i Capital Asset Pricing Model: nvestment portfolio

An investment portfolio, according to Bodie, Z. (2013), is a collection of financial assets such as bonds, stocks, and cash equivalents, as well as other fund counterparts such as closed funds, that are held directly by investors or managed by financial professionals. While putting together an investment portfolio, there are numerous aspects to consider. Age, debt level and assets, marital status, parental status, risk tolerance, time perspective, and overall economic conditions are all factors. In terms of age, an investor should consider the asset allocation options available to different age groups, such as the legal requirements for trading in bonds. The level of debt and assets also affects financial portfolio construction for example; an individual with high asset value can trade in long term assets such as bonds while one with low asset value should trade in short term financial assets such as treasury bills. On the marital status, married people tend to prefer a portfolio with assets having long term maturities contrary to single people. On parental status, an individual who is a parent may not have time to follow through transactions in the financial market hence will have a portfolio which is not highly volatile such as long term bonds.

Risk tolerance, on the other hand, plays a vital role in constructing a portfolio. Risk averse people would want less risky financial assets while risk lovers prefer to earn higher returns on a high-risk financial asset. Time horizon would mean the maturity duration of the financial assets. Some investors prefer short-term low reward assets while others prefer long-time high reward assets. Finally, the general economic conditions affect portfolio construction for instance; a developed economy with a working stock exchange market would have investors prefer stock as part of their portfolio.

Part two

Task one

An efficient market is a market in which prices of securities fully reflect all known information quickly and accurately. Efficient Market Hypothesis (EMH) therefore states that the current stock prices reflect all known information and that for this to happen; the following assumptions must be met. One, there must be a large number of rational, profit maximizing investors. Two, information should be available at no cost. Three, the information should be generated in a random fashion and four; investors must react quickly and fully to new information (Bodie, Z. 2013).

For a market to be considered efficient, the stock prices must change in a random and unpredictable manner. This is called the random walk notion.

Forms of market efficiency

There are three forms of market efficiency (Bodie, Z. 2013). These forms are the weak form market efficiency, semi strong market efficiency, and strong market efficiency. In weak form, the stock prices reflect all the publicly available information, and it is impossible for any investor to take advantage of the market using historical data. In the semi strong market efficiency, the stock prices reflect all the public information available and the insider information hence an investor cannot beat the market b analyzing the present market or the historical data. In semi strong form efficiency, the stock prices do not only reflect public and private information but also takes into considerations possible future events such as inflation making it impossible for investors to make abnormal profits in the market by predicting the future or analyzing any publicly or privately available information. The efficient market hypothesis, therefore, inspires confidence in investors and promotes active trading since all investors are sure that no one can beat the market, however, there is no single efficient market in the world which is in a strong form.

Task two

There are many pieces of legislation that are aimed at reducing and ultimately eliminating unethical investing practices. An example of such practice is the use of insider information to gain extra profits at the expense of other investors (Brinson, G. P., Hood, L. R., & Beebower, G. L. 1995).

One, the investment law has defined the roles of an investment adviser, an investment advice representative, and a portfolio manager so that an investor does not be overcharged during a transaction with the mentioned intermediaries. Two, the securities Act of 1933 regulates the primary market and requires non-exempt issuers to register securities and provide full disclosure to investors. Three, the Uniform Securities Act is a model act in which state or government securities are based on. The act provides necessary protection to investors by preventing fraud through the regulation of the agents and brokers among other payers in the financial market. Four, the Securities Exchange Act of 1934 prohibits any person from fraud, and it is credited for having created the Securities Exchange Committee (SEC). Finally, the Insider Trading and Securities Fraud Enforcement Act of 1989 which addresses the insider trading and lists the penalties for violation of the Act.

Task three

From the information given, the couple has to invest $200,000 in two different sets of portfolios each having three common stocks, one American Depository Receipt (ADR) and three bonds with an option of leaving liquid cash.

Portfolio One

Invest 80% on common stock, 10% on the 10-year bonds earning and 5% on ADR and retain %yield to maturity 5% as cash.

Portfolio two

Invest 60% on common stock, 15% on 10-year bonds with a yield to maturity of 10% and 15% on ADR then save the rest as liquid -cash.

The financial assets are allocated according to the risk-reward relationship. For instance, investing in corporate bonds is riskier due to the high risk of default.

The Following graph is a representation of a positive correlation between risk and reward.

The X axis represents the standard deviation and beta (risk) while the Y axis represents the rate of return on the portfolios. The line showing the positive correlation between the risk and reward is called the security market line.

Part three

Dividend discount model

According to Brinson, G. P., Hood, L. R., & Beebower, G. L. (1995), a dividend discount model is a model used to determine the price of a stock using the predicted dividends and to discount the dividends back to the present value. If the value obtained using this method is higher than the current value of shares in the market, then the stock is said to be undervalued.

According to the model, value of stock = Dividend per share / (Discount rate – Dividend growth rate). One of the most used form of the model is the Gordon Growth Model which uses the formula Price per share = D(1) / (r - g) where, D(1) is the estimated value of the next year’s dividend, r is the company’s cost of equity and g is the constant growth rate for dividends in perpetuity.

Capital Asset Pricing Model

The CAPM model was introduced by Treynor, Sharpe, Lintner, and Mossin having built on the work of Harry Markowitz (Brinson, G. P., Hood, L. R., & Beebower, G. L. 1995). The model provides a precise prediction of the relationship which should be observed between risk of an asset and the expected return. Just like any other model, there are four assumptions which guide CAPM. One, all investors will choose to hold the market portfolio. Two, the market portfolio will be on the efficient frontier. A passive strategy is efficient.

The mutual fund theorem implies that only one mutual fund of risky assets is sufficient to satisfy investor’s demands. Three, the risk premium of the market portfolio is proportional to both the degree of risk aversion and risk of the market of the average investor, and finally, the risk premium on individual assets will be proportional to the risk premium on the market portfolio and to the beta of the security on the market. CAPM model can be mathematically expressed as E(rp) = rf + βp[E(rM) – rf].

In conclusion, the performance of a portfolio is based on the relationship between the risks of the specific financial assets and the rewards of those assets.

References

Bodie, Z. (2013). Investments. McGraw-Hill.

Brinson, G. P., Hood, L. R., & Beebower, G. L. (1995). Determinants of portfolio performance. Financial Analysts Journal, 51(1), 133-138.