Finance Assignment Sample- Financial Risk Analysis

Monthly Returns = – 1
Average Return =Σ prices/Number of prices considered
See Portfolio.xlsx

‘β’ indicating the slope of the stock measures the market related component of the portfolio risk. The sensitivity of the stock in a broad market index such as S&P 500 index is indicated by the ‘β’ of a stock. Low ‘β’ reflects low risk and high ‘β’ reflects high risk. (See Portfolio.xlsx)

Thus, an investor considers ‘β’ of a stock as a pure measure of the risk in order to evaluate that how much reward can be earned by him for the non-diversifiable risk* which is being assumed in regard of a security.

*Non-diversifiable risk / Systematic risk (in relation to portfolio investment)

It is a type of risk that cannot be eliminated even by diversification. Every security has a tendency to move with the fluctuation in the market, which is the major cause of this risk. Every investor is exposed to a market risk, no matter how well diversified his portfolio of securities is. The reason behind this is that each individual security moves together exactly in the same manner & hence, it is not possible to avoid or eliminate this risk, whatsoever precautions of diversification may be taken.

Following are the different forms of Systematic Risk:

Interest Rate Risk: the welfare of the investors depends on the fluctuations in the interest rates. The interest and the price of the security moves in opposite directions. If the interest rate goes up, the market price of the security will fall and vice versa. This happens because no buyer of a fixed income security will buy the security at its face or par value if the interest rate is lower than the prevailing rates over a similar security.
Social or Regulatory Risk: this type of risk arises where a profitable investment is impaired due to the adverse legislation (such as an increase in the corporate tax rate, the government starts massive deficit financing, strong regulatory climate, or in extreme situations socialistic government resorts to nationalization).
Purchasing Power Risk: Inflation or rise in prices has a direct relation with the rise in costs of production, deteriorating margins, rise in wages and squeezing of profit etc. The expected return of the investors will change due to the change in the real rate of returns.

The actual return of the fund can be compared with a benchmark portfolio with the same risk using “Jensen’s Alpha”. Usually in the way of comparing the portfolios, this ratio is applied and then it is compared to the market return. It reflects the comparative risk and return from the said portfolio. Alpha is the excess of actual return when compared with the expected return. (See Portfolio.xlsx)

“Jensen’s Alpha” indicates excess of actual return when compared with the expected return, whereas the linear relationship between the expected return and the systematic risk of all the portfolios are depicted by “Security Market Line (SML)”.

Thus, if an asset has a positive Jensen’s Alpha, i.e. if the actual return exceeds the expected return, it will be plotted above the SML.

The residuals in the regression refer to the unexplained risk/unsystematic risk of the portfolio. This unique part affects only the individual company but not the entire market on account of micro events such as fire, strike etc.

(See Portfolio.xlsx)
Beta [as computed in 3 (a)] i.e. 0.3674 indicates that Colgate-Palmolive stock is 0.3674 times riskier than S&P 500 index. The relative volatility of Colgate-Palmolive stock with returns for the aggregate market is measured by the Beta. It is the sensitivity in the portfolio on account of market movements.
(See Portfolio.xlsx)
Stock Risk Premium = Return on Stock – Risk Free Rate

Market Risk Premium = Return on S&P 500 – Risk Free Rate

Fitted line in 3 (d) captures the “Characteristic Line”. With the movement of the major market, most of the securities also move in the same direction but at different rates. The relationship between return on the market portfolio with return on individual securities can be expressed using a characteristic line.

The relative volatility of the returns of a portfolio with the returns for the aggregate market is measured by the slope of a Characteristic line. The slope is represented by ‘β’.

Deviations from the fitted line represents the unexplained variance of the portfolio, which is often termed as residual variance or unsystematic risk.

Unsystematic Risk

This type of risk can be eliminated using diversification. The changes in return of a security due to some specific factors of particular firm only and not to the market as a whole is represented by this risk. When a portfolio is formed by a large number of securities, the random fluctuations in returns due to these securities automatically set off each other.

Unsystematic Risk can be of the following types:

Business Risk: being a holder of equity shares or debentures, the investor has to face the risk of poor business performance. Factors like the expert of the Research and Development leaves the company; a competitor enters into the market; loosing a big tender; introduction of new technologies; shifts in the preferences of the consumer etc. are the major causes of this risk. However the principle cause is the poor management.
Financial Risk: it is related to the prevailing method of financing in the company, due to high leverage the problems of large debt servicing arises or the problems of the short term liquidity due to delayed receivables and change in working capital.
Default Risk: this risk occurs due to a default in paying the interest and/or principal on time by a borrower. Except in the case of a highly risky debt instrument, the investors are more worried due to the apparent risk of default rather than the actual occurrence of default. Though it is unlikely that the actual default may occur but due to the perceived risk of default has a bearing effect on its market price.

Hence, the deviations relate to risk on account of unexpected pieces of good and bad news relating specifically to the company or industry in which it is engaged.

(See Portfolio.xlsx)
Beta [as computed in 4(a) i. ] i.e. 0.4704 indicates that colgate-palmolive stock is 0.4704 times riskier than S&P 500 index. The relative volatility of Colgate-Palmolive stock with returns for the aggregate market is measured by the Beta. It is the sensitivity in the portfolio on account of market movements.
(See Portfolio.xlsx)
(See Portfolio.xlsx)
(See Portfolio.xlsx)
As regards the arguments for and against using shorter versus longer period while the computation of beta and other factors, the following points must be considered.

Though, longer the estimation period the lower the chances of errors in the estimation of beta, but with a longer estimation period there are chances of a significant change in the beta. Thus, the beta which is estimated using longer estimation periods is considered to be biased and usually not used by the financial manager. Also, studies have demonstrated that longer horizons give more accurate betas. Shorter periods can reflect market or company aberrations more readily.

The longer time frame we choose, the more accurate the beta calculation will become.

Monthly data should be used

(1) So as to provide sufficient time for trading to transpire between measurements, especially for stocks which are illiquid,

(2) To give enough data points for a statistically sound measurement, and

(3) To provide a sufficient history of the return of the stock to properly project the true potential risk of the stock.

If daily or intra-day returns are used, then the number of observations in the regression will be increased, but the estimation process will be exposed to a significant bias in the estimation of the beta in relations of non-trading. For instance, when the betas are estimated for small firms using daily returns, have to suffer from non-trading, and are biased downwards. However, the non-trading bias can be reduced significantly using weekly or monthly returns.

Weekly data would be preferred over daily data, because the daily fluctuations may exaggerate the fluctuation of the stock price. Quarterly data isn’t preferred and is not common as it would not be able to minimize the realistic movement of the stock price.

A period of five-year is considered to be a more representative business cycle. The variation in the stock price can be best captured in terms of calculating the beta during a period of five years.

Some people prefer using daily data because it will give a better estimate of the beta by using same time period for estimation. However daily data can only be used if some conditions are fulfilled. The conditions that are necessary for using the daily data are that the securities should be traded frequently so as to make the daily data reliable.

The sources I used to compile the above answer:

University of Pennsylvania Papers
London Business School Faculty Sheets
Mihaylo College of Business and Economics Project Report

Yahoo Finance states the Beta of Colgate-Palmolive as 0.36 which is pretty much close to the beta we calculated by using the past 36months data.

The reasons for the difference can be:

Difference in time periods used.
The rounding off policy of calculations may differ.

The selection of data to compute beta can be different.