INVESTMENTS IN BUSINESS

Investments in Business



Investments in Business

Introduction

The case study presents an issue in financial management. John and Marsha are facing an issue in which they were unable to resolve on certain aspects. The purpose of this case study is to solve the case using appropriate theoretical models. Number of theories and models will be used in the solving the case. The main requirement of the case is to determining the appropriate weight of security PRIONEER in the total portfolio so that it maximizes the return while minimizing the risk. Range of financial management theories are applicable here namely, capital asset pricing model, beta coefficient, Pearson's correlation coefficient, sharp ratio. These theories will be explained comprehensively in the next section followed by the solution of the case study.

Description of Relevant Models

Capital Asset Pricing Model

Capital asset Pricing Model (CAPM) is a share price valuation model in which the major factors of short-term share-price determination are explained. The capital-asset pricing model provides a method of computing the return on a financial security which specifically identifies and measures the risk factor within a portfolio holding (Fama & MacBeth, 1973, 607-36). The expected rate of return on a particular investment has two components:

The risk-free percentage return which could be obtained from, say, a gilt-edged, government financial security;

The risk return associated with the investment. (Risk itself can be split into market or non-diversifiable risk and specific or diversifiable risk.) This relationship between risk and return is shown in Fig. 1.

The total expected return on an investment is 0rm, but risk only attaches to non gilt-edged securities which are why the capital market line intercepts the vertical axis at rf. The capital market line shows how, in a competitive market, the additional risk premium varies in direct proportion to ß (known as the beta coefficient) (Brooks, 2010). At point M in the figure there is perfect correlation between movements in the market generally as detailed by an all-share index, and a particular investment. Therefore ß= 1 at point M. Where there is no risk, as in Treasury bills, ß= 0. ß is a measure of market risk because investors have it within their power to diversify away specific risk to almost zero by holding a broad portfolio of shares. It is possible to estimate the beta coefficient of a security from published information.

Figure 1: Capital-asset pricing model. This identifies the market risk factor for the expected rate of investment.

A model of the market for different financial assets that suggests that asset prices will adjust to ensure that the return an asset makes precisely compensates investors for the risk of that asset when held with a perfectly diversified portfolio. The model has dominated economists' understanding of the financial sector. Under simplifying assumptions, the following propositions hold:

everybody will hold a portfolio of assets which is as diversified as possible (diversification);

this means the particular risks of each individual asset will be unimportant because the ups and downs of assets' performances will tend to cancel out (portfolio theory);

there will, nevertheless, ...