Situations Where Investors Do Not Diversify - Assignment Example

 Situations Where Investors Do Not Diversify Question 1 Benefits of diversification Investment diversification is commonly adopted by investors so as to reduce the risk elements associated with market investments. The idea of a diversified portfolio is to invest in securities of different kinds with the sole motive of reducing risks and thereby, increasing returns. When an investor invests in a single type of security there are higher chances of suffering loss, if the company in which the investments are made does not earn sufficient profits. Since the portfolio consists of only one type of security, the losses incurred cannot be compensated in any manner. A diversified portfolio of investments however facilitates, distributing the risk factors across a number of securities issued by different firms. Therefore, if there are losses earned on a particular stock, it can be easily compensated by the profits earned on other stocks (Medo, Yeung & Zhang 2009). Investors are seen to diversify their portfolio by including not only common stock but also bonds and cash. Investing in stock is considered to be less risk induced than investing in debt securities. However, investments in stock do not yield fixed rates of return. The returns obtained from stock or the dividend earned, depends upon the residual earnings of the firm. If a firm’s profits are high, it is likely that the returns are high. Since organizations operate in complex business environment, it is difficult to predict the profits earned by a firm accurately. Considering such factors, investors find it risky to invest in common stock only (Loutskina & Strahan, 2011). Most investors prefer including debt and other forms of borrowings in their portfolio. The advantage of including debt securities is that, it facilitates fixed rates of returns. Investments made in cash are usually considered as a short term reserve. Such investments can be liquidated easily. Usually investors are seen to invest in money market securities so that they can be used in the state of emergencies. It is also important to understand that asset allocation and portfolio diversification are closely related. A diversified portfolio gets created through allocation of assets (Goldstein & Pauzner, 2004). Situations where investors do not diversify Diversification is required to be planned and approached with caution. Investors are normally seen to refrain from having a diversified portfolio during times when the market is highly volatile and there are risks associated with liquidity. Under such circumstances investors avoid investing in debt and prefer common stock only. Hence, there is no limited diversification. The assessment of risk, liquidity and demand plays an important role before taking decisions related to portfolio diversification (Driessen & Laeven, 2007). Question 2 The price of a security under the capital asset pricing model can be calculated as follows: CAPM= rf + β ( rm -rf) rf = Risk free rate of return. β = Beta factor rm = market rate of return Capital asset pricing model facilitates estimating cost of equity and helps in the estimation of risk and the expected returns from a given investment. The idea behind CAPM model is that the investors are expected to be compensated from two aspects, namely; risk and time value of money. The time value of money is calculated as the risk free rate of return (rf). The risk factor is calculated by incorporating beta-factor (β). The beta-factor calculates the additional amount of compensation which requires to be paid for taking up the risk of investing. The additional risk payment is measured by multiplying the beta-factor with the difference between market rate of return (rm) and the risk free rate of return. The CAPM model states that the expected rate of return must be equal to the risk free rate and the risk premium (Fama & French, 2006). Diversification in CAPM Investors diversify because increased profits can be obtained. When investors spread their earnings across a range of different types of securities, risk factor also gets spread out. The CAPM facilitates identifying the exact rate of return which an asset is required to earn in order to add the same to an already well diversified portfolio of securities. The model calculates the specific cost of capital of investing in a given stock. This is then combined with the specific costs of other forms of capital such as debt and borrowings, in order to estimate the overall cost of investment in a given portfolio. Uses of CAPM in finance CAPM takes into account only systematic risks. Thus, it is considered to be a more realistic method of calculating the cost of investment in a diversified portfolio. CAPM also facilitates establishing a relation between systematic risks and the required rate of return. The capital asset pricing model is considered as the most suitable model for estimating the cost of equity, than the weighted average cost of capital method. One of the primary advantages of CAPM is that it takes into perspective systematic risks in relation to the stock market. The model is also useful in studying how the changes in risk affect the stock or asset values (Estrada, 2002). Question 3 The given problem has been solved by using the CAPM as shown below. Figure 1: CAMP calculation CAPM= rf + β ( rm -rf)     rf = 4 β = 1.25 rm = 10     ( rm -rf) = 6 β ( rm -rf) = 7.5 rf + β ( rm -rf) = 11.5 The obtained price of the asset, using the CAPM is 11.5. Question 4 Figure 2: CAPM under differential beta and risk free rates CAPM= rf + β ( rm -rf)                   rf β rm CAPM Case 1 3 1.15 10 11.05 Case 2 4 1.25 10 11.5 Case 3 5 1.35 10 11.75 In the above CAPM calculation the asset prices are calculated taking into perspective differential beta-factor values and risk free rates of return. The market rate of return has been kept the same as in the previous question. Question 5 Sock price= D1/ (k-g) D1= Dividend for the coming year k = required rate of return g= growth rate of dividends. Required rate of return (k) = risk free rate of return+ (market risk premium*beta factor) Based on the above stock pricing model, it is first required to calculate the required rate of return. This is shown in the figure below. Figure 3: Calculation of risk free rate of return Risk free rate of return= 6 Market risk premium= 12 β= 1.5 Required rate of return (k)= 24 Once the required rate of return has been estimated, the next step is to calculate the stock price using the formula: D1/ (k-g). This has been shown in the figure below. Figure 4: Calculation of stock price using dividend growth model D1 = 2 k = 0.24 g = 0.05 D1/ (k-g) = 10.52632 Question 6 Figure 5: Stock price under differential beta and growth rates Risk free rate of return (k) Market risk premium β Required rate of return (k) Case 1 6 12 0.5 12 Case 2 6 12 1.5 24 Case 3 6 12 2.5 36 Sock price= D1/ (k-g) D1 k g Stock price Case 1 2 0.12 0.03 22.22222222 Case 2 2 0.24 0.05 10.52631579 Case 3 2 0.36 0.07 6.896551724 Based on the given information in question 6, the price of the asset or stock has been calculated by altering the beta values and the growth rates. Since the beta values were taken to be different, the resultant rate of returns were also altered. Accordingly, the growth rates were also altered. The stock prices obtained therefore under the three different scenarios are shown in the above table. It can be understood from the above analysis that the variations in the beta values and the rate of growth may impact the stock prices greatly (Jordan, Miller & Yuce, 2008). When the beta and the growth rates are high, higher stock values are obtained. It is therefore important that a firm accurately estimates the values of beta and growth. Since these values are derived from the market, firms are seen to usually calculate the stock values by taking into consideration differential rates and thereby analyze its effect on stock prices when the risk elements are altered (Paiella, 2004). References Driessen, J. & Laeven, L. (2007). International portfolio diversification benefits: Cross-country evidence from a local perspective. Journal of Banking & Finance, 31(6), 1693-1712. Estrada, J. (2002). Systematic risk in emerging markets: the D-CAPM. Emerging Markets Review, 3(4), 365-379. Fama, E. F. & French, K. R. (2006). The value premium and the CAPM. The Journal of Finance, 61(5), 2163-2185. Goldstein, I. & Pauzner, A. (2004). Contagion of self-fulfilling financial crises due to diversification of investment portfolios. Journal of Economic Theory, 119(1), 151-183. Jordan, B. D., Miller, T. W. & Yuce, A. (2008). Fundamentals of investments. New York: McGraw-Hill. Loutskina, E. & Strahan, P. E. (2011). Informed and uninformed investment in housing: The downside of diversification. Review of Financial Studies, 24(5), 1447-1480. Medo, M., Yeung, C. H. & Zhang, Y. C. (2009). How to quantify the influence of correlations on investment diversification. International Review of Financial Analysis, 18(1), 34-39. Paiella, M. (2004). Heterogeneity in financial market participation: appraising its implications for the C-CAPM. Review of Finance, 8(3), 445-480. Read More