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Strategic Financial Management Finance 462

Case 13: Risk and Return Flirting with Risk

Presented to: Dr. Michael T. Young

By Student

TABLE OF CONTENTS

COVER PAGE I TABLE OF CONTENTS II EXECUTIVE SUMMARY 1 QUESTIONS: 1. Relationship between risk and return 2 2. Beta meaning and relation to stock 2 3. Meaning and advantage of diversification 2 4. Security Market Line (SML) 3 5. Interest rate effect on diversified portfolio 3 6. Should she put money in fixed income security 3 7. Reaction to hot tips suggestion 3 8. Counter cyclical and High-Tech portfolio calculation and analysis (attachment included on excel) 4 KEY(BOOK FORMULAS) 4 9. Adjustment to Index Funds and High-Tech Portfolio(attachment included on excel) 5 10. What to propose to Mary as possible combinations 5 FOOTNOTES 6 FIGURES: Figure 1, Total risk analysis 2 Figure 2, Security Market Line (SML) 3 ATTACHMENTS: Excel Spread sheet for question 8. Showing all returns and risks for entire portfolio and each economic situation. Excel Spread sheet for question 9. Showing all returns and risks for entire portfolio and each economic situation. Excel Spread sheet showing all excel formulas for questions 8 and 9.

II

EXECUTIVE SUMMARY

After the death of her husband, a woman with no previous financial experience needed help dealing with her personal finances. Her late husband had left her approximately $900,000 invested three risky stocks. Being a stay at home mother, the investor did not know the terms of her husbands financial dealing. The financial analysis quickly realized that she did not understand the terminology of finances. Therefore, the purpose of the case was to disclose different terms and options that the widow could pursue. The analyisist drew a chart with several different types of securities. From this information, we were able to determine expected returns based upon the suggestions. However, being the investor was not knowledgeable, and did not have a job; her risk aversion was very high. This indicated that fixed income assets may be appropriate given an assumed older age and unemployment. The case focused on explaining the different terminology of the stock market and exploring different portfolio options given a probability of an economic situation. Although the information includes new terminology and its fairly difficult to read, it was meant to inform and is supported by excel spreadsheet calculations and two graphical figures displaying the written material.

In Bills situation, I would explain to Mary the relationship between risk and return by showing that based upon my experience, that if she were to invest in more risky securities, the amount she could possibly earn would be higher but at a cost. The cost that she would endure would be the risk. The more risky investments have high losses but also when they are successful tend to have higher returns. Being that Mary would simply like enough money to live out the remaining years of her life, she would like to have a security that did not have much risk because she really needs this money to live, and if she were to lose it, then she would be in big financial trouble. So, I would try to explain that in order to obtain a more expected return on your money, you have to invest in securities that are not expected to return very much money. These low risk investments tend to have low returns but also very low risk. She should focus the majority of her money on such investments. As an investment analysis I could only recommend a risky investment if the return would completely compensate for the risk. This could be shown as an equation of the expected return on the investment. This equation that I would use to find an expected return would be: r = r f + x ( r - r f )
p

The Beta( ) is a value that shows how a particular stock will react if the entire market were to change. If for instance a stock has a beta of 1(which is perfect in correlation with the market) then the stock will move in exactly the same percent as whatever the entire market movement is. Also, if a stock had a beta of -1, then it would move in the direct opposite of the market change. Thus, with a beta of 1, and a market change of 2%, then the corresponding stock would have a 2% change as well. Bill could explain to Mary diversification by showing how each security has risk and the market has risk as well. The market risk cannot be changed, but unique risk(which is a stock) can be changed by altering how much of your portfolio is invested in it. [Unique Rick + Market Risk=Total Risk] However, by adjusting the type and amounts of securities owned does not move the market risk. Rather, the diversification will lead to a lowering of unique risk so that it is closer to the given market risk.

FIGURE 1

The figure above shows that up to a given point, the more diversification will tend to lower the unique risk of the securities. This is the primary advantage of diversification. By lowering the unique risk that each stock has, we are able to obtain a security portfolio with the least possible amount of risk. While diversification can be shown to reduce risk,

the Security Market Line (SML) can be used to indicate a relationship between an individual securities return and market risk. The SML uses a graph to depict its meaning and the vertical side is shown to have a line intersecting it. This line is the risk-free rate(

), or where you will be able to earn money with no risk involved(also assuming no

reinvestment risk). Typically this line, the risk-free rate, is depicting a treasury bill(or tbill) that is backed by the government. These securities(bonds) have a fixed rate of interest similar to a bond that you could buy through a corporation. However, with a tbill, they are backed financially by the U.S. Government. Because the government holds the power to raised taxes or make money, these funds will be paid for sure. The SML can be depicted as:

Figure 2

The formula used to determine the points(securities) on the SML are depicted by the capital asset pricing model (CAPM) which is used to determine the efficient portfolio, because each security can be placed upon the SML, which also means that a collection of the securities(portfolio) will also be on the SML. The efficient security in my example is stock B, this is because it has a beta of 1, which mirrors the market, and the return is equal to the amount of risk on the vertical axis. The points of A, C, and D are not efficient, suggesting that they are not worth investing in because the return is not equally efficient in relation to the risk. Once you have determined that you would like to have a diversified portfolio, interest rates can have an effect. For bonds in particular, a decline in interest rates will cause bond prices to rise and vice versa. For stocks, a change in interest rats will affect them as well. If for example, the interest rates on a fixed t-bill were 5%, then we could invest your money in that and be guaranteed to get a 5% return at the time of maturity. However, if we believe that a stock, say EBAY were expected to rise by 7% over the same time period of the t-bill, and the risk of the expectation were not high, then it would be wise to invest in EBAY. Conversely, if the T-Bill changed to 10%, then it no longer would be profitable to invest in EBAY. Being that the stock price were low (or expected to rise yielding the 5% return) both situations indicates that it would be still profitable to invest in this stock but not as profitable as it would be to invest in the T-Bill now. We can assume based on the arbitrage pricing theory(APT) that if a price is 3

deemed to be low then it will rise to an accurate price given that the market is operating in strong-form efficiency which eliminated arbitrage opportunities such as the EBAY example above. Taking out all of Marys money and placing it into fixed income securities may be an option, but it still must be diversified. This could possibly be done through placing the securities in a fixed income ladder, wherein the maturities of the securities would occur at different times. One option would be to break the $900,000 into 20% increments. The 20% increments would be approximately $180,000 before my fees, which after this lecture are going to be at record levels. These $180,000 increments could then mature once every 5 years, therefore you only have to beginning value of 180,000 once a year, at a new fixed income interest rate that will reflect the given economy. Thus, you would buy a 5 year, 4 year, 3, year, 2 year, and 1 year bond of $180,000 which would be all of your 900,000. Also, by doing this, Mary could take out a proportionate amount per year for living expenses, such as $25,000 per year. At this amount, if no interest were earned at all, the money would last 36 years, so there is no doubt that you would be taken care of and have extra interest income earned on the maturing debt to spend. For instance, after only one year invested at 5%, Mary would earn $9,000 on interest, so she therefore would have $34,000 her first year as income. The income she would receive would be a very good income for a woman who most likely has the home paid for and is only looking for extra money for grandkids and vacations. Well, first and foremost, if your money is in a fixed income security, these values are set, and no tip will change the situation, only the market conditions affecting interest rates will change the security. However, being that I (Bill) do not operate or know anyone on an executive board of a corporation, I know only what the market reflects. Any information that I hear, even if by word of mouth, will have already been reflected in the stock price. The fact that information is reflected in stock prices so quickly means that our stock market is acting efficiently and adjusting based on the past public and private, and current public information available. Technology is partially responsible for this. Moreover, this is known as strong-form market efficiency, and it also implies that the amount you will earn in the stock market is a fair amount because the stock prices are accurately reflected. See Excel Spread Sheets Attached for questions 8 and 9 ************************** *********************************************************************** * KEY: Expected Re turn = returnonIn dividualSe curity * probabilit y =#*.5(WEIGHT )
i =1 N

Hi Tech Variance=[Probability*(Return on Individual Security-Return on Portfolio)

]+ Counter Cyclical Variance =[Probability*(Return on Individual

Security-Return on Portfolio)

] OR High Tech Variance + Counter Cyclical

Variance=Variance of portfolio in a given economy 4

Standard Deviation=

V ria ceo a n f

P rtfo i o lio

nG E n iven co

o y m

The expected return on this portfolio, 5.45%, as compared to the risk level(standard deviation), 27.98383%, definitely shows that it would not be worth the investment. The standard deviation is a measure to determine the risk of the actual returns based upon expected variables. These expectations are not always correct. Moreover, these economic situations and returns are only expectations of what are to take place in the future, and cannot be the sole factor in determining whether to invest in these stocks. It is very difficult to determine numbers to be accurate. Most important are the economic situation. If investors would know what the economic situation was going to be they would be able to maximize returns by fluctuating investment amounts based upon an expected economic change. However, given that stock market prices in the United States are generally only at strong-form efficiency, we cannot accurately predict what all companies are planning to do in the future. The uncertainty of inside information allows us to only base our predictions on the history of our economy, which by definition is not an appropriate measure for an estimate. Furthermore, Mary is a conservative person who knows little about the market in general, to place her money in such a risky account would be foolish for this particular investor. Finally, these expectations are not realistic only because they try to judge what the economic state will be. The risk associated with trying to determine appropriate expected probabilities is again difficult. Furthermore, these calculations are not realistic because the overall return on such a risky security would on average tend to have a much higher return than a fixed income asset such as a T-Bill. Also, simply because there is a boom in the economy in general does not necessarily always/or on average indicate that the Hi-Tech company will experience such booming success. The risk is appropriate simply because it is a warning sign of how difficult such companies are to judge. *************PLESE SEE ATTACHMENTS*************** If Mary were to adjust her portfolio to more High-Tech supplemented with 30% Index Funds her risk would be slightly lowered, but because the returns of the index funds are cyclical as are the High-Tech Company, she would experience significant losses if the economy were to turn poor, which based upon the probabilitys, will occur 40% of the time. This combination would not be better for her because her risk would increase in the near boom economy and not decrease in another type to offset such a risk. Being that Mary is in a situation where she has a very high risk aversion, this combination of stocks would be unadvisable. Based upon the calculations and my previous example of a fixed income security ladder, it would probably be wise for Mary to place 80% into the fixed income assets, of which she draw interest at a given rate each year. By the chart in the problem, this would be utilities. The final 20% should be diversified in a stock that has minimal risk, given Marys large risk aversion. Therefore, an Index fund would be appropriate, also because this would give her a large liquidity option as well in case of financial distress. However, given the amount of money she was given there would be several options that she could undertake and still most likely be able to live comfortably.

FOOTNOTES Worked alongside classmate Thea Klug on the basic number format of the problems and how to check amortization schedules. Furthermore, we may have similar quantitative answers, simply because we formulated computations together, but all of the actual work formulating written answers and opinions was done individually. Did not use Corporate Finance book that accompanies case, because this book did not directly pertain to the case or show formulas

REFERENCES Corporate Finance by Stephen A. Ross, Randolph W. Westerfield, and Jeffery F. Jaffe McGraw-Hill Irwin Companies Investments 6th Edition by William Sharpe, Gordon Alexander, and Jeffery Baily Prentice Hall, Upper Saddle River, New Jersey 07458