 2003, p. 178). There are three forms of EMH, weak, semi-strong and strong. Weak EMH assumes that current stock price reflects all market information about the security (Reilly and Brown, 2003, p. 178). Semi-strong EMH assumes that current stock price reflects all the market and non market information available (Reilly and Brown, 2003, p. 178). Strong EMH assumes that the current stock price quickly reflects all the public and private information available (Reilly and Brown, 2003, p. 179). For The stock of price of BP fell from 655.4 pence to 558.5 pence within a time period of 20 days. The price started falling when the news of oil spill reached the masses. Investors started getting rid of BP stocks because a general investor behavior is that they fear losses a lot more than they want gains. Hence, with news of oil spill, the prices fell by 3% within a day’s time. This price fall continued on but with lesser percentages, however, when the President Obama has declared the company’s fault in the spill, the stock prices declined by 7% which later on fell further by 4%. The reason behind such consistent fall is obviously lack of demand for the stock.. Lastly, it is important to highlight the relationship between EMH and investors’ approach for trading BP’s stocks. It can be said that the price of the stock is in line with EMH after the accident, because it is always predicted that if a company’s operations meets accidents, the effect is reflected in the decreasing stock price. The analysts are of opinion that the investors are over reacting by not trading in BP’s stocks. They believe that the spillover accident is not going to affect the financial performance of the company thus investors are being overly conservative. However, investors do not agree with the analysts assumptions. References Bodie, Z., et. al., 2008. Investments. 8th ed. New York: Mc-Graw Hill/Irwin. Reilly, F.K. & Brown, K.C., 2003. Investment Analysis and Portfolio Management. 7th ed. Ohio: Thomson Learning, Read More