Essay Sample about Diversification of Investment Portfolios

Question 1 Assessment

Diversification is not only a risk management strategy but a concept that can be applied in all other fields of human study. Although the diversification concept has been in existence for a long time, most people especially the risk investors do not clearly understand the meaning of this concept. Diversification is one of the risk mitigation techniques which combine a mixed variety of investments within a given portfolio. This technique is preferred because the idea contends that a portfolio constructed by considering a number of different risks will on the average tend to yield more return and is accompanied by a lower risk as compared to an individual investment that is found within the portfolio. There are a number of benefits that an investor can get that are associated with diversification. The main benefits of diversification include the minimization of risk of loss. This can be explained as one of the investments in the portfolio performs poorly in terms of the return in yields over a given period of time, the remaining other investments in the portfolio may perform better over the given period of time. This reduces the overall loss the investor would have incurred if he had invested in only one type of investment. Another benefit of diversification is that of preservation of the capital for future use. This is because not all investors are in their phase of life where they are accumulating capital or wealth hence there is need for the investors to accumulate capital that can be used during their retirement life phase. Another benefit of diversification is that of generating returns because sometimes investments do not yield the profits as expected hence diversification helps generate more capital by not depending on one investment only.

One of the instances where an investor would not want to embrace diversification is when the investor is assured of the returns of the individual investment he is investing in.Another case where diversification cannot be applicable is when the investor has one and only one possible investment. This limits the investor from the concept of diversification.

Question 2 Assessment

The Capital Asset pricing model (CAPM) is one of the most used models in the field of finance. The model is used to estimate the required rate of return of a given asset which helps in decision making in terms of allocating the assets to a well and a diversified portfolio. This model is used throughout the finance field and other related fields to calculate the costs of capital, in the generation of the expected rates of return for the given assets and the pricing of the risky securities. The CAPM model is given by the following equation;

E (ri) =Rf+vi (E (rm)-Rf)

Where the meanings of the variables are highlighted below;

E (ri) =Is the average rate of return that is required on the given financial asset i

Rf=is the risk-free rate of the return of the given return from the given asset

vi=The beta value for the financial asset I and lastly

E (rm) =is the average return on the capital market

This equation estimates the required return for a money-related resource as the aggregate of the risk-free rate of return and a hazard (risk) premium which repays the speculator for the deliberate danger of the budgetary resource. In the event that offers are being considered as E (rm) is the required return of value financial specialists, normally alluded to as the 'cost of value'.

The equation is similar to that of a straight line, y = a + bx, with vi as the autonomous or the independent variable, Rf as the intercept with the y-axis, and lastly (E(Rm) - Rf) as the incline or the slope of the line, and E (Ri) as the qualities being plotted on the straight line. This model assumes that the investors have a number of diversified portfolios. This implies speculators or the risk taker are assumed by the CAPM to need a return on a venture in view of its deliberate risk alone, instead of on its aggregate i.e. the total risk. The measure of risk utilized as a part of the CAPM, which is called 'beta', is in this manner a measure of efficient/systematic risk.

The base level of return required by financial specialists happens when the real return is the same as the expected return so that there is no hazard at all of the return on the speculation being unique in relation to the expected return. This base level of return is known as the 'risk-free rate of return'.

Question 3 Assessment

The Capital Asset pricing model (CAPM) is given by the equation

E (ri) =Rf+vi (E (rm)-Rf)

Where the meanings of the variables are highlighted below;

E (ri) =Is the average rate of return that is required on the given financial asset i

Rf=is the risk-free rate of the return of the given return from the given asset

vi=the beta value for the financial asset I and lastly

E (rm) =is the average return on the capital market.

These values are as given below;

Rf=3%

E (rm) =8%

vi=1.05

hence to find the Capital Asset Pricing model from the given above assumptions is given below;

E (ri) =3+1.05(8-3)

E (ri) =3+5.25

The CAPM (ri) =8.25 which is the expected rate of return that will be gained from the given assumptions

Question 4 Assessment

The Capital Asset pricing model (CAPM) is given by the equation

E (ri) =Rf+vi (E (rm)-Rf)

When the beta values are 0.75, 1.05 and 1.75; the following table to estimate the CAPM values is given in the summarized table below;

Rf v E (RM) market premium=E(RM)-v) CAPM is E (RI) =Rf + v [E (RM) - Rf]

3% 0.75 8% 5% 6.75%

3% 1.05 8% 5% 8.25%

3% 1.75 8% 5% 11.75%

When the risk free rate is valued at 1%, 3% and 6.5%, the following table was created to show the Capital Assets Pricing Model (CAPM) with the given different values of beta;

Rf v E (RM) market premium=E(RM)-v) CAPM is E (RI) =Rf + v [E (RM) - Rf]

1% 1.05 8% 7% 8.35%

3% 1.05 8% 5% 8.25%

6.5% 1.05 8% 2% 8.08%

When the risk free rate are 1%,3% and 6.5% and the beta values are 0.75,1.05 and 1.75 respectively, the following table shows the CAPM values for the above scenarios using the given assumptions

Rf v E (RM) market premium=E(RM)-v) CAPM is E (RI) =Rf + v [E (RM) - Rf]

1% 0.75 8% 7% 6.25%

3% 1.05 8% 5% 8.25%

6.5% 1.75 8% 2% 9.13%

Question 5 Assessment

From the statement above, the following information about the CAPM is given in the table below;

D0 = $ 1.75, Rate of return g= 6%

CAPM is E (RI) =Rf + v [E (RM) - Rf]

Given that is E (RI)=? Rf = 6% ,v = 1.1,E (RM) = 12%

Hence E (RI) =0.06 + 1.1[0.12 - 0.06]

Market premium is (0.12-0.06) = 0.06

Hence E (RI) =0.06 + 1.1(0.06)

Hence E (RI) =0.06 + 0.066= 0.126 or 12.6%

K=E (RI) = 12.6%,

The valuation model for any equation is given by

Valuation model = P= D0 (1+g)/k-g

= 1.75(1+0.06)/0.126-0.06

=$ 28.10606061

Question 6 Assessment

The given growth rates are as follows;2%,6% and 9%.The beta values from the statement above are given as 0.75,1.1 and 1.8.We are required to create a tables that shows the combinations of the above growth rates and the different beta values.

Rf v E (RM) market premium=E(RM)-v CAPM is E (RI) =Rf + v [E (RM) - Rf]

6% 1.1 12% 6% 12.60%

D0 $1.75

G 2% 6% 9%

k 12.60% 12.60% 12.60%

P= D0 (1+g)/k-g $16.84 $28.11 $52.99

Rf v E (RM) Market premium CAPM IS E (RI) =RF + v [E (RM) - RF]

6% 0.75 12% 6% 10.50%

6% 1.1 12% 6% 12.60%

6% 1.8 12% 6% 16.80%

v 0.75 1.1 1.8

D0 $1.75

g 6% 6% 6%

k 10.50% 12.60% 16.80%

P= D0 (1+g)/k-g $ 41.22 $ 28.11 $ 17.18

From the tables produced above for the diverse CAPM demonstrate factors; it demonstrates that as the expected rate of return change because of changes in the estimations of beta as beta shows the level of unpredictability or volatility of stock change and in return the cost of stocks increments. The purpose for that will be that as returns increment it draws in financial specialists such as investors driving appeal of stock which sequentially prompts stock cost increment. As the numerous investors run to purchase stocks in the organization its achieve a point that the value begins to fall because of weakening of the investments ,an ascending of profits payout to the investors. At the point when the values of the stocks begin falling still the investors purchases the stock because of averaging down idea.

References

Levy, H., & Sarnat, M. (2014). International diversification of investment portfolios. The American Economic Review, 60(4), 668-675.

Goldstein, I., & Pauzner, A. (2004). Contagion of self-fulfilling financial crises due to diversification of investment portfolios. Journal of Economic Theory, 119(1), 151-183.

Merton, R. C. (2011). An intertemporal capital asset pricing model. Econometrica: Journal of the Econometric Society, 867-887.

Glosten, L. R., Jagannathan, R., & Runkle, D. E. (1993). On the relation between the expected value and the volatility of the nominal excess return on stocks. The journal of finance, 48(5), 1779-1801.