Risk Premium and Uncertainty

Portfolio theory could be deemed as a modern theory focusing on the ways through which the risk-averse investors could form portfolios for maximising or optimising expected return depending on a provided market risk level. This emphasises that risk is a significant part of greater reward. The theory states that an efficient frontier of optimal portfolios could be developed providing the maximum expected return for a provided risk level. This assignment would shed light on the various aspects of portfolio theory based on the provided scenarios.

Risk premium could be defined as the excess of risk-free return that an investment is estimated to yield. The risk premium of an asset is a kind of compensation for the investors tolerating additional risk in contrast to that of an asset, which is risk-free, in a provided investment. For instance, the enhanced quality corporate bonds that the established organisations issue earning bigger profits have lower default risk.

The major sources of uncertainty associated with the future payments include the following:

Unpredictability of future events:

This implies the inability to gain an insight about the future. The analysts might undertake efforts for addressing the same by estimation; however, the uncertainty might exist despite of such attempt.

Limitations on the precision of data:

This implies the inability in gauging many variables having greater degree of precision at an affordable cost. As a result, the future payments could not be ensured.

The decision related to asset allocation is not an individual choice, since a fixed return is expected from the portfolio and the weight of that particular asset is reliant on other investments. For instance, the market return is expected to be 12%, while 50% of the money is invested in risk-free return of 7%, it is necessary to take into consideration the same. Accordingly, investment would be made for obtaining a return of 12%. Therefore, it could be said that the asset allocation decision is not an independent choice.

It is not possible to know whether an investment is sound or bad by looking into the return of the portfolio and thus, it is necessary to compare the same with other investors making similar investments. There are two standards to evaluate portfolio performance, which are enumerated briefly as follows:

Conventional method:

This method does not consider the risks undertaken by the portfolio managers. In this method, the portfolio performance is assessed by contrasting the returns of the portfolio with those of the benchmark, which could be a market index or another identical portfolio.

Risk-adjusted methods:

In these methods, the portfolio return is contrasted with the benchmark returns by taking into account the risk level difference. Sharpe ratio and Treynor ratio are the two popular techniques used to carry out the same.

3. Capital market instruments are long-term financial instruments in the form of equity or debt, which are traded either on stock exchanges or between the borrowers and the investors. Capital market instruments are of various types, which include the following:

Shares:

Shares could be deemed as the share capital of an organisation. It is a unit into which the business capital is divided. Any individual holding the shares of an organisation is termed as its shareholders and thus, the person is considered a part of the business owner. Shares could be classified further into preference shares and equity shares.

Asset Allocation Decision

Debentures:

Debentures are those borrowed funds for an organisation, which are for long-term. The maturity periods and interest rates of the debentures are fixed. More precisely, debentures are the certificates, which are issued in accordance with the common seal of the organisation.

Bonds:

Bonds are funds borrowed from the government as well as organisations, which are for long-term. The bonds have fixed interest rates and maturity periods like bonds. The interest, which is charged on bonds, is considered as the coupon rate.

Derivatives:

Derivatives are derived from other securities and they are termed as underlying assets as well. The riskiness, function and price of the derivative rely on the underlying assets, as the factors influencing the underlying assets would influence the derivative as well. For instance, derivatives include options, swaps, futures and exchange-traded commodities and funds.  

A financial market is a process by which the purchasers and sellers could communicate about the pertinent aspects of the transactions. There are agents in the markets, who provide vital information as well as logistics support for passing over the ownership of the traded securities. A good financial market possesses the following characteristics:

• Correct and quick information for the investors needed for share transactions
• Ensuring that there is not variation of prices from one transaction to another until the availability of new information
• Trading is made at prices below and exceeding the existing market price
• There is minimum transaction cost
• All information regarding demand and supply factors should be readily available

In primary capital market, the investors purchase securities directly from the organisations issuing them and the organisations mainly use this market when they sell new bonds and stocks for the first time publicly as initial public offering. The organisations issuing shares in this market mainly hire investment bankers for gaining commitments from big institutional investors to buy the securities at the time of initial offering.

In secondary capital market, the investors are involved in trading shares among them and there is no participation of the organisations in such transactions. More precisely, shares are traded in this market after all stocks and bonds are sold in the primary market.

The security market indexes are used for the following purposes:

• It could be used in the form of a benchmark for analysing the performance of the professional money managers
• To develop as well as monitor index fund
• To gauge the market rate of return in economic analysis
• To estimate the movements in the future market by technical experts
• It serves in the form of a substitute for the market portfolio of assets that are risky at the time of computing systematic risk

Efficient capital market could be defined as the market where shares are traded and there is quick incorporation of new information regarding prices. Despite the fact that this theory is applicable to all kinds of financial securities, it mainly emphasises on one type of security, which are shares of a common stock in any business organisation.

The capital market theory is based on certain assumptions, which are discussed as follows:

• It becomes easy for the investors to lend or borrow money that are risk-free
• All investors in the market are perceived to be efficient
• All the investors have the same time horizon
• It is possible to divide the assets indefinitely
• There is no existence of transaction costs and taxes
• Inflation is not considered at all in this theory
• All the investors have identical probability for outcomes

Industry analysis could be defined as a tool facilitating an organisation in gaining an understanding of its position compared to the other organisations in the industry offering identical products or services. This analysis mainly comprises of these elements. They include underlying forces of work in the industry, overall industry attractiveness and crucial factors ascertaining the success of an organisation. A technique that could be used to evaluate is by contrasting a specific business with the average of all participants in the sector by using ratio analysis and comparison. Another technique is the Porter’s five forces model, which depends on certain attributes. These attributes mainly include bargaining power of the suppliers, rivals and nature of rivalry, bargaining power of the buyers, potential for new entrants and ability of substitute products. Despite after assessing if the industry is in maturity stage or declining stage, it is not a feasible option to invest in the industry. On the other hand, despite performing well in a slow growth sector or the sector is not performing, as the forces such as climatic, political and inflation are influencing the sector, it is not viable to invest in the sector.

Business cycle, termed as trade cycle or economic scale, is the upward and downward movement of the gross domestic product (GDP) around its long-term trend of growth. The business cycle duration is the timeframe containing only one contraction and boom in place. Such cycle is gauged by taking into account the real GDP growth rate. If any business is associated with infrastructure in a developing nation, then the investment is advantageous, since the nation requires infrastructure greatly.

Conclusion:

It is evaluated from the above discussion that portfolio theory plays a crucial role in the decision-making process of the investors. This is because it takes into account all the risks and returns that the investors could earn by evaluating the stock market scenarios and industrial nature.

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