Reducing Portfolio Risk

Assignment Task:

1) Assume you have invested half of your savings in a risk-free asset and half in a risky portfolio P. Is it theoretically possible to lower your portfolio risk if you move your risk-free assetholdings into another risky portfolio Q? In other words, can you ever reduce your risk more by buying a risky security than by buying a risk-free asset?

2) Is it possible that the holdings of an open-end fund are worthmuch more or less than what the shares of the fund are trading for? Explain with clear examples supported and referenced with relevant data. This question is designed to test your familiarity with sources of financial information which you will need collate market for valuation purposes. You will therefore be marked on solid demonstration of this capability?

3) If a firm repurchases 1% of its shares, does this change the capitalisation of the stock market

on which it is listed? If a firm distributes 1% of its value throughdividends, does this change the capitalisation of the stock market on which it is listed?

You are required to explain your reasons including:

i) Impact of share repurchase on market capitalisation

ii) Impact dividend payment on market capitalisation

1. In the stock market, investors may face high volatility in the investor’s portfolio. And sometimes the investor may have low volatility in the investor’s portfolio. The market condition of the stock market does not stay in the good mood for long time period. Sometimes the stock market may have good time and sometimes the stock market may have bad times. It totally depends on the market condition and the economic condition and also political condition of a country.

If the investor invest half of the investor’s savings in a risk free asset in portfolio P and also invest half of the investor’s savings in a risky portfolio, then the investor should keep three things in mind:

a) The investor should keep different types of bonds, equity, mutual funds in the risky portfolio. So that if the market condition of one asset is in bad mood another asset can balance the portfolio.

b) The investors should not keep only blue chip stocks in the portfolio. As the price of the blue chip stock is very high, and if the stock price falls then the investor rate of return will also fall very badly (Agrawal, 2009). So, if the investor picks different types of assets whose rate of return is also different then the investor may ensure large gain from the investor’s risky portfolio.

c) The investor should keep in mind to minimize the unsystematic risk to the companies or group who are small in size and are from different industries.

Beta: The volatility of a stock can be measured by beta. The beta of a stock one means that the price of the stock will be in tandem. If the value of beta of a stock is equal to less than one that means the volatility of the stock as compared to the overall market condition is less. And if the value of the beta is above one that means the volatility of the stock as compared to the overall market condition is more and the equity can respond more strictly.

Ways to Reduce Volatility

The investor can reduce the volatility by selling the high beta shares and substitute them with low beta shares.

Hedging: Hedging strategy means when the traders gets into the long position or in the short position in the capital market the trader can use the hedging strategy. When the traders make the portfolio, the traders should keep in mind that from all the securities or the shares, the trader cannot earn a profit (Crouhy, Galai and Mark, 2000). May be the trader may run in loss while investing in the market. To minimize the loss the traders should hedge their portfolio with different shares or securities so that the loss from one share gets minimize by making a profit from other securities.

Bonds: When the investors have a high risk factor in the portfolio of the investor, there is a chance for the investor to face less return from the investor’s investment (Holmes, 2002). That time the investor wants to find a safe place to keep his investment after facing the loss from the investment.

The investor can reduce the risk from the investment by investing the investment into the bond. It also helps the investor to bring good amount of income.

Cash: The investor should keep some amount of cash with the investor so that if the share price or the portfolio goes down then the investor can buy shares at the time of inflation which will make the portfolio less risky (Hopkin, n.d.). This is because when the share price will go high the investor can sell out the share and can earn a large margin of profit from the share which can minimize the loss occurred by the other shares of the portfolio.

2. Open end fund means the collection of stocks which can be redeem and issue at any time. Open end fund is offered mostly in the countries which are already developed. The investor can buy the share directly from the fund. An open ended fund can also be known as big pool of money. The open end fund contains plenty of money which belongs to the investors. The fund of the open end fund is alienated into units. In open end fund, the investor can buy or sell the units at any time. When the investor invests in the open end fund, the fund gets bigger in size.

The price of the unit is calculated in daily basis. It is measured by the values of the bonds, equity and other assets and divides the price of the assets by the total number of assets.

An open ended fund generally invests in both the bonds and equities. They also keep cash in hand for future purpose and an open ended fund also invest in the market of derivative. The cash which are kept to manage the portfolios are saved for the future purpose (Jordão and Sousa, 2010).

When the investor wants to invest the money in the open end fund, the fund manager of the open end fund will guide the investor about what type of assets can be purchased by the investors. The main aim of the fund manager of the open end fund is to give maximum return to the investor with respect to the investment made by the investor. The main reason of investing the money in the open end fund by the investor is to get the maximum return and after getting the profit from the investment, the investor will again invest in the open end fund (Krause, 2006). This situation will make the fund of the open end fund much bigger.

Open-End Funds

The two main kinds of open ended funds are:

Unit trusts: The unit trusts are dual price. When the investor buying the unit trust, some amount of money is charged by the fund manager (Bell and Jenkinson, 2001). The variation between the buying price and the selling price is the profit for the investor.

Open ended investment companies: It contains single unit price. Most of the unit trust is now converted into the open ended investment

Forward Pricing: The forward pricing is one of the most valuable characters in open end fund. The main function of the forward pricing is when the investor wants to buy or sell the units from the fund, the investor will not know the exact price of the unit until and unless the deal gets done (Cohen, 2012).

For example: In the afternoon time at 12 o clock, the fund gets its tag. If the investor wants to buy or sell a unit in the morning. And placed an order for the unit from the fund. The investor will not have any idea about the buying price or the selling price of the unit.

The main aim of the forward pricing is to dispirit the trading which is short term in open ended fund.

In share repurchasing, the company ignores the taxation part of the company. But it will make an effect on the cash dividend of the shareholder. The company is distributing the cash to its shareholders. This shows that the company is really thinking about the shareholders wealth.

Some share holders do not want sell the shares of the company, because they think the market price of the share will increase  (Kari, Karikallio and Pirttilä, 2009). Sometimes they repurchase the shares of the same company. The share holders think that the company will give high dividend value to the share holders. This situation will make the share holders to increase the ownership of the company in a greater fraction (Xu, Yasinzai and Lev, 2013).

Theoretically, repurchasing the share of the same company will not change the market price of that particular share in the market. The problem faced by the share holders are the market price of the shares gets reduced by the amount value given as the cash dividend to the share holders. The main reason of this prospectus is the company concentrates on the rights of the company but simultaneously, the value of the company gets reduced by the equal amount of cash spent in shares buy back (Idowu et al., 2013).

According to taxation rule, the buy back shares of the company treats the profit of the company as the capital gains. When the share holders get the dividend from the company, the share holders need to pay tax to the government. This is because the amount of dividend earned by the shareholders is treated as the capital gain for the shareholders which are fully taxable. When the company earns profit, company thinks about the share holders wealth and gives dividend to the share holders of the company. Sometimes, the company refused to give the dividend amount to their shareholders because the company wants to spend the profit by giving dividend to the share holders of the company (Lease, 2000).

Types of Open-End Funds

Another alternative impact of repurchasing the shares of the same company is to reinvest the earnings in the company’s project which will help the company to grow rapidly in the market and can earn more amounts of dividends from the company, as the company will earn more profit (Xu, Yasinzai and Lev, 2013).

Dividend policy of a company means the total amount of dividend paid by the company and the amount of profit earned by the company retained in the company to invest in a new project. The dividend policy is associated to dividing the profits earned by the company between the share holders of the company and the amount of profit retained in by the company for investing in a new project (Poterba, 2004).

Many corporate analysts studied that the impact of company’s dividend is recorded on the risk factor of the company. They made many research on this risk factor and found that the company’s size, firm’s leverage and company’s dividend policy have major relationships of company’s risk factor. The corporate analyst studied that the company which have higher beta values are related to lower dividend payments among the share holders (Santoro and Wei, 2008). This shows a negative union between the dividend policy of a company and the risk factor of the company. This means the company who have more beta value has high financing cost, so the company is like to follow low dividend policy among the share holders of the company.

Another union of corporate analysts studied the relationships between the dividend payment to the share holders and the volatility of the market price of the share. When the market price of the company is highly volatile in the market, the company should not take the risk to pay out the dividend to the share holders of the company (Xu, Yasinzai and Lev, 2013). If the company still spent the profit among the share holders of the company, then the company is thinking about the share holders wealth and secondly, the company wants to attract more share holders towards the company so that the share holder will invest more in buying the shares of the company due to the dividend policy. This will make the fund of the company more efficient and can invest more amounts of money in new projects of the company to earn more profit from the projects. When a firm reduces the amount of cash by paying out the money as dividend paid by the company to the share holders, then the company’s value of the equity fall by the identical amount of dividend paid by the company to its share holders (Appendix).

For example: Newco has 20,000 shares outstanding and total income is $ 100,000. The market price of share is $ 40. How does it effect on 1 % stock repurchase.

Price per Earnings ratio of Newco = $100,000 / 20,000 = $ 5 per share

P/E ratio = $ 40 / $ 5 = 8x

With 1 % stock repurchase,

Newco’s shares outstanding are reduced to 19,800 shares (20,000 * (1-0.1))

Newco’s EPS = $ 100,000 / 19800 = $ 5.26

References:

Casey, K. (2009). Dividends. [Bradford, England]: Emerald.

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Lease, R. (2000). Dividend policy. Boston, Mass.: Harvard Business School Press.

Poterba, J. (2004). The impact of population aging on financial markets. Cambridge, Mass.: National Bureau of Economic Research.