Security Analysis and Portfolio Management - Assignment Example

Section A Question a) Beta is dead! Long live alpha – Absolute returns are more important than relative returns In investment management, two terms are quite common i.e. beta and alpha. In order to understand the terminologies of beta and alpha, it is equally important to understand the some investment management concepts in brief so that those concepts can be linked with beta and alpha. Capital Asset Pricing Model (CAPM) Capital asset pricing model is that technique which evaluates and generates the expected return of an asset given certain other variables such as market return, risk-free return, riskiness of the asset. The following is the equation of CAPM E(r) = Rf + Beta (Rm – Rf) In the above equation, Rf denotes to the risk-free return earned over government securities such as treasury bills. Beta refers to the riskiness of the stock associated with the overall market. Lastly, Rm means the overall return generated by the market. In the above equation, a relationship is identified upon the expected return that can be generated by a particular asset e.g. stocks. The equation shows that expected return of a stock should be at least the risk-free return plus the excess return of the market generated over the risk-free return associated with the riskiness of that particular stock. The difference between the market return and the risk-free return is regarded as the market premium as it is that return which the investor demands by bearing the risk on that stock as denoted by beta. As defined earlier that beta refers the riskiness of the stock, it works on the basis of the market beta which is benchmark beta with the figure of 1. Every particular stock has its own beta which can be greater than, less than or equal to the market beta of 1. A stock with the beta of 1 means that the stock is perfectly aligned with the market fluctuation such that if the market is up by 2% than that particular stock will be up by 2% and vice versa. If the beta of the stock is less than 1, it means that the stock is less risky as compared to the market. For instance, if the market goes up by 2% and the beta of the stock is 0.5, it will result in the upward movement of 1% only. Likewise, if the market is down by 3%, it will result in 1.5% of the downside movement of the stock. The third situation can be developed in such a manner where the beta of the particular stock is greater than that of 1. In such cases, if the market moves in upward direction by 3% it will result in an increase of 6% of that stock. Conversely, if the market is down by 5%, the stock will be declined by around 10%. This shows the importance of beta factor as the overall fluctuation in stock can be triggered by the behavior of beta with respect to market. In other words, beta is the most integral factor in deciding the relative return of the stock as it demonstrates the relative movement of the stock with respect to the market’s movement. Another important terminology is alpha factor which shows the actual return generated over the expected return. For instance, if a particular stock forecasts the expected return to be earned should be around 15% by using CAPM model and the actual return on the stock earned is 20%, it means the stock has the alpha factor of 5%. It may also be possible that the actual return may vary such that it can be 16% or may be 12%. In this way, alpha factor be substantially declined and even can be negative. The behavior of alpha factor mainly demonstrates the absolute return earned on a particular stock. The question now arises whether the beta factor which denotes the relative return over the stock is important for the investors or it is worthwhile for the investors to go for alpha factor which shows the absolute return earned over the stock. The beta factor is somehow based upon the past trends of the stock as well as of the entire market. It is important to note that the past patterns and trends are not indicative of the future performance of any stock or market. There are other macroeconomic factors which may drive the stocks or markets or other assets into a certain way which can deteriorate the expected returns earned over the stock. Investment analysts, fund managers and other associated professionals now consider what actually investor is earning rather than the expected earnings derived from the past figures. Actual earnings are portrayed with the help of alpha which is the most dominant factor in deciding absolute returns earned by the investors. Investors are also concerned with the actual performance of the stocks and the market rather than what expected returns show a misleading picture. The investment managers’ own performance is judged with the help of alpha such that it is alpha that they have earned over the computed expected returns. Expected returns on the other hand, set a benchmark return target for a particular stock based on the previous returns earned by that stock. If alpha is positive, it means that the investor has not only achieved the benchmark return on that stock but it has also earned excessive returns over that benchmark return. On a concluding note, beta only aims at the expected return and does not incorporate what actual earnings are received by the investors. Whereas, alpha is actual performance indicator which shows that actual amount of return earned and credited into the investors’ account. In this way, the relative measure of investment’s performance i.e. beta is not entirely relevant rather the alpha factor is more important as it shows the actual amount of return generated by the investors in the absolute form which is over and above the associated expected returns which are computed as a relative measure. In short, “Beta is almost dead! Long live alpha” b) Market risk is less important than company specific risk is share valuation and investment management The statement of Warrant Buffet and his mentor is quite appropriate which states that company-specific risks are more relevant than overall market risk in evaluating share prices and investment management. This statement can be evaluated on the two bases i.e. market risk basis and company-specific risk basis. Market risks are those risks which are beyond the control of market forces such that market participants have to bear those risks at any cost. For instance, change in the interest rate of the company, changes in tax laws, changes in foreign exchange reserves of the country, change in political climax of the country, change in peace and tranquility situation of the country and many others. When these factors make an impact upon the financial markets, the securities exist in the market experience severe fluctuations besides the fact that the overall business and financial performance and position of the companies remains the same. On the other hand, if company-specific risks are taken inconsideration, these are the risks that directly hit the company’s business and financial performance and position. Risks such as change in net revenues, change in growth of earnings, change in the product lines of the business, change in company’s policies, impact of a ban on some activities of the business in a region, change in capital structure of the company, etc. All these mentioned risks of the company, has an impact upon its own share performance but other companies’ share performances are not hurt with any other company’s performance. If the impact of market risks and company-specific risks are taken into consideration directly upon the share valuation, there are various differences in both types of risks that can be observed. Firstly, during share valuation phase of any stock, only those risks are incorporated which are company-specific risks such as expected change in revenue streams, expected growth in earnings, expected increase in debt financing as compared to equity, expected free cash flows to be generated etc. All these variables are considered while tracking the nearest share values to educate the investors in taking a certain position. In terms of investment management, diversification is the most important factor that should be considered while accounting for market and company-specific risks. The main purpose of creation of an investment portfolio is to achieve diversification. The question arises as how can diversification provide benefits to investors. Diversified portfolios are created in order minimize or even eliminate the company-specific risks from the portfolio. This occurs because of the fact that a perfectly well balanced portfolio absorbs the changes occurring in all the securities included in the portfolio and thus the overall performance of the portfolio does not get affected. However, investment portfolios are subject to market risks in such a manner that if the overall market is affected in either upward or downward side, it can also be reflected in the investment portfolios. This occurs because the securities included in the portfolio will be moving upward or downward direction all at the same time irrespective of their own company’s performance. In short, diversification can provide mitigation of company-specific risk in investment management but the same is not true for market risk as all the investors have to face this risk which is beyond the control of any industry participant. Section B Question 2 (a) 1 8.5 7.7273 0.0840 0.0840 2 8.5 7.0248 0.0764 0.1527 3 8.5 6.3862 0.0694 0.2083 4 8.5 5.8056 0.0631 0.2524 5 8.5 5.2778 0.0574 0.2868 6 8.5 4.7980 0.0522 0.3129 7 8.5 4.3618 0.0474 0.3319 8 108.5 50.6161 0.5502 4.4015 91.9976 1.0000 6.0306 Macaulay duration is 6.0306 and modified duration is 5.4823 (6.0306 / 1.10) b) Macaulay duration is higher for zero coupon bonds as compared to other coupon-paying bonds because of the discounting of coupon payments. As in case of zero-coupon bonds, all the cash flows associated with the bond are received at the maturity of the bond and thus are discounted with a higher discount factor. On the other hand, the periodic payments of coupon after regular intervals are discounted with relatively less discount factors to compute their present values. In this way, the present value of zero-coupon bonds is slightly less as compared to coupon-paying bonds and this also affects the Macaulay duration exactly in the similar manner. c) Financial markets are regarded as markets for loanable funds because mostly these markets work on the basis of debt financing. Apart from equity markets, all other markets principally work on the basis of providing loans to entities. For instance, banking companies provide different sort of debt financing and loan facilities to their clients whereas corporate entities arrange their financing mainly through issuing debt-based securities such as bonds and loan stock. In this way, the financial markets mostly serve the market participants in terms of arranging loans to other entities. d) Explain the following terms. i. Eurobond Market The Eurobond market is comprised of banks, investors, trading agents, and borrowers that transfer, sell, and buy Eurobonds. Eurobonds are a special type of bond that is issued by European companies and government, but denominate in currencies other than European such as yen and dollars. International bodies such as the World Bank also issues Eurobonds. The development of European currency, that is the euro, has created a significant concern in euro-denominated bonds. However, some analysts warn that tax harmonization policies of European Union may reduce the appeal of the bonds. Eurobonds are of recent origin and are considered as complex and unique instruments. They were introduced in 1963 but did not gain significance in international world until 1980s. Since then, Eurobond became an active and large constituent of international finance. Having important differences yet similar to foreign bonds, Eurobonds gained popularity among investors and issuers as they could offer anonymity and tax shield to their buyers. Another advantage of Eurobonds is that they could offer their borrowers international exchange rates as well as favorable interest rates. ii. Foreign Bond Foreign bonds refer to those debt securities that are issued in a domestic market by international borrowers, which are primarily financial institutions, Private Corporation, municipal and local government, central government and their respective agencies as well as international organizations. Foreign bonds are usually denominated in the domestic currency of the market. For instance, a bond issued by the government of Canada in the United States and is denominated in U.S. dollars is a foreign bond. The asset class of foreign bonds also comprise of foreign entities that were issued out of the country in their domestic currency. Comparable to the international equity markets, investments in foreign bonds also provide multiple latent benefits including diversification possibilities and higher returns for any investment portfolio. Appropriate international diversification can help in gaining benefits of growth rates of different countries and regions and balance out returns by avoiding or decreasing losses when the markets of U.S are not performing well. Despite being the largest bond market in the world, the U.S. bond market was top performing only twice in the past 15 years. A lot of investors find foreign debt securities attractive for they can include some of the best performing bond of the world to their portfolio. iii. Internal Market or National Market Typically known as domestic marketplace for offering services and goods within the boundaries of and governed by standard regulations of a specific country. The method of trading and issuing securities within a nation including its foreign market and domestic market is called as internal market or national market. Internal market is a market for trading securities in a single country within the jurisdiction of that respective country. A British corporation might issue a bond within the UK and the bond is denominated in pound sterling, such an instance will be regarded as Internal Market. Such bond is thereby subject to all trading laws and securities of Britain. Internal markets operate in opposed to external markets that are more commonly known as Euromarkets. iv. External Market or Offshore Market As explained by its name, being based outside the national boundaries of a country, the offshore market is described as corporations, foreign banks, deposits, and investments. It can be rightful decision of a company to move offshore in order to avoid tax or enjoy easy regulations. Offshore markets can also be used for illegitimate purpose such as tax evasion and money laundering. Many territories, jurisdictions, and countries possess offshore financial centers (OFCs). Some of the well-known centers include Bermuda, the Cayman Islands, and Switzerland. Some lesser known centers include Belize, Dublin, and Mauritius. The level of transparency and regulatory standards differs broadly among OFCs. Proponents of OFCs claim that they facilitate transactions of international business and enhance the flow of capital. v. Interbank Foreign Exchange Market Interbank foreign exchange market refers to that financial system and trade of currencies that occur among financial institutions and banks, excluding smaller trading parties and retail investors. While few interbank trading is conducted on behalf of bigger customers by banks, most interbank trading occurs from own accounts of banks. For foreign exchange, the interbank market serves commercial proceeds of currency investments along with a large amount of short-term, speculative currency trading. In 2004, the Bank for International Settlement compiled a data according to which nearly 50% of all foreign exchange transactions are particularly interbank trades. In a centralized market, every single transaction is recorded by volume traded and price dealt. Usually, there is one central place to which all the transactions can be traced and there is often only one market maker or specialist. It is crucial for individual investor to learn how the interbank market work as it is the best way to understand whether the price offered by broker is fair or not and how the spreads are priced. Question 3 1. Yields 0.04 0.0425 0.045 0.0475 0.05 0.0525 0.055 0.0575 0.06 Values 97.2449 97.0787 96.9132 96.7484 96.5842 96.4208 96.2579 96.0958 95.9343 Yields 0.06 0.0625 0.065 0.0675 0.07 0.0725 0.075 0.0775 0.08 Values 95.9343 95.7735 95.6133 95.4537 95.2948 95.1365 94.9788 94.8218 94.6654 2. (a) Yields 0.05 0.055 0.06 0.065 0.07 0.075 0.08 0.085 0.09 0.095 0.1 Values 123.384 119.034 114.877               87.538 (b) There will be a price change of -3.32 when yield increases from 8% to 8.5%. (c) There will be a price change of +3.47 when yield decreases from 8% to 7.5%. (d) Since the absolute gains and losses are not the same with the same percentage of price increase and decrease is applied, it shows there is no symmetry between gains and losses. 3. The lower quality bonds are those bonds which have a lower credit rating as mentioned by various credit rating agencies such as Moody’s, Finch, and Standard & Poor. These are the bonds that provide even higher returns in order to attract the investors but investors lack trust in these bonds and thus the overall yield of these bonds suffer. The other bonds which are classified as high quality bonds are likely to place their positive slope on yield curve but the low-rated bonds suffer a lot especially when the maturity period is quite long and the investors do not have big hopes in respect of future rating of these bonds. Question 4 a. Not in every case it can be better to have a portfolio with more convexity than the one having less convexity. There are two illustrations that can be provided in order to validate this point. First, if the yield curve shifts parallel then two portfolios having similar dollar duration will not yield the same performance. This is because the two portfolios might not possess the same dollar convexity. The second reason is that even though other things are equal, it would be better to possess more convexity than having lesser convexity, the market will charge convexity not in the form of lower yield but in the form of higher price. However, the advantage of higher convexity relied on how much yields change. b. A lot will disagree with the statement mentioned above. It is because a bullet portfolio depends on the extent to which the yield curve steepens. The crucial point to note here is that measures such as yield, convexity, or direction informs us very little about the performance of investment horizon for performance relies on the change in magnitude of yield curve as well as shifts in yield curve. Thus, if a manager requires placing a portfolio based on the expectations about how much the yield curve may shift, it is crucial to perform total return analysis. Works Cited Johnson, R. Stafford. Bond Evaluation, Selection, And Management. Hoboken, N.J.: John Wiley & Sons, 2010. Print. Read More