finance assignment (10 june, 2010)

source: http://www.visionapexcollege.blogspot.com

Q. Collect and write about 'risk and return in finance' and submit by 11 june.
help: google, book: brigham et. all etc

EXAMPLE:
(The assignment done by Amish is given below as a sample, do not copy it.)

Risk and Return:

What does that mean, exactly? It starts with the idea that all securities have an inherent level of risk. Next, all securities have an expected return, based on several scenarios. Finally, using statistical measures, one must weigh the risk against the return and find the asset that has the best return per unit of risk assumed.

Risk
There are many different forms of risk in the market place. These factors come in all shapes and sizes, and sometimes surprise many people. They don't pop out of nowhere, but are sometimes difficult to see.

For example, business risk is the risk inherent in a firm's business operations. A firm may operate in a niche market that relies on the economy to be running along smoothly. This could be a luxury niche or something of that nature. One example could be a high priced restaurant.

During good times, they have great revenues because people feel they are wealthy enough to celebrate. However, during economic hardship, trips to fancy restaurants are usually the first to go. It would be said that this firm's business risk is positively correlated with the overall cycle of the economy. Sometimes a firm can be negatively correlated, such as cheap substitute products. When times are hard, people usually avoid buying expensive name brand items. That is when store brand or no name brands become more attractive.

Business risk can be eliminated by investing in many different firms in different fields. It is diversifiable. This is why the phrase "diversify your portfolio" is such a hot button. It is rooted in real, financial logic.

Return
Return is the percent amount of money that you get back for every unit you invest. If you invest $100 and get back $105, you would have a 5% return. This is a pretty simple concept, but predicting return can get pretty tricky.

Let's say you expect an asset to appreciate 15% in the next year. You have 60% confidence that this will happen. However, if there is a recession it will only appreciate 1%, and if there is an economic boom it will appreciate 20%. There is a 20% chance of either an economic boom or a recession over the next year.

These numbers and probabilities may not seem entirely believable, but try for the sake of argument. To compute an expected return for this security, all you have to do is multiply each expected return by the probability of that state of nature.

The equation would look like this: (15%)(.6) + (1%)(.2) + (20%)(.2) = 13.2%

This is the expected return for this security. Although it will never be exactly 13.2%, given this model, this is what is used when calculating a risk adjusted return. It is most probable that the return will be 15% or greater, but there is a 20% chance that it could be 1%. Therefore, 13.2% is the best number to use when calculating an expectation.

Deciding which asset to buy
The next step is deciding which asset to buy. This usually involves some statistical measures, which I won't get into here. Terms like standard deviation, correlation and covariance are usually used when describing portfolio management. All of these terms have to do with the basic idea that you need more expected return per additional unit of risk. If you can grasp that basic concept, then you are well on your way to getting a better understanding of finance.

When he's not playing racquetball or studying for a class, Clayton Reeves enjoys writing articles about entrepreneurship. He is currently an MBA student at the University of Missouri with a concentration in Economics and Finance.

Systematic and unsystematic risks
Investments have two components that create risk. Risks specific to aparticular type of investment, company, or business are known asunsystematic risks. Unsystematic risks can be managed throughportfolio diversification, which consists of making investments in a variety of companies and industries. Diversification reduces unsystematic risks because the prices of individual securities do not move exactly together. Increases in value and decreases in value of different securities tend to cancel one another out, reducing volatility. Because unsystematic risk can be eliminated by use of a diversified portfolio, investors are not compensated for this risk.

Systematic risks, also known as market risk, exist because there are systemic risks within the economy that affect all businesses. These risks cause stocks to tend to move together, which is why investors are exposed to them no matter how many different companies they own.

Investors who are unwilling to accept systematic risks have two options. First, they can opt for a risk-free investment, but they will receive a lower level of return. Higher returns are available to investors who are willing to assume systematic risk. However, they must ensure that they are being adequately compensated for this risk. The Capital Asset Pricing Model theory formalizes this by stating that companies desire their projects to have rates of return that exceed the risk-free rate to compensate them for systematic risks and that companies desire larger returns when systematic risks are greater.

The other alternative is to hedge against systematic risk by paying another entity to assume that risk. A perfect hedge can reduce risk to nothing except for the costs of the hedge.

Modern portfolio theory (MPT)

Modern portfolio theory (MPT) is a theory of investment which tries to maximize return and minimize risk by carefully choosing different assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel prize for the theory, in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics.

MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. This is possible, in theory, because different types of assets often change in value in opposite ways. For example, when the prices in the stock market fall, the prices in the bond market often increase, and vice versa. A collection of both types of assets can therefore have lower overall risk than either individually.

More technically, MPT models an asset's return as a normally distributed random variable, defines risk as the standard deviation of return, and models a portfolio as a weighted combination of assets so that the return of a portfolio is the weighted combination of the assets' returns. By combining different assets whose returns are not correlated, MPT seeks to reduce the total variance of the portfolio. MPT also assumes that investors are rational and markets are efficient.

MPT was developed in the 1950s through the early 1970s and was considered an important advance in the mathematical modeling of finance. Since then, much theoretical and practical criticism has been leveled against it. These include the fact that financial returns do not follow a Gaussian distribution and that correlations between asset classes are not fixed but can vary depending on external events (especially in crises). Further, there is growing evidence that investors are not rational and markets are not efficient.

Balancing Risk and Return
1.Appreciate the crucial relationship between risk and return and the way this affects all business finance decisions.

2.Understand the issues involved in short-term capital management and methods that managers can use to increase the rate of return on capital.

3.Understand the issues involved in long-term capital management and financial tool like net present value and breakeven analysis that help managers decide where to invest.

4.Describe four different methods companies can use to finance capital investments.

5.Differentiate the roles of debt and equity securities in financial decision making.

Four Ways to Use Capital
•Borrowing
•Lending
•Spending
•Investing