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Power Financial Management-1-July-Dec-14

Power Financial Management-1-July-Dec-14

Section A (20 Marks)

Write short notes on any four of the following

1.      Scope and Nature of Financial Management

2.      Public Deposits and ICDs

3.      Economic Value Added (EVA) vs. Earning Per Share (EPS)

4.      Security Market Line (SML)

5.      Cost of Equity and Cost of Preference Shares

 

Section B (30 marks)

 

(Attempt any three)

1.      Explain the Calculation of the Compound Growth Rate.

2.      Evaluate leasing as a source of finance. Discuss the types of lease.

3.      Discuss about Beta Factor of a Market Portfolio.

4.      Elucidate the Capital Asset Pricing Model (CAPM) Approach.

 

Section C (50 marks)

 

(Attempt all questions. Every question carries 10 marks)

 

Read the case “Unique Risk – Market Portfolio.” and answer the following questions:

 

Case Study: Unique Risk – Market Portfolio

 

In this case, we will bring together everything discussed so far and describe how the ideas can be applied to your investments.

A two-asset portfolio still carries with it a great deal of unique risk that should be diversified away.

 

As the above graph from illustrates, adding more assets to your portfolio decreases the unique risk of your portfolio.

So what is the best way to diversify your portfolio to eliminate unique risk completely?

Every Stock

Let’s create a graph, but instead of the graph only representing a two-asset portfolio, let’s graph portfolios containing all of the stocks in the market. Just as with the two-asset portfolio, there are combinations of assets that are more efficient than others.

 

The dots represent portfolios that aren’t efficient and the curved line represents the efficient portfolios. Remember, an efficient portfolio is one whose expected return can’t increase without also increasing the standard deviation of the portfolio.

Let’s also assume, as we did in the previous article, that there is a risk-free asset available to investors that allow lending and borrowing at the risk-free rate (this is labeled rf on the graph).

As was described in the previous article, it is better to invest in the efficient portfolio that is tangent to the risk-free rate line and then lend or borrow at the risk-free rate than it is to invest in a different efficient portfolio or a non-efficient portfolio.

Market Portfolio

It turns out, the point of tangency between the risk-free line and the efficient portfolio frontier of all available assets, labelled m in the graph above, is actually the market portfolio (i.e. the weighted average of all the assets in the market)!

Therefore, what the theory concludes is that investors should invest in the market portfolio and then lend or borrow at the risk-free rate in order to obtain the highest expected return with the desired level of risk exposure.

By investing in every stock in the market, you are able to eliminate unique risk, thus leaving yourself exposed only to market risk!

Application

Market portfolio. Risk-free asset. Aren’t these all just theoretical ideas? Yes, but there are close analogues in the real investing world.

The easiest way to invest in the market portfolio is not to go out and buy every stock in the market. Companies like Vanguard have already done the hard work for you and offer total stock market index funds to invest in. The even better news is, they actually charge very low fees for this service so you get the benefits of diversification without having to pay a lot of money in management or transaction fees!

How about the risk-free asset? While the risk-free asset is just a theoretical financial instrument, there are risk-almost-free assets that come close. Short-term US Treasuries, for example, are probably the closest analogue to a risk-free asset, since they are backed by the US government and carry very little risk of default.

 

 

Questions:

1.      Discuss how the market portfolio is the ideal efficient portfolio to invest in.

2.      How adding more assets to your portfolio decreases the unique risk of your portfolio?

3.      Suggest the easiest way of investing in the market portfolio.

4.      Discuss about the features of risk-free asset.

5. By investing in every stock in the market, you are able to eliminate unique risk, thus leaving yourself exposed only to market risk. Elucidate.

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