Study on Standalone Risk and Portfolio Risk Finance Essay

Firstly we will define Investment as “commitment of money or capital to purchase financial instruments or other assets in order to gain profitable returns in form of interest, income, or appreciation of the value of the instrument” (Investment, 2010) and Risk “is an uncertain outcome or chance of an adverse outcome.” (Risk, 2010) In any investment there is bound to be categorised risks namely Standalone risk and Portfolio risk. According to an online post by phillykelloggguy (2008) the standalone risk measures the undiversified risk of an individual asset. An investor has the option to invest in a single asset which will be explained later with an example. But on the other hand, there are portfolios, which is a group of individual assets forming a single investment for an investor. This portfolio is exposed to what is known as portfolio risk, this risk is further broken down into other risks and according to Scott Besley, E F. Brigham(2008) those risks are diversifiable risk (company-specific, unsystematic) and non-diversifiable (Market Risk, systematic). An investor who only acquires a single asset as an investment, that asset is known as standalone asset. This asset will be exposed to what is known as Standalone risks. An example will be buying stocks worth RM 100.000,00 in Oil industry only. The likely hood of your cash flow declining or losing the stocks is high due to standalone risks. But according to (Brigham and Daves 2007) the risk of a single asset’s cash flow can be considered on a standalone basis, If this investment cash flow is combined with other assets cash flows then its risk is reduced through diversification with the overall aim of improving the investment expected return while reducing risk. If the same investor above had known about diversification, he could have invested the RM 100.000,00 as follows, 20% buy stocks in a motor industry, 20% in property, 20% in security bonds, 20% buy stock in telecommunication industry and 20% buy stock in oil industry. In the scenario above the investor has acquired more than one asset and once all assets cash flows have been combined the investor has created a portfolio of assets, which is maximising returns for a given level of risk. Other authors Stephen Kealhofer, Jeffrey R. Bohn (2001) state that “Measuring the diversification of a portfolio means specifying the range and likelihood of possible losses associated with the portfolio. All else equal, a well-diversified portfolio is one that has a small likelihood of generating large losses.” This portfolio is exposed to portfolio risk or market risks. These risks are impossible to eliminate and the investor is compensated for barring this risks. There are inventors who are known as risk averters, they tend to have portfolios that have low-risk with guaranteed certain returns. But it is safe to say that the higher return you desire the greater the risk you must endure. So if an investor with low-risk portfolio wants to gain a higher return on an investment, the investor has to remix the assets in the low-risk portfolio. Let us use the example of the investor above who invested RM 100.000,00 in buying stocks in 5 different industries. If this investor wants a low-risk portfolio then 20% – 40% of the portfolio will be invested in stocks and the remaining percentage will be invested in fixed interest investments (government and corporate bonds) [figure 1]. But on the other hand if the investor wants high return which will automatically include high risk, then 80% of portfolio will be invested in stocks and the remaining percentage in cash or fixed interests investments [figure1]. The investor has leverage a low risk portfolio for higher returns. [Figure 1] Investor Risk Profile, (Outlook Financial Solutions 2006) According to (Awerbuch, Bazilian et al. 2008) ” investors have learned that an efficient portfolio takes no unnecessary risk to its expected return. In short, these investors define efficient portfolios that maximize the expected return for any given level of risk, while minimizing risk for every level of expected return.” Investors today tend to use modern portfolio theory (MPT) which entails that a portfolio should include some security assets. Wikipedia (2010) gives the following example of MPT, when prices in the stock market fall, prices in the bond market often increase, and vice versa. A collection of both this types of assets can therefore have lower overall risk in a portfolio than either individually. Some investor use borrowed money to purchase a security in a low-risk portfolio, if the security bought with borrowed money returns a loss, then the investor will be reliable to pay back that loss incurred to the borrower, but if the security results in a gain, then the investor has made a profit without using his initial capital. For any investor to earn high return from a low-risk portfolio, combinations of low risk assets and high risk assets have to be combined in the portfolio. Some investors like property assets Figure 2 shows the types of assets in relation to the returns and risks. It shows that properties returns are high but the risk also increases. It also shows which assets to acquire to bring down a relatively high risk portfolio to a low risk portfolio. [Figure 2] A Guide to Investment Risk, (Chelsea Investments Ltd 2006-2010)

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PART B

Equilibrium is defined as “A state of rest or balance due to the equal action of opposing forces. (Wikipedia, 2010) Looking at Table 1 provided,

SECURITY

EXPECTED RETURN ON SECURITY

BETA OF SECURITY

1 17.1 1.3 2 10.9 0.8 3 18.2 1.4 4 18.5 1.5 5 9.8 0.2 Table1 Market return 15% Risk free rate 8% For a security to be in an equilibrium situation the expected ROR is equal to the required ROR and it may fall on the Security Market Line (SML) which is the state of rest mentioned in the definition. According to Investopedia (2010) when the securities are plotted on the graph, the securities that are above the SML are said to be undervalued and those securities that are below the SML are said to be overvalued. Although in my case I think it should be the other way around, overvalued stocks should be above the SML and undervalued below the SML. To determine all this theory mentioned above, we will be plotting a Security Market Line (SML). Wikipedia (2010) defines SML as “a graphical representation of the Capital asset pricing model. It displays the expected rate of return of an individual security as a function of systematic, non-diversifiable risk (its beta).” To plot the graph, Graph Setup 4.3 software will be used. The slope of the SML will be plotted on the following points on the graph according to betas axis of 0.5, 1.0 and 2.0, but first we need to calc the market premium: Market return – Risk free rate = Market risk premium 15% – 8% = 7% Using the market premium, we will be calculating the required return of the betas mentioned above, Risk free rate + Market premium (Beta) = required rate of return 8% + 7% (0.5) = 11.5

8% + 7% (1.0) = 15 same percentage as the Market return.

8% + 7% (2.0) = 22 Figure 3(Graph 4.3 software) SML Figure 3 clearly indicates the red line as the SML and were the security beta = 1.0 the required rate of return = 15%. To plot each security on the graph, we need to calculate the required return of each using the formula by (Kobold 1986): Security 1 Required Rate of Return: 17.1 = 8% + (15% – 8%) 1.3 = 8% + 7% (1.3) = 8% + 9.1%

Security

Required Rate Of Return

1 17.1 2 13.6 3 17.8 4 18.5 5 9.4 Table 2 (Results after calculating the rest of the securities ROR) The graph is now plotted using the Table 2 required rate of return against the beta of each security in Table 1, represented by black squares boxes in figure 4. Figure 4 (Graph 4.3 software) SML Security 1 expected return is equal to the required rate of return 17.1 it is in an equilibrium situation, plotted on SML. Security 2 expected return is 10.9 and it’s less than required rate of return 13.6, it is overvalued. “The investor would be accepting less return for the amount of risk assumed.” (Investopedia, 2010) Security 3 expected returns 18.2 is greater than required rate of return 17.8, it is undervalued. “The investor is accepting a greater return for the inherent risk.” (Investopedia, 2010) Security 4 expected return equal to the required rate of return 18.5 it is in an equilibrium situation. Plotted on SML. Security 5 expected returns 9.8 is greater than required rate of return 9.4, it is undervalued. “The investor is accepting a greater return for the inherent risk.” (Investopedia, 2010) As shown in figure 5, Security 2 is plotted in the shaded area. Meaning Market risk premium is 7%, so it is an average security. Figure 5 (Graph 4.3 software) SML

REFERANCES

Awerbuch, S., M. Bazilian, et al. (2008). Analytical methods for energy diversity and security : portfolio optimization in the energy sector: a tribute to the work of Dr Shimon Awerbuch. Amsterdam ; London, Elsevier. Besley, S. F., Brigham, (2008). Essentials of managerial finance. 14th edition, Manson, OH: Thomson south-western College Publishing. Brigham, E. F. and P. R. Daves (2007). Intermediate financial management. Mason, Ohio, South-Western College Publishing. Chelsea Investments Ltd (2006-2010) A Guide to Investment Risk [Online image] Available from: https://www.chelseainvestments.co.uk/index.php?page=guide-to-investment-risk [Accessed: 30 October 2010]. ‘Equilibrium’ 2010, Dictionary.com, viewed 03 November 2010 Available from: https://dictionary.reference.com/browse/equilibrium ‘Investment’ 2010, Wikipedia, viewed 28th October 2010, Available From: https://en.wikipedia.org/wiki/Investment Kobold, K. (1986). Interest rate futures markets and capital market theory : theoretical concepts and empirical evidence. Berlin, Walter de Gruyter. ‘Modern portfolio theory’ 2010, Wikipedia, viewed 03 November 2010 Available from: https://en.wikipedia.org/wiki/Modern_portfolio_theory Outlook Financial Solutions (2006) Financial Management [Online image] Available from: https://www.cisfs.com.au/ [Accessed: 30 October 2010]. ‘Risk’ 2010,Wikipedia, viewed 28th October 2010, Available From: https://en.wikipedia.org/wiki/Risk. ‘Security Market Line – SML’ 2010, Investopedia, viewed 03th November 2010, Available From: https://www.investopedia.com/terms/s/sml.asp Stephen Kealhofer, Jeffrey R. Bohn, 2001, Portfolio Management of Default Risk, KMV, LLC (KMV), SAN FRANCISCO, CALIFORNIA, USA, viewed 20 October 2010, Available from: https://www.moodyskmv.com/…/Portfolio_Management_of_Default_Risk.pdf The Equation of a Line (part I) 2009, YouTube, viewed 04 November 2010, <https://www.youtube.com/watch?v=mwzvP7DQjgs&feature=related>. University of South Australia, Resources and Services for students 2010, The Harvard Author-Date Referencing System , viewed 20 October 2010, Available from: www.unisa.edu.au/ltu/students/…/referencing/harvard.pdf Yahoo answers (2008) phillykelloggguy. Resolved Question. [Online] Available from: https://answers.yahoo.com/question/index?qid=20081205103311AA6KRDp. [Accessed: 28th October 2010].

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