Risk and Expected Returns - Assignment Example

Running Header: Risk and Expected returns Assignment Your name: Course name: Professors’ name: Date Question 1 (a) The historical return for each of the above portfolios for the years 1992 to 2011 and include the numbers in the table. The completed table should be submitted with your assignment. (See hint on how to do this below Table One on page 5.) Show ALL workings here in an appendix at the end of your assignment Year Australian shares International shares Property Australian bonds Cash Beta Kappa Omega 1992 -2.30% 5.40% 7.00% 10.50% 6.90% 6.54% 7.63% 1.87% 1993 45.40% 24.60% 30.10% 16.30% 5.40% 27.64% 10.05% 36.10% 1994 -8.70% -7.60% -5.60% -4.70% 5.30% -5.86% 2.21% -7.75% 1995 20.20% 26.50% 12.70% 18.60% 8.00% 16.56% 10.59% 20.59% 1996 14.60% 6.80% 14.50% 11.90% 7.60% 13.48% 9.15% 12.24% 1997 12.20% 41.70% 20.30% 12.20% 5.60% 15.44% 8.39% 22.67% 1998 11.60% 32.60% 18.00% 9.50% 5.10% 13.32% 7.27% 19.18% 1999 16.10% 17.50% -5.00% -1.20% 5.00% 0.74% 2.76% 12.30% 2000 3.60% 2.50% 17.80% 12.00% 6.20% 12.64% 8.52% 6.11% 2001 10.10% -9.40% 14.60% 5.50% 5.30% 10.06% 6.27% 5.15% 2002 -8.10% -26.90% 11.80% 8.80% 4.80% 6.62% 6.30% -9.76% 2003 15.90% 0.00% 8.80% 3.00% 4.90% 7.90% 4.91% 9.71% 2004 27.60% 10.80% 32.00% 7.00% 5.60% 21.12% 8.52% 23.44% 2005 21.10% 17.60% 12.50% 5.80% 5.70% 11.54% 6.40% 18.33% 2006 25.00% 12.30% 34.00% 3.10% 6.00% 19.84% 8.22% 22.99% 2007 18.00% -1.60% -8.40% 3.50% 6.80% 1.64% 4.62% 6.84% 2008 -40.40% -24.90% -54.00% 14.90% 7.60% -23.72% 2.90% -38.47% 2009 39.60% 5.00% 7.90% 1.70% 3.50% 11.76% 3.58% 22.88% 2010 3.20% -0.70% -1.10% 6.00% 4.40% 2.60% 4.17% 1.17% 2011 -10.50% -5.30% -1.50% 11.40% 5.00% 1.86% 5.63% -7.14% (b) Calculate the expected (average) return, denoted by E(R), and risk (standard deviation), denoted by σ, for each of the five asset classes as well as the three portfolios in Table One and include your answers in the table. Again, show ALL workings here in the appendix. (4 + 6 = 10 marks) Year Australian shares international shares Property Australian bonds Cash Beta Kappa Omega 1992 -2.30% 5.40% 7.00% 10.50% 6.90% 6.54% 7.63% 1.87% 1993 45.40% 24.60% 30.10% 16.30% 5.40% 27.64% 10.05% 36.10% 1994 -8.70% -7.60% -5.60% -4.70% 5.30% -5.86% 2.21% -7.75% 1995 20.20% 26.50% 12.70% 18.60% 8.00% 16.56% 10.59% 20.59% 1996 14.60% 6.80% 14.50% 11.90% 7.60% 13.48% 9.15% 12.24% 1997 12.20% 41.70% 20.30% 12.20% 5.60% 15.44% 8.39% 22.67% 1998 11.60% 32.60% 18.00% 9.50% 5.10% 13.32% 7.27% 19.18% 1999 16.10% 17.50% -5.00% -1.20% 5.00% 0.74% 2.76% 12.30% 2000 3.60% 2.50% 17.80% 12.00% 6.20% 12.64% 8.52% 6.11% 2001 10.10% -9.40% 14.60% 5.50% 5.30% 10.06% 6.27% 5.15% 2002 -8.10% -26.90% 11.80% 8.80% 4.80% 6.62% 6.30% -9.76% 2003 15.90% 0.00% 8.80% 3.00% 4.90% 7.90% 4.91% 9.71% 2004 27.60% 10.80% 32.00% 7.00% 5.60% 21.12% 8.52% 23.44% 2005 21.10% 17.60% 12.50% 5.80% 5.70% 11.54% 6.40% 18.33% 2006 25.00% 12.30% 34.00% 3.10% 6.00% 19.84% 8.22% 22.99% 2007 18.00% -1.60% -8.40% 3.50% 6.80% 1.64% 4.62% 6.84% 2008 -40.40% -24.90% -54.00% 14.90% 7.60% -23.72% 2.90% -38.47% 2009 39.60% 5.00% 7.90% 1.70% 3.50% 11.76% 3.58% 22.88% 2010 3.20% -0.70% -1.10% 6.00% 4.40% 2.60% 4.17% 1.17% 2011 -10.50% -5.30% -1.50% 11.40% 5.00% 1.86% 5.63% -7.14% Expected average return 10.71% 6.35% 8.32% 7.79% 5.74% 8.59% 6.40% 8.92% Risk standard deviation 0.19 0.17 0.19 0.06 0.01 0.11 0.03 0.16 Question 2 Briefly describe the purpose of a superannuation fund. Superannuation funds is a form of pension plan provided by companies and encouraged by the government setting aside of funds towards the pension plan which is to be paid once the worker is retired. This form of plan is aimed at increasing the morale of workers by minimizing their financial worries in the future (Lasher 2010). Question 3 Important characteristic of each of the asset classes Australian shares This class of asset has the highest rate of returns, 10.7% as compared to the other classes; it also has the highest Risk standard deviation of 0.19 %. Like other form of shares, Australian shares need at least 5 years in order to give maximum returns on investments. Notably it is not income focused but rather growth focused and hence the reason for the high return rates witnessed in the average rates of returns. Its inflation hedge is also high and hence a good investment option as compared to cash and fixed interest that do not have substantial inflation hedge. It also has a high liquidity ratio as compared to property. This essentially means that shares are easily disposable as compared to property (Brigham &  Houston 2009). International shares The expected rate of returns on this asset class is 6.35%; its risk standard deviation is 0.17 %. Just like the normal shares or local shares, international shares need a considerable period of time to yield maximum returns on investments. It is also not income focused but growth focused and hence the considerable rates of returns it has as compared to cash asset portfolio. As noted by Brigham &  Houston (2009, p.240) just like Australian shares it has a high inflation hedge as compared to cash and fixed interest. It also has a high liquidity tendency as compared to property, this means that the asset can be easily converted to cash for other uses. International shares offer diversification option in across markets and economies which are not there is Local shares. It also allows easy exchange of traded funds since it provides low cost access to a variety of commodities. With a variety of options globally some attract higher liquidity options as compared to the ones available in Australian market, it also allows employers to invest in their employees shares overseas. Property The expected average return on investment in this option is 8.32 %, while the standard risk is also high (0.19 %). As evident, the rate of return in this option is medium, it normally requires a period not less than 3 years. It is income focused and also growth focused; it has a high inflation hedge, possible the highest because it is rarely negatively affected by inflation. It is low in terms of its liquidity because of the time it takes to get a client and process the transfer. Essentially this form of investment offers moderate returns over a longer period of time; it is normally used to achieve income or capital growth or a combination of the two (Brigham &  Houston 2009). Australian bonds This class of assets attract a high returns on investment, in this case it is 7.79%, it also experiences a lower standard deviation risk of 0.06. Trading of bonds in Australia is not limited to a central place, provided the seller and the buyer strike a deal, it is often completed within a short time and normally done over counter (Ehrhardt & Brigham 2010). Notably bonds have varying qualities, yields and maturities. This diversity of bonds makes it hard for it to be traded on exchanges. Another reason for not trading bonds on exchanges is because of the difficulty of accurately listing current prices; this is due to the fact that prices are influenced by changing interest rates as well as credit ratings. Australian bonds offer investors a more positive real return because the country is more stable (Besley & Brigham 2011). Australian bonds also connect with China/Asia through exports; there is a potential growth as a result of stronger commodity export as evidenced by the China and Australia trading. Bonds are thus more liquid, growth focused, lower risk, and relatively high rate of return and diversification (Leibowitz, Bova & Hammond 2010). Cash This form of asset class has an average return rate of 5.74% and standard deviation risk of 0.01. As noted, the rates of returns on this form of asset class is lower, it has no minimum time for investment. As noted by the lower risk standard deviation 0.01, this class is the lowest in terms of risk and hence the significantly lower returns on investment. It is income focused with no potential growth; its inflation hedge is low hence meaning that it is more prone to the effects of inflation as compared to the other asset classes such as shares and property. Cash and other forms of fixed interest are normally high in liquidity as compared to other classes of assets (Leibowitz, Bova & Hammond 2010).. Question 4 Explain what is meant by the expected return and risk in finance. Include in your answer the relationship between the two concepts and use your answers from Question 1 above to illustrate this relationship. Expected return is the return which is expected as earnings by an investor from a particular asset in which the investor invests in with the consideration of the asset prices, growth rate potential and risks involved in the investment. There are a number of ways used in calculating expected returns based on the present data (historical data about the asset class), if there is no historical data, probability can be used as a predictive model while if there is are historical data, calculating the expected return utilize the past data or historical data in order to predict the future or the expected returns, the historical provided in question 1 above uses this method to calculate the expected returns of different asset classes and investment portfolio (Mankiw 2008). According Mankiw (2008) a risk is the possibility that the actual returns achieved differ from the expected returns, this is normally in a negative way (lower actual returns). It can also be defined as uncertainty in the distribution of the possible outcome. There are varying relationships between risk and expected return, it is commonly asserted that the higher the risk the higher the expected returns, however this is not always the case. There are risk preferences such as risk indifferent where the returns do not change as the risk increases, risk seeking where the return decreases for increased risk and the most common one called risk averse where the expected returns increases as risk increases Besley & Brigham 2011). Question 5 Discuss the meaning of diversification in finance and how it impacts the risk and return. Again use your answers from Question 1 to illustrate. Diversification in finance means the act of trying to reduce risk by investing in varied asset classes. In essence, a diversified portfolio will experience less risk as compared to the weighted risk of a single asset. A risk-averse investor will likely diversify to varying assets in order to significantly reduce the risks involved. Diversification can be achieved by investing in foreign and local assets classes such as bonds, property commodities and private equity among others. This can be done as provided in the question 1 example of the three portfolio packages Betta, Kappa and Omega. In Betta, the average returns are 8.59% while the risk standard deviation is 0.11. In Kappa, the, the average returns are 6.40% while the risk standard deviation is 0.03. In Omega, the average returns are 8.92% while the risk standard deviation is 0.16. As noted, a particular balance of investment yields the most investment plan as shown by Omega 8.92 %. A percentage of investment is made to different asset classes in order to reduce the risk involved in each investment plan. This geographic diversification provides a better and superior risk adjusted returns. In essence, the more diverse the investment the more returns expected and significantly reduced risk as compared to undiversified investment. Question 6 For each of the three customer types that you have, recommend the most suitable portfolio option and justify your choice. Use language here that the customers will understand. You might wish to use a graph here to show the historical return performance of each of your portfolios to assist with your recommendation. Rhiannan is a young graduate with a long career life expected; the best portfolio for her is Omega (50% Australian shares; 30% International shares; 20% property). The rationale for this choice is based on the fact that it has the highest expected returns of 8.92 %; it also has a highest standard deviation risk of 0.16. Rhiannan has time in case the risk occurs; on the other hand, the expected returns are more attractive especially considering her young age. Since 50% of the portfolio is Australian shares which attract high returns but requires a longer time frame, it is also income focused and growth focused with high potential of liquidity if she needs to readjust her investments in future. The 20 % property investment is also a form of long term plan which can be readjusted to increase in the future, this can be achieved by reducing the Australian shares and incorporating more property consideration. The graph on the of Omega from 1992 to 2011 is as shown below; Harry and Penelope are Middle Ages couple who are high income earners; they plan to retire in 10 years. The best portfolio for this couple is Beta (20% Australian shares; 40% property; 40% Australian bonds). The rationale for this recommendation is based on various aspects, the first one is the fact that property investment requires a larger amount of capital; this couple is in a position to fund property acquisition, property investment is income focused, growth focused and medium but constant returns with minimal risk involved. Property also has inflation hedge and hence important as a long term investment plan. This portfolio plan has a high return of 8.54 % and a small standard deviation risk of 0.11 and thus the best plan for Harry and Penelope as they prepare to retire in a decade. The graph on the of Beta from 1992 to 2011 is as shown below; For Phoebes, Kappa portfolio (70% cash; 20% Australian bonds; 10% property) is recommended because of the following reasons; considering the age of Phoebes, he is old and expected to retire in 18 months. By consideration, Phoebes does not need a high risk investment portfolio because he will not have time to invest again in the future, he hopes to enjoy his retirement benefits as soon as he retired in less than two years. The average expected returns in this plan as analyzed is 6.40 % with significantly low risk standard deviation of 0.03. The fact that the risks are lower is this investment portfolio is the rationale for the choice considering the age of the client (Lee & Lee 2009). The returns are also substantial and adequate to cater for the later years of the client and hence making it suitable. This portfolio is also high in liquidity Cash and bonds which makes up 90 % of the investment are highly liquid, this is important in case the client needs cash for other things (especially medical concerns of an aging person), this portfolio is also income oriented and hence offering the client adequate funds for survival in everyday life. The graph on the of Kappa from 1992 to 2011 is as shown below; Question 7 I will choose Omega (50% Australian shares; 30% International shares;20% property) the reason for my choice is because of the high rates of returns 8.92 %, despite the higher standard deviation risk of 0.16, I have time for readjustment and balance my portfolio in future in order to decrase the risks significantly. More so, Australian shares are highly liquid, offer high returns, growth focused and have a better hedge to inflation. On the other hand international shares will provide a good oportunity for diversification an aspect that will reduce risk and at the same time offer new opportunities in the global arena (Parrino, Moles & Kidwell2011). References Besley, S & Brigham, EF 2011, Principles of Finance, Cengage Learning, Sydney.p.45-67. Brigham, EF &  Houston, JF2009, Fundamentals of Financial Management, Cengage Learning, Sydeny.  pp. 240-243. Ehrhardt, MC & Brigham, EF 2010, Corporate Finance: A Focused Approach, Cengage Learning, Thausand Oaks. PP.123-143. Lasher, W 2010, Practical Financial Management, Cengage Learning, Sydney.PP.36-56. Lee, AC & Lee, JC 2009, Financial Analysis, Planning & Forecasting: Theory and Application, World Scientific, Sydney. PP. 113-117. Leibowitz, ML , Bova,AP, & Hammond, B 2010, The Endowment Model of Investing: Return, Risk, and Diversification, John Wiley & Sons, Melbourne. PP. 234-245. Mankiw, NG 2008, Principles of Macroeconomics, Cengage Learning, New York.PP.34-45. Parrino, R,  Moles, P & Kidwell, DS 2011, Fundamentals of Corporate Finance, John Wiley & Sons, Sydney.PP.89-102. Read More