case exec sum widow 1

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Strategic Financial ManagementFinance 462

Case 13: Risk and ReturnFlirting with Risk

Presented to:Dr. Michael T. Young

ByStudent

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TABLE OF CONTENTS

COVER PAGE ITABLE OF CONTENTS IIEXECUTIVE SUMMARY 1QUESTIONS:

1. Relationship between risk and return 22. Beta meaning and relation to stock 23. Meaning and advantage of diversification 2

4. Security Market Line (SML) 35. Interest rate effect on diversified portfolio 36. Should she put money in fixed income security 37. Reaction to hot tips suggestion 38. Counter cyclical and High-Tech portfolio calculation

and analysis (attachment included on excel) 4KEY(BOOK FORMULAS) 4

9. Adjustment to Index Funds and High-TechPortfolio(attachment included on excel) 5

10. What to propose to Mary as possible combinations 5FOOTNOTES 6

FIGURES:Figure 1, Total risk analysis 2Figure 2, Security Market Line (SML) 3

ATTACHMENTS:Excel Spread sheet for question 8. Showing all returns and risks for entire portfolio andeach economic situation.

Excel Spread sheet for question 9. Showing all returns and risks for entire portfolio andeach economic situation.

Excel Spread sheet showing all excel formulas for questions 8 and 9.

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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.

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In Bills situation, I would explain to Mary the relationship between risk and returnby showing that based upon my experience, that if she were to invest in more riskysecurities, the amount she could possibly earn would be higher but at a cost. The costthat she would endure would be the risk. The more risky investments have high lossesbut 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 tohave 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 toexplain that in order to obtain a more expected return on your money, you have to investin securities that are not expected to return very much money. These low riskinvestments tend to have low returns but also very low risk. She should focus themajority of her money on such investments. As an investment analysis I could onlyrecommend 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= fr + x (

pr - fr )

The Beta( ) is a value that shows how a particular stock will react if the entiremarket were to change. If for instance a stock has a beta of 1(which is perfect incorrelation with the market) then the stock will move in exactly the same percent aswhatever the entire market movement is. Also, if a stock had a beta of -1, then it wouldmove in the direct opposite of the market change. Thus, with a beta of 1, and a marketchange 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 andthe market has risk as well. The market risk cannot be changed, but unique risk(which isa stock) can be changed by altering how much of your portfolio is invested in it. [UniqueRick + Market Risk=Total Risk] However, by adjusting the type and amounts ofsecurities 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.

The figure above shows that up to a given point, the more diversification will tend tolower 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 portfoliowith the least possible amount of risk. While diversification can be shown to reduce risk,

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FIGURE 1


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

rf ), 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 t-bill) that is backed by the government. These securities(bonds) have a fixed rate ofinterest similar to a bond that you could buy through a corporation. However, with a t-bill, they are backed financially by the U.S. Government. Because the government holdsthe power to raised taxes or make money, these funds will be paid for sure. The SML canbe depicted as:

The formula used to determine the points(securities) on the SML are depicted by thecapital 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 ofthe securities(portfolio) will also be on the SML. The efficient security in my example isstock B, this is because it has a beta of 1, which mirrors the market, and the return isequal to the amount of risk on the vertical axis. The points of A, C, and D are notefficient, suggesting that they are not worth investing in because the return is not equallyefficient 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 willcause bond prices to rise and vice versa. For stocks, a change in interest rats will affectthem as well. If for example, the interest rates on a fixed t-bill were 5%, then we couldinvest 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 thesame time period of the t-bill, and the risk of the expectation were not high, then it wouldbe wise to invest in EBAY. Conversely, if the T-Bill changed to 10%, then it no longerwould be profitable to invest in EBAY. Being that the stock price were low (orexpected to rise yielding the 5% return) both situations indicates that it would be stillprofitable to invest in this stock but not as profitable as it would be to invest in the T-Billnow. We can assume based on the arbitrage pricing theory(APT) that if a price is

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Figure 2


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deemed to be low then it will rise to an accurate price given that the market is operatingin strong-form efficiency which eliminated arbitrage opportunities such as the EBAYexample above.

Taking out all of Marys money and placing it into fixed income securities may bean 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 atdifferent times. One option would be to break the $900,000 into 20% increments. The20% increments would be approximately $180,000 before my fees, which after thislecture are going to be at record levels. These $180,000 increments could then matureonce every 5 years, therefore you only have to beginning value of 180,000 once a year, ata new fixed income interest rate that will reflect the given economy. Thus, you wouldbuy a 5 year, 4 year, 3, year, 2 year, and 1 year bond of $180,000 which would be all ofyour 900,000. Also, by doing this, Mary could take out a proportionate amount per yearfor living expenses, such as $25,000 per year. At this amount, if no interest were earnedat all, the money would last 36 years, so there is no doubt that you would be taken care ofand 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 wouldhave $34,000 her first year as income. The income she would receive would be a verygood income for a woman who most likely has the home paid for and is only looking forextra money for grandkids and vacations.

Well, first and foremost, if your money is in a fixed income security, these valuesare set, and no tip will change the situation, only the market conditions affecting interestrates will change the security. However, being that I (Bill) do not operate or knowanyone 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 inthe stock price. The fact that information is reflected in stock prices so quickly meansthat our stock market is acting efficiently and adjusting based on the past public andprivate, and current public information available. Technology is partially responsible forthis. Moreover, this is known as strong-form market efficiency, and it also implies thatthe amount you will earn in the stock market is a fair amount because the stock prices areaccurately reflected.

See Excel Spread Sheets Attached for questions 8 and 9**************************************************************************************************

KEY:

=

==N

i

WEIGHTyprobabilitcuritydividualSereturnonInturnExpected1

)(5#*.*Re

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

Portfolio)2

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

Security-Return on Portfolio)2

] OR High Tech Variance + Counter Cyclical

Variance=Variance of portfolio in a given economy

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http://opt/scribd/conversion/tmp/scratch26334/case3excelq8.XLShttp://opt/scribd/conversion/tmp/scratch26334/case3excelq9.xlshttp://opt/scribd/conversion/tmp/scratch26334/case3excelq9.xlshttp://opt/scribd/conversion/tmp/scratch26334/case3excelq8.XLShttp://opt/scribd/conversion/tmp/scratch26334/case3excelq9.xls


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Standard Deviation= omynGivenEconPortfolioiVarianceof

The expected return on this portfolio, 5.45%, as compared to the risklevel(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 actualreturns based upon expected variables. These expectations are not always correct.Moreover, these economic situations and returns are only expectations of what are to takeplace in the future, and cannot be the sole factor in determining whether to invest in thesestocks. It is very difficult to determine numbers to be accurate. Most important are theeconomic situation. If investors would know what the economic situation was going tobe they would be able to maximize returns by fluctuating investment amounts based uponan expected economic change. However, given that stock market prices in the UnitedStates are generally only at strong-form efficiency, we cannot accurately predict what allcompanies are planning to do in the future. The uncertainty of inside information allowsus 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 whoknows little about the market in general, to place her money in such a risky accountwould be foolish for this particular investor. Finally, these expectations are not realisticonly because they try to judge what the economic state will be. The risk associated withtrying to determine appropriate expected probabilities is again difficult. Furthermore,these calculations are not realistic because the overall return on such a risky securitywould on average tend to have a much higher return than a fixed income asset such as aT-Bill. Also, simply because there is a boom in the economy in general does notnecessarily always/or on average indicate that the Hi-Tech company will experience suchbooming success. The risk is appropriate simply because it is a warning sign of howdifficult 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 indexfunds are cyclical as are the High-Tech Company, she would experience significantlosses if the economy were to turn poor, which based upon the probabilitys, will occur40% of the time. This combination would not be better for her because her risk wouldincrease 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, thiscombination of stocks would be unadvisable.

Based upon the calculations and my previous example of a fixed income securityladder, it would probably be wise for Mary to place 80% into the fixed income assets, ofwhich she draw interest at a given rate each year. By the chart in the problem, this wouldbe utilities. The final 20% should be diversified in a stock that has minimal risk, givenMarys large risk aversion. Therefore, an Index fund would be appropriate, also becausethis 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 couldundertake and still most likely be able to live comfortably.

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FOOTNOTES

Worked alongside classmate Thea Klug on the basic number format of the problems andhow to check amortization schedules. Furthermore, we may have similar quantitativeanswers, simply because we formulated computations together, but all of the actual workformulating written answers and opinions was done individually.

Did not use Corporate Finance book that accompanies case, because this book did notdirectly pertain to the case or show formulas

REFERENCES

Corporate Finance by Stephen A. Ross, Randolph W. Westerfield, and Jeffery F. JaffeMcGraw-Hill Irwin Companies

Investments 6th Edition by William Sharpe, Gordon Alexander, and Jeffery BailyPrentice Hall, Upper Saddle River, New Jersey 07458

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case exec sum widow 1

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