The Rate of Return - Essay Example

Name Course Instructor Date Rate of Return The rate of return is the gain or the loss on a particular investment over some specific time. The rate of return is explained as the percentage increase during the first investment costs. The gains that come from the investments are usually considered as any income that may be received from a security added to the capital gains. The rate of return measurements can be used when measuring any type of investment vehicle. This can be done if the assets are purchased at a time and produce some cash flow in future. The financial securities in this context are usually judged depending on their previous rate of return. This can also be compared with assets of identical type in order to determine the investments that are most attractive. (Van Greuning, 2011)This can also be simply defined as the average profit that comes from an investment and is divided by the average investment. It can be obtained by taking the average accounting net income and dividing it by the average investment that has been invested in a project. This will help in determining whether an investor should proceed with a particular project or not. This rate of return is mostly based on the changes in value of an underlying asset which is usually adjusted for some payouts. For example, a bond usually has a rate of return that is equal to the total interest that is paid by the bond that is adjusted for any changes in the price of a bond in context. For a stock, the rate of return for the stock is usually the change in the price of which has been adjusted for any upcoming dividends. The rate of return should always account for any form of capital distributions with the pooled funds and any other investments. Rate of return is an annual percentage. An annual rate of return of 8 percent also means that the investment has gained 8 percent over the last year or over the period of twelve months. (Van Greuning, 2011)On the other hand, interest rate risk is any chance that the value of an investment can be affected by an unexpected change in the interest rates. This means that it explains the chance of the investment value being affected negatively by an external unexpected change which in this case is the interest rates. For example, if an individual purchase or buys a bond from a company, because most of the time the bond prices usually fall then the interest rate increases, when there is an unexpected increase in the rates of interest, it will automatically mean that the investment made will most likely lose its value. If the individual wishes to sell the bonds before they mature, they will record losses and this will be termed as a capital loss. The interest rate risk is the probability of any unexpected change of interest rates that negatively affect the value of an investment. When it comes to the importance of the rate of return, it goes without saying that it is very beneficial to the balance sheet when making investments on equipment and purchases on the assets. The calculation of the rate of return will help when evaluating on whether it is wise to purchase equipment or not. This calculation is very important as it will help the company to identify if it an investment that is purchased would yield returns that will warrant the investment made. It is also helpful when the rate of return is calculated as it will help in the confirmation of the assumptions use in allocating the fair value of any business that has been purchased. The accounting standards usually require for a company to allocate the fair value of any purchased item be it an asset or a liability. The profit rate swap is an agreement that is held between two parties or groups who are known as counterparties. (PLC, 2012) This is where a stream of future interest payments is usually exchanged for another one. This is mostly based on a specified principle amount. These profit rates swaps usually exchange an amount that is fixed with a floating payment which is mostly linked to an interest rate. Companies mostly use profit rate swaps so that they manage their exposure to the fluctuations and changes in interest rates. The profit rate swap and interest rate swap are almost identical. The two parties will tend to exchange the periodic fixed and floating rates of payments. There are some advantages and disadvantages when calculating of rate of return. (Account learning, 2011)The main advantages are that it is usually based on accounting information only and does not require any special form of reports for it to be determined. It is also very simple and easy to understand. It also helps in the measuring of the profitability of an investment made. This is because it is determined and calculated from accounting profits. The three main disadvantages that are clearly known are that it usually ignores the time value of the money which is in context. It is also disadvantageous because it usually ignores the cash flow that is from investments. This usually makes it difficult for the estimation and determination of the rate of return. It also does not consider the terminal value of any project that is being undertaken. This makes it not so convenient for the accounting of the rate of return. Supervisory Discretion Formula The supervisory discretion formula requires the IIFS so as to hold displaced commercial risk in respect to the capital. Most of the assets that are funded by UPSIA are included in the denominator of the Capital adequacy ratio. The value of alpha is also subject to supervisory discretion formula. The supervisory authority can also decide to increase the treatment that is to be given to all restricted investment accounts. The Institutions offering Islamic Financial Services (IIFS) recommend that the supervisors should assess the extent of the risks that are borne by the Profit-Sharing Investment Accounts (PSIA). They should reflect the assessments when it comes to the computation of the capital adequacy. The main challenge facing Institutions offering Islamic Financial Services and their leaders is to assess the risk sharing level that is between the Institutions offering Islamic Financial Services’ own capital which is in most cases the shareholders money and that of the investment account holders (IAH). The supervisory assessment on how an IIFS is able to manage the risk return mix of PSIA, it would help in determining the alpha factor, with a value of alpha which is near zero. This reflects an investment like product where the investor bears the commercial risk. On the other hand, a value of alpha which is close to one would reflect a deposit like product with the depositor effectively bearing virtually almost no commercial risk. Alpha is also the ratio of risk that is being transferred to the company’s’ shareholders. In other terms, it is the Displaced Commercial Risk in the situation where there is the transfer of full risk to the shareholders. There are several importance’s of the supervisory discretion formula which includes to provide and make a methodology that will help to estimate the values of alpha that will be used in the when calculating the Capital adequacy ratio (CAR) of Institutions offering Islamic Financial Services. It is also used to demonstrate how an individual can measure the Displaced Commercial Risk (DCR). This is the additional risk that Institutions offering Islamic Financial Services shareholders can assume so that they can use it to cushion the returns payable to Investment account holders (IAH) against variations in asset returns. There are several studies that have been conducted by the IFSB and they have indicated that the CARs of IIFS are mostly very sensitive to the value of alpha when it changes. The implication of this finding is that if the Capital adequacy ratio of an IIFS is calculated and not estimating a value of alpha that is reasonably realistic, the CAR will not provide an adequately accurate measure of the Institutions offering Islamic Financial Services’ capital adequacy. For example, if a value that has been set as alpha is too high, it would entail excessive capital requirements for the Institutions offering Islamic Financial Services. This negatively affects the efficiency of IIFS. For almost the same reason, setting a value of alpha that is too low would include insufficient capital requirements for the IIFS and resultant prudential risks. Therefore, regulatory and supervisory authorities should satisfy themselves that the estimated value of alpha and their corresponding capital requirements are reflecting as accurately as possible the true risk profile of IIFS at both national and institutional levels. It is also very important that the supervisors realize the stress conditions which arise when determining the alpha. The Displaced commercial risk is higher during stressed conditions because investment returns are lower. This leads to increased needs for an IIFS to draw upon the reserves which are mostly the shareholders funds. This will help in maintaining the same level of payout to the Investment account holders. To account for the potentially higher Displaced Commercial Risk during stressed conditions, the supervisors should all aim to incorporate the historical data from meaningful and significant stressed periods where they may be available. This is reflected as stressed alpha. Under this scenario that all commercial risks arising from the assets that are funded by Investment account holders are borne by themselves, the Investment account holders bear no losses and any commercial risks that may be arising from assets funded by the Investment account holders are borne by shareholders. This means that the Displaced Commercial Risk will be at its maximum and the values of “alpha” and “w” will also be at their maximum which is 1.Any other risk determinants such as income transfer from shareholders to Investment account holders will vary and differ according to the payout policies that have been adopted by the Institutions offering Islamic Financial Services. Liquidity Risk This is the risk that is stemming due to the lack of marketability of an investment that cannot be sold or bought quickly so as to reduce loss. (Investing Answers, 2012)The liquidity risk is usually reflected in an unusually wide bid-ask spreads or even the large price movements especially to the downside. The rule is that, when the size of the security is small, the liquidity risk is larger. It can however affect even the largest stocks in case of times of crisis. The liquidity risk can also be termed as the profitability of loss that is arising from a particular situation where there is no enough money or cash equations which will meet the needs of borrowers and depositors. Also, when the sale of illiquid assets leads to yielding less than their fair value or finally when illiquid assets are not sold at the desired time due to the lack of sufficient buyers. Liquidity risk is generally the risk that a company or institution or even a bank may be unable to handle and meet the short term financial demands. This can occur due to the inability to change a security or hard assets into cash without making any losses of capital or income in the whole process. (Finra, 2013)The liquidity risk usually arises when a business or an individual with important and immediate cash requirements and needs, holds a valuable asset which cannot trade or even sell at the market value from the lack of people to buy. It can also happen when there is an inefficient market where it makes it difficult to bring the buyers and the sellers together. A good example is when there is a home worth ten million but there are no people to buy it the home is obviously very valuable but since the market conditions are not favorable at the moment and time, there may not be any interested buyers. When the economic times improve and the demand increases, the home may be able to be sold for a better price slightly above the value of it. However, due to the need of the home owner and his financial desperation too meet urgent financial needs, the home owner can be unable to wait for the economy to improve and make the sale. The owner has to sell the house in a market that is illiquid leading at a loss. This causes the liquidity risk of holding this particular asset. There are different and various types of liquidity methods. (Finra, 2013) The first one is the cash balance in account. This is usually the highest and largest form of liquidity but it usually earns no interest due to the simple reason that it is not deposit that is kept for a specific period. On an average, companies tend to keep and maintain a minimum of at least five percent upon the nature of the business. If the business is cash oriented, the company will have to maintain a cash balance of 20 percent of their total assets in an account. Some of the companies that usually fall in this bracket are the trading and financial enterprises. But companies that are service oriented tend to have les amounts of cash in the accounts. The other type of liquidity is the overdraft arrangement with banks. (Tutor Sonnet, 2013)This type of liquidity is only available for businesses with current accounts. The amounts of money that are lying idle in their current accounts do not earn any type of interest. At any point in time, the company is not allowed to borrow or make any payments that may be above the fixed limit. The overdraft that has been availed is usually repayable if the bank demands. There are cases that the bank can require for the banks to keep a security against it. There are also marketable securities. They are short term investment instruments which help to obtain a return on the idle funds. The characteristics of marketable securities affect marketability. For a security to be liquid there must be two major characteristics. They include a safety of principle and a ready market. When selecting a proper marketable security, there are several things to be considered namely: financial risk, interest rate risk, taxability, liquidity and yield. The most used form of securities is the Treasury bill. Factoring is also another form of liquidity. (Tutor Sonnet, 2013)Factoring is a method that uses receivables for financing. The accounts that are receivable act as security for financing that is made by the bank. Factoring is hence the outright sale of accounts receivable to a bank without any resource. Factoring has several advantages like it usually offers immediate cash and this helps in liquidity. Factoring also allows for the receiving of advances which are required on seasonal and occasional basis. This usually strengthens the company’s position in the balance sheet. References: Account learning, (2011), Account-Management: Advantages and Disadvantages of Accounting Rate of Return (ARR), Retrieved from, http://accountlearning.blogspot.com/2011/07/advantages-and-disadvantages-of.html?m=1 Finra, (2013), Smart Bind Investing: Inflation and Liquidity Risk, Retrieved form, www.finra.org/investors/investmentchoices/bonds/smartbondinvesting/risk/p133238 Hennei Van Greuning, (January 29, 2011), Risk Annalysis foor Islamic Banks: Supervisory Discretion Formula, Retrieved from, http://books.google.com/books?id-EjlsEs4yPMC&pg=PA227&PA227&dq=supervisoy+discretion Investing Answers, (2012), Liquidity Risk Definition & Example: Investigating Answers, Retrieved from, http://www.investigatinganswers.com/financial-dictionary-corporation/liquidity-risk-630 Investing Answers, (2013), Definition & Example: Investing Answers http://www.investinganswers.com/financial-dictionary/bonds/interest-rate-risk-979 PLC, (July 15, 2012), Profit Rate Swap, Retrieved from, http://construction.practiceallaw.com/6-501-7101 Tutor Sonnet, (2013), Online Tutoring: Types of Liquidity, Retrieved from, http://www,tutorsonnet.com/homework_help/cash_management/types_of_liquidity_assignment_help_online_tutoring.htm Read More