Question 1
In business terms, risk can be explained as the inability to make correct anticipations or predictions about the incomes a business expects to realize in the future. A business faces risk due to the fact that it cannot accurately predict whether it will earn enough money to sustain its existence in future periods. Diversification, on the other hand, refers to the process of making several different investments that are not related so as to reduce the level of risk an investor faces.
Businesses may measure the amount of risk they face by analyzing the level of standard deviation they record in their cash flows. An analysis of the coefficient of variation in a business’s earnings may also be done to establish the level of risk it faces. The evaluation of a business’s Beta can also illustrate the level of risk a business faces.
An analysis of the level of risk facing a business is useful according to the portfolio theory since it enables investors to make informed decisions on the right mix of investments to make. Investors are required to make a wide variety of appropriate investments according to the portfolio theory so as to reduce the risk of receiving an aggregate amount of earnings that is lower than what they had anticipated.
The standard deviation method is not a suitable in measuring the level of risk facing an investment portfolio. This is because it cannot measure the level of inter-relatedness between the different investments in the portfolio that contribute to the reduction of the risk that an investor faces. The use of Beta to measure a business risk using the Capital Assets Pricing Model (CAPM) is inconsistent. This is because the CAPM method only considers the beta as the only factor that affects a business’s required rate of return. In actual fact, other factors such as a business’s ability to resist the negative effects of inflation and the amount of dividends it pays to shareholders affects its required rate of return.
Question 2
The CAPM method has several disadvantages. The first disadvantage of the CAPM method is that it makes false assumptions that do not apply in the real world. Some of its assumptions include; that financial assets only face market risk. It also assumes that assets can be easily divided and sold which may not the case. The assumption that returns from assets are normally distributed is also not true. The second limitation of the CAPM method is the fact that it only analyses the returns made by a business once per year instead of analyzing the returns throughout the year. The fact that it is not possible to empirically test the expectations of investors is another limitation of CAPM. Finally, the assumption that the required rate of return from an investment is only affected by the stock market is false. There are other factors that affect a business’s rate of return such as its ability to be affected by inflation and the amount of dividend it pays to its shareholders.
Question 3
The Arbitrage Pricing Theory (APT) works on the same principle as that of the CAPM model that is, both models try to measure the likelihood of a business to achieve its required rate of return. However, the main difference between the models is that the CAPM method only considers the stock market as the only factor that can affect a business while the APT model considers the ability of more than one factor to affect a business’s returns.
Question 4
The Capital Market Line (CML) is the line drawn to link all points that represent efficient investment portfolios after considering the rate of return that is free of risks for a business and the level of risk facing a business. The Security Market Line (SML), on the other hand, joins points representing the combinations of the most likely portfolio returns for a business verses the level of risk a business faces.
The concept of the CML and SML can be explained by analyzing the differences between risks that are systematic and risks which are unsystematic. Systematic risks are those risks which and are beyond the control of an investor and thus they cannot be prevented from affecting a business. Unsystematic risks, however, can be controlled by an investor and thus they are risks that can be prevented from affecting a business. The CML is, therefore, the line draw to join all the points that represent the best required rate of returns that can be achieved by investors who have eliminated all the unsystematic risks facing the different investment portfolios available to them. The SML, however, joins all the points representing different required rates of return that can be achieved by an investor who has not eliminated the unsystematic risks facing the different investment portfolios available to him.
Question 5
Technical Analysis is an evaluation of the behavior of a business’s securities through observing the statistics of various market factors such as price and volume that affect the security. It involves predicting the future performance of a security by analyzing the patterns of its present and past performance.
When conducting a technical analysis it is assumed that the security’s market discounts everything. It is also assumed that prices affecting the security changes according to some underlying trend. The final assumption of the technical analysis is the fact that it is expected that the history of a security will repeat itself.
There are several benefits of carrying out a technical analysis. The first benefit of carrying out a technical analysis is the fact that the trends and patterns of a security can be easily derived and understood. The second advantage of carrying out a technical analysis is the fact that the formulation of charts is quick and very cheap. Finally, the fact that technical analysis mostly concentrates on price movements makes it an advantage over other methods of analysis since it does not require many source documents or materials for it to be done.
In my view, I would use the technical analysis technique to inform my investment decisions. Through observing chart patterns, I would buy stocks when their prices are falling, hold them when the patterns indicate that prices are about to rise and sell them when the stock prices are at their highest.
Question 6
The Efficient Market Hypothesis (EMH) explains that the price of a stock or security can be used to give elaborate information about it. There are three forms of EMH. The first form of EMH is the weak EMH. The weak EMH explains that the price of a stock can be used to provide historical information about it. However, the weak EMH cannot be used to explain the information affecting a stock in present times. The second form of EMH is the semi-strong EMH. The semi-strong EMH explains that all information that is available to the public concerning a security is reflected in its price. The last form of EMH is the strong form of EMH which explains that all information concerning a security is reflected in its price.
There are several assumptions made when using the EMH. The first assumption made when using the EMH is the fact that there are many buyers and sellers. It is also assumed that stock agents are rational and can be able to use the EMH to make correct decisions. The final assumption made by the EMH is that there is perfect information about a stock’s trends and profits.
The EMH renders both the technical and fundamental analysis as useless practices. This is because the EMH assumes that a stock’s price gives all information about it and, therefore, there is no need to conduct a further technical or fundamental analysis on the price of a stock. Random walk theory refers to the theory that the changes in a stock’s price are completely independent of each other. The theory, therefore, assumes that it would not be prudent to use the past information of a stock’s prices to predict its future prices since the prices do not relate with one another.
The boss could have been angry at me for suggesting the company’s adoption of the strong form of EMH on several grounds. First, my suggestion that the company adopt a strong form of EMH would have meant exposing the company’s private information to the public. I believe the manager was not happy with the idea of revealing the company’s private information to the public hence my suggestion must have made him angry. Secondly, the adoption of a strong EMH would have meant that the company’s strategies would have been predictable by its competitors hence making it impossible for the company to remain competitive and achieve good profit margins.
References
Brigham, E. F., & l Ehrhardt, M. C. (2010). Financial Management Theory and Practice. London: Cengage Learning.
Chandra, P. (2008). Financial Management. New Delhi: Tata McGraw-Hill Education.
Jain, K. (2007). Financial Management. New Delhi: Tata McGraw-Hill Education.
Shim, ,. J., & Siegel, J. G. (2008). Financial Management. New York: Barron's Educational Series.
