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BSM002: Finance Theory Assignment sample

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BSM002: Finance Theory Assignment sample

Task 1

1a

Portfolio Theory: The theory which includes the Investing decision of a person correlated by risk and return depending on the market conditions and expectations. In other words it can be said that ways in which one individual can maximise profit by investing in a diversified portfolio.

There are many portfolio theories such as Modern portfolio theory, Traditional Approach, Random Walk Theory based on market Hypothesis which aim at maximising return but with a reasonable risk. Such as modern portfolio theory also states that variance and covariance with a good investing decision is must before investing in financial securities. One should maximise return by attaining the minimum risk by selecting the best portfolio available with us. Such as depending on the situation such as minimum risk with greater return and maximum risk with greater return. Portfolio should be in such way that there is minimal risk associated with stock of different securities, so these theories help us in deciding which stock to choose

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Risk and Return: It is the amount of profit that is earne4d over a period of time with taking possible risk with one's own capacity. Risk is the amount of unpredictable loss or unforeseen situations that are hard to remove but can be minimised to some extent by selecting the best option available with us. So it can be said that there is a positive relation not an adverse one with each other. So the financial securities must be taken into consideration taking this into account with the utmost priority (Kelly et al., 2019).

Generally to start with the portfolio theory is directly related with risk and return and older concept of portfolio allocation, one thought that return could be minimised but risk should be lower in nature and now in this era it has completely changed an investor thinks that his/her portfolio should be diversified with maximum return. It is said that higher the risk greater the return and lower the risk lower the return. Time frame also plays a vital role in determining the risk and return because in long run we can assume and predict more return. By this he means to take more risk in order to gain more return which is completely opposite to the previous concept.  Variance and Co variance both play a vital role in determining one's risk and return and hence deciding the ultimatum portfolio risk. One of the major contributions of portfolio theory is that it suggest measures how to diversify the various assets and minimize risk to a large extent and earning a quantifiable amount (Kelly et al., 2019).

Financial Securities: It is a wide term which is used to describe bonds, securities, stocks which have a tendency to earn maximum profit under given set of conditions with maximum future benefits. It is financial instrument which states that investing is done by these forms. Traditionally these were in physical forms but nowadays they are in electronic form (Begley & Purnanandam, 2017).

Major characteristics of Financial Securities in understanding risk and return are as follows:

  • One must not invest money is single asset but should have sufficient knowledge of various financial securities so that he has a diversified portfolio leaving him with maximum return.
  • Market risk is one of the major components that should be kept in mind while allocating different financial securities in the portfolio (Begley & Purnanandam, 2017).
  • Determining the portfolio of financial securities another component that should be kept in mind is the market risk through which expected return is hampered sometimes.
  • Investing can be in many ways in financial assets or financial securities with the aim of attaining maximum expected return.
  • Financial Securities are issued at a specific date
  • Financial Securities are tradable financial asset.
  • Financial Securities have a specific Monetary Value.
  • It can be in Long term form or short term form (Begley & Purnanandam, 2017).
  • Financial securities are redeemable in nature that means they can be redeemed anytime in the nearby future, which is the utmost feature of the financial securities.
  • It is fully in the negotiable form
  • Financial Securities is a legal proof of the ownership
  • Financial Securities are convertible in nature (Mutende et al., 2017).
  • There is no specific return in investing in Financial Securities, so analysing the scenario is must.

So, while deciding diversified portfolio with different financial securities with the aim to maximise return and minimise return market return should be kept in mind. It also depends on the market situations and economic fluctuations. The market scenario that is sometime positive and sometime negative which will determine the expected return in the nearby future and also the risk associated with it (Mutende et al., 2017).  The contributions of Portfolio theory is therefore must in analysing the market conditions and picking up the best stocks which are expected to earn good return. Risk can also be high in case of adverse economic conditions and can be minimal in case of good economic conditions. Likewise, it is always said that there should be favourable economic conditions with more growth , more GDP so that there is maximum expected return in the nearby future with the diversified portfolio.

 

1.b

 

Stock X

Stock Y

 

Expected (Mean) Return

10%

15%

 

Standard Deviation

13%

17%

 

 

 

 

 

Correlation

90%

 

 

 

 

Weights

 

Portfolio Statistics

 

Stock X

Stock Y

Std Dev

Exp Return

0.00%

100.00%

17.00%

15.00%

5.00%

95.00%

16.74%

14.75%

10.00%

90.00%

16.48%

14.50%

15.00%

85.00%

16.23%

14.25%

20.00%

80.00%

15.98%

14.00%

25.00%

75.00%

15.74%

13.75%

30.00%

70.00%

15.50%

13.50%

35.00%

65.00%

15.27%

13.25%

40.00%

60.00%

15.05%

13.00%

45.00%

55.00%

14.84%

12.75%

50.00%

50.00%

14.63%

12.50%

55.00%

45.00%

14.43%

12.25%

60.00%

40.00%

14.23%

12.00%

65.00%

35.00%

14.05%

11.75%

70.00%

30.00%

13.87%

11.50%

75.00%

25.00%

13.70%

11.25%

80.00%

20.00%

13.54%

11.00%

85.00%

15.00%

13.39%

10.75%

90.00%

10.00%

13.25%

10.50%

95.00%

5.00%

13.12%

10.25%

100.00%

0.00%

13.00%

10.00%

       

 

Maximising return in a portfolio can be done by choosing the best alternatively by finding low cost ways for investing and by diversifying the portfolio and thinking about the nearby future what a good portfolio should have to maximise the return. It can be considered as an investment tool to maximise the return and try to minimal the risk.

Optimal Portfolio is one in which risk in minimised to an extent at a given level of return that is they both are correlated, one cannot be taken individually. In other terms it can be said that higher risk is taken to gain higher profits in the nearby future. It can also be said that it is the efficient frontier at which one gains the maximum return. Generally it can be related with the demand and supply where they both meet. The point at which they meet is called the optimal level. It depends upon investor's preference with respect to risk and return. In respect of that one should optimize its financial securities by expecting highest return.

Reference Source: https://www.motilaloswal.com/article-details/what-do-we-understand-by-an-optimal-portfolio-/1924

Market Portfolio: It is combination of different types of investments that includes different stocks and bonds having market value with expected returns. It also measures the weighted average of beta coefficient of different individual stocks in a portfolio. In other words it can also be said that it is a portfolio that consists of all different securities where the proportion invested in each one corresponds to their relative market value. Investors hold a certain positive amount of each and every risky security. It is a cluster of investments that includes every possible investments which are good for one's portfolio (Fjesme, 2020).

 

Capital Market Line is a line that depicts portfolios that usually combine risk and return. It shows various points of combinations and one can select the optimal level, where risk in less and return is more. Generally it is straight because it is a tangent drawn between the two assets which are positively correlated.  It is a theoretical concept that links risk and return (Fjesme, 2020).

In the first case, where we have two stocks, with expected return of stock X of 10% and of stock Y with 15% and deviation from the mean of 13% of stock X and 17% of stock Y . The correlation in this case is higher that is 90% which is the second case. Here we are considering the first scenario where correlation is higher that means that the expected return should be maximised in this case, and it is in the first case where sock Y is completely favourable and there is no role of stock x. Here it depends on individual that whether he wants to optimise maximum return with minimal risk or whether he wants to have less return with neutral risk.

For example if an individual opt for maximum return he can go for stock Y and if one wants lesser risk than he can go for solely with stock X. At one point there is reasonable amount of risk with return which is investing 60% in stock X and 40% in stock Y. After this point the return keeps on decreasing with increasing risk. So, ultimately one is responsible for the options available (Arslanalp & Tsuda, 2015).

 

 

Stock X

Stock Y

 

Expected (Mean) Return

10%

15%

 

Standard Deviation

13%

17%

 

 

 

 

 

Correlation

10%

 

 

 

 

Weights

 

Portfolio Statistics

 

Stock X

Stock Y

Std Dev

Exp Return

0.00%

100.00%

17.00%

15.00%

5.00%

95.00%

16.23%

14.75%

10.00%

90.00%

15.48%

14.50%

15.00%

85.00%

14.77%

14.25%

20.00%

80.00%

14.10%

14.00%

25.00%

75.00%

13.47%

13.75%

30.00%

70.00%

12.89%

13.50%

35.00%

65.00%

12.36%

13.25%

40.00%

60.00%

11.90%

13.00%

45.00%

55.00%

11.51%

12.75%

50.00%

50.00%

11.20%

12.50%

55.00%

45.00%

10.98%

12.25%

60.00%

40.00%

10.85%

12.00%

65.00%

35.00%

10.81%

11.75%

70.00%

30.00%

10.87%

11.50%

75.00%

25.00%

11.02%

11.25%

80.00%

20.00%

11.26%

11.00%

85.00%

15.00%

11.59%

10.75%

90.00%

10.00%

11.99%

10.50%

95.00%

5.00%

12.46%

10.25%

100.00%

0.00%

13.00%

10.00%

 

In this condition which is the second most there is expected return of10 % in stock X and of13 % in stock Y and standard deviation of 13% of stock X and 17 % of stock Y. Here the correlation is less that is 10% which is to be considered in the second case .Here, it is the case with minimum return that is in the case with the option in which one invests fully in stock X with 10% return and more of risk. Here the expected return is minimum i.e 10% when compared to other options. Now talking about optimal level which is reasonable risk with return is preferred over other cases. At some point risk is higher with more return and gradually the risk keeps on decreasing at one point the risk is reduced to a larger extent and which is preferred. Mostly it is not taken into account as by taking 13% of risk one is able to earn only 10% of profit and there are much good options available other than this. Therefore, one should be sharp while analysing which option to go for (Arslanalp & Tsuda, 2015).

Now looking at the market capital line first it increases and at reaching at one point which is maximum it decreases till .1%. It depends on the market conditions and economic fluctuations which hampers the decision of an individual which option to choose. This clearly shows that the x axis shows the risk and y axis the expected return. Hence the portfolio opted should be in that manner that one gains maximum return with minimal amount of risk in the scenario. So, the market conditions should be carefully studied and depicted.

Looking at past data we can again see that the WG Group has lesser return when compared with the other one.

Task 2 

(Source: World Government Bonds, 2020)

Interest Rates:

It is defined as the amount that is due for the amount lended for a period of time which generally varies time to time. Interest rates are generally decided by the head institution in the country which other follows for time being till it is not changed periodically. The highest authority determines the interest rates also keeps on changing because highest interest rates over a period of time may lead to inflation and then it will hamper the economic conditions of the country so there should be constantly improvising the interest rates so that inflation does not occur in the country which hampers the purchasing decision of the people and  also the standard of living is also hampered over a period of time (Saymeh & Orabi, 2013).

Inflation Rates:

Inflation is generally described as a hike in price level in which the value of the particular country's currency keeps on declining which can be positively sloped or negatively sloped. These rates should be minimised up to some extent so that inflation does not persists over a long period hampering the country status in the world. The inflation rates are generally determined by the economic conditions of the country and directly impact the purchasing power of individuals (Saymeh & Orabi, 2013).

Future Economic Activity:

The prediction as to how things will work in the nearby future with past and present records and some assumptions for future. The economic conditions of a country such as GDP, Growth Rate, Inflation rates, Interest Rates all are considered to be economic activities. If we look at the present scenario that is of Covid-19, the growth rate has subsequently declined over past few months.

The yield curve is a line that shows idea of future interest rates and current yield curve is represented above and is somewhat neutral and when compared with previous years, and generally it depicts a fair picture of long term and short term interest rates. Current Yield Curve is a curve that depicts the current picture of the country.  Inflation rates also play a vital role as to which the yield curve is plotted against.

We can also see that during the last years there was a gradual rise which indicates that there is growth and when related with interest rates it has an inverse relationship with growth prospect. That means higher the interest rates lesser the growth prospect and vice versa.  In the graph depicted above also we can see that in the last month there was huge rise and during last 6 months there were ups and downs in the yield curve which meant that there were no stability in the interest rates and growth profile.

This yield curve is of India and states that there was a major fluctuation in this time frame which was somehow due to the interest, Market conditions. 

Task 3 

(Source: Investing.com, 2020)

Market anomalies generally mean the factors that are responsible for the changes in the price level. It also states these are those factors which contradict our expectations about the future market growth and future value of our stocks and bonds in the portfolio. It can also be said as the abnormal or irregular conditions in the market which will hamper our expected return.

  Some of them which are so common are Holiday effect, Monday effect, Value effect, Momentum Effect, January Effect, and Turn-of-the-month Effect etc. These are some which have a higher impact in the prices of the stocks.  Likewise, here it is seen that the market anomalies have played a vital role in determining the prices of the shares. UK Stock market has shown a great variation during this period. Here we can see the previous data that is the prices of the last year. We can clearly see that market situations have a great impact which is clearly visible like in January we have a higher price and as soon as we had Corona news in the market it had a huge impact in the price (Degutis & Novickyt?, 2014). The price had reduced to a larger extent by approximately Rs1000. This lockdown had an impact on the economic conditions of the country which stated that there was no one who was investing money to a larger extent as before. Somehow there were negligible changes too. Again the prices were about to increase as there was some news in the market about the corona Vaccine which led to the increase in the prices of the share. Besides the market anomalies there are more situations which affect the prices and in other words it can be said that the efficient market Hypothesis is solely represented by the share prices which is somewhat true in the cases. Market Hypothesis could be Strong, Semi-Strong and weak which means sometimes there can be variation in the hypothesis and the prices in the current scenario. Efficient market hypothesis should be reflection of all the share prices over a period and should be optimised. And we can clearly see that is the case here also. Total average change is negative which means that there is huge change in the prices. It also shows that when the investors will be gaining the maximum profit and what is the right time to go for the purchasing decision. And this crucial decision should be taken considering all the factors which are right for investment (Degutis & Novickyt?, 2014).

Reference:

Arslanalp, S., & Tsuda, T. 2015. Emerging market portfolio flows: The role of benchmark-driven investors.

Begley, T. A., & Purnanandam, A. 2017. Design of financial securities: Empirical evidence from private-label RMBS deals. The Review of Financial Studies30(1), pp.120-161.

Degutis, A., & Novickyt?, L. 2014. The efficient market hypothesis: A critical review of literature and methodology. Ekonomika93, pp.7-23.

Fjesme, S. L. 2020. Foreign market portfolio concentration and performance. Financial Management49(1), pp.161-177.

FTSE 100 Historical Rates - Investing.com India. (2020, December 11). Retrieved December 13, 2020, from Investing.com India website: https://in.investing.com/indices/uk-100-historical-data

?Kelly, B. T., Pruitt, S., & Su, Y. 2019. Characteristics are covariances: A unified model of risk and return. Journal of Financial Economics134(3), pp.501-524.

Mutende, E. A., Mwangi, M., Njihia, J. M., & Ochieng, D. E. 2017. The moderating role of firm characteristics on the relationship between free cash flows and financial performance of firms listed at the Nairobi securities exchange. Journal of Finance and Investment Analysis6(4), pp.1-3.

Saymeh, A. A. F., & Orabi, M. M. A. 2013. The effect of interest rate, inflation rate, GDP, on real economic growth rate in Jordan. Asian Economic and Financial Review3(3), pp.341.

World Government Bonds. 2020. India Government Bonds - Yields Curve. Retrieved December 13, 2020, from World Government Bonds website: http://www.worldgovernmentbonds.com/country/india/

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