Concepts of Systematic and Unsystematic Risk, Variance, Covariance - Essay Example

? Number: Whether the present value of cash flow approach and the relative valuation approach to security valuation can be considered to be competitive or complementary Valuation is the process of determining the value of an asset. Present value of cash flow approach to security valuation has three subdivisions of measuring the value of an investment. These are the present value of dividend, present value of free cash flow to equity, as well as the present value of operating cash flow. Present value of Dividends employs the cost of equity as the discount figure. Operating free cash flow is the cash residue after eliminating direct costs, working capital and capital expenditure needed for future growth, but before any payments to suppliers of capital. The firm’s weighted average cost of capital (WACC) is the discount rate employed in determining operating free cash flow. Free cash flow to equity refers to operating free cash flow less payment to debt holders (Strong, 2008). The firm’s cost of equity is used as the discount rate. Present value of Cash flow allows a degree of flexibility for changes in sales and expenses, which implies varying rates of growth over time. However, present value of cashflow valuation approach has a weakness in that it is heavily dependent on growth rates of cash flows and the discount rate estimates. Relative valuation approach to security valuation offers information on how the market is presently valuing the stock. Components measured using the relative valuation technique include the price earning ratio, price to sales ratio, price to book value and the price to cash flow. Unlike the present value of security valuation, relative valuation approach does not offer insights as to whether current valuations are appropriate. Thus, valuations could be too low or high at a certain point in time. As such, Relative valuation is suitable when there are comparable firms in terms of the risk, industry and size in the market. It is also appropriate when the aggregate market and the entity’s industry are not under valuation extreme. That is to mean that the collective market and the firm’s industry should not be acutely overvalued or undervalued (Strong, 2008). Both cash flow approach and relative valuation approach have several factors in common. One is that they are both affected by the investor’s required return on the stock since this return rate becomes a significant element of the discount rate. Secondly, the two valuation approaches are affected by the growth rate estimation employed in the valuation technique such as dividends, sales or earnings. Therefore, the two approaches may be considered as complementary. 2. The concepts of systematic and unsystematic risk, variance, covariance, standard deviation and beta as each of these relate to investment management. Unsystematic risks refer to the kind of uncertainty that is associated with the industry in which a company operates. Unsystematic risks are also referred to as specific risks or diversifiable risks for they are specific in each industry, and they are reduced through diversification. Unsystematic risks arise as a result of factors particular to an industry or the firm such product category, marketing, research and development and pricing. Systematic risks refer to the kind of uncertainty that is inherent in the whole market segment. They are also referred to as market risks or non-diversifiable risks because they are inherent in the entire market and diversification do not result in their reduction. Systematic risks are such as war, inflation, change in taxation, global security perils and political instability that affect the functioning of firms in all industries. Total risk is a combination of systematic and unsystematic risks. Variance is the measure of volatility from the mean. Variance helps an investor to establish the risk involved in purchasing a certain security. A higher variance indicates greater variability and thus greater risk. A greater variance also implies that the mean is less helpful in estimating future values for the data. Covariance reflects the extent to which different assets are correlated with each other. The covariance of an asset with itself is just its variance. Standard deviation refers to the arithmetic measurement on historical volatility of an investment. Standard deviation is the square root of variance and helps an investor to know the extent of variation or dispersion from the mean or the anticipated value. Beta is a computation of the instability or systematic risk of a portfolio or a security in relation to the market as a whole. Beta helps an investor to understand the market risks of a certain stock by comparing it to the risk of the greater market.” ?” is used to denote beta in the capital asset pricing model. 3. Why might an investor choose to invest in the common stock of a company rather than its corporate bonds? Common stock holders are the owners of the company and their ownership entitles them to the form’s earning that remain after all other groups having the claim on the firm have been paid. Every holder of the common stock owns a certain proportion of the company, which is represented by the fraction of the number of shares held. Common stockholders receive common stock dividends as their return on investment. Corporate bonds are issued by a corporation and pay their owners interest throughout the life of the bond, as well as the principal amount upon maturity (Fabozzi & CFA, 2009). An investor may choose to invest in common stocks over corporate bonds due to flexibility that common stock has over bonds. Common stocks can be easily liquidated at a fair price. An investor may also opt to invest in common stock if he/she is interested in dividends and capital gains. When the company becomes more valuable, the ownership interest represented by each common stock also increases in value (Ferri, 2010). The reason is that common stockholding represents ownership of the company. Therefore, appreciation in the price of common stock reflects a market gain. Moreover, when a company has earned profits, it may opt to distribute the excess profits to its owners; common stockholders. Common stock has a probability for resulting in high gains of more than 100 percent for investors, unlike corporate bonds, whose returns do not exceed the interest rate. Common stocks also are an excellent mode for long term investments. The reason is that there is adequate time for the market to correct any downtown that might cause a decrease in the stock value (Klein, Dalko & Wang, 2012). A long time investment in common bonds has a relatively higher rate of return as compared to corporate bond investment over the same period. The following example shows the growth of $ invested in common stocks against $1 bonds invested in a similar period. Source: Russell Investments, 2013 4. Provide an example on an empirical work that produces results which challenge the semi strong form of the efficient market hypothesis. Describe these results and outline specifically why these results did not support the hypothesis. Semi-strong efficiency theory holds that stock prices react almost immediately after any fresh public information regarding an asset. This implies that only information that is not in the public domain may be beneficial to investors wishing to earn abnormal profits on investments. A class of efficient market hypothesis implies that all public knowledge is incorporated into a stock’s current share price. Several studies provide evidence that challenge the semi-strong market efficiency. Engelberg, Sasseville, and Williams carried out a study using 246 original commendations offered by Jim Cramer on his Mad Money on CNBC, in the period 28 July 2005and 14 October 2005. Their results revealed that viewers of Cramer’s show who bought the recommended securities when the markets opened the subsequent day were losers in general (Dodson, 2006). The study also found that stock-price run up and volume increases before Cramer’s purchase recommendations. The study thus concludes that that Cramer’s advice has a short term effect in the short run, and thus the show led to mispricing in the market. 5. How the four main asset allocation strategies differ from each other Assets allocation may be divided according to various strategies. These are the policy asset allocation, dynamic asset allocation, tactical asset allocation and integrated asset allocation. Dynamic asset allocation steadily adjusts the mix of assets whenever market increases or declines, as well as when the economy grows and slumps. In dynamic strategy, an investor sells off the assets whose value is reducing, and buys assets whose value is increasing. In dynamic asset strategy, the asset mix is mechanistically shifted in response to changing market conditions. Dynamic asset allocation is the long term policy decision and the intermediate efforts to purposefully position the portfolio to gain from major market moves (Lustig, 2013). Tactical asset allocation seeks to diverge from the rigidity that may be associated with long term strategic asset. Tactical allocation is thus the short term deviations from the portfolio so as to benefit from extraordinary investment opportunities. Tactical allocation thus helps an investor to engage in favorable economic conditions for one classification of assets than for others. The policy asset strategy is loosely characterized as a long term asset allocation decision. In policy asset strategy, the investor attempts to evaluate a suitable long term asset that represents an ideal mixture of controlled risk and enhanced return. Strategies that give the largest prospects for greater long term rewards to accomplish goals tend to be inherently risky strategies. The policy asset allocation helps in balancing these conflicting objectives. Integrated asset allocation strategy considers both the economic prospects and the risk in determining as asset mix. While the other strategies incorporate anticipations for future market returns, not allocation strategies account for risk tolerance in investments. Integrated allocation incorporates all aspects of the above strategies, accounting for both real changes in capital markets as well as, risk tolerance. Reference list: Ferri, R.A., 2010. The Power of Passive Investing: More Wealth with Less Work. NJ: John Wiley & Sons. Fabozzi, F.J. & CFA, 2009. Institutional Investment Management: Equity and Bond Portfolio Strategies and Applications. NJ: John Wiley & Sons. Lustig, Y., 2013. Multi-Asset Investing: A Practical Guide to Modern Portfolio Management. UK: Harriman House Limited. Klein, L., Dalko, V. & Wang, M., 2012. Regulating Competition in Stock Markets: Antitrust Measures to Promote Fairness and Transparency through Investor Protection and Crisis Prevention. NJ: John Wiley & Sons. Russell Investments, 2013. Stocks and bonds. Accessed on 7 May 2013 from. Strong, R.A., 2008. Portfolio Construction, Management, and Protection [With Stock-Trak]. Connecticut: Cengage Learning. Read More