BUU33680 Investments Assignment Example TCD Ireland
Investments can be a great way to secure your financial future, but it’s important to do your research before investing in anything. There are a variety of investment options available, so it’s important to understand the risks and benefits of each one before making a decision.
When investing, it’s important to remember that there is always some risk involved. No investment is guaranteed to make you money, so it’s important to be financially prepared for any potential losses. It’s also important to diversify your investments and not put all your eggs in one basket.
This assignment example covers the fundamental concepts and theories of investments, including risk management. It also covers portfolio performance both domestically as well as internationally, and provides a summary of the most common strategies for investors.
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In this unit, there are many types of assignments given to students like individual assignments, group-based assignments, reports, case studies, final year projects, skills demonstrations, learner records, and other solutions given by us.
In this section, we are describing some tasks. These are:
Assignment Task 1: Assess the main concepts of investment theories and their applicability to individuals, financial firms, and companies.
Investment theories assess the relationship between risk and return. Investment decisions are driven by an array of factors, including inflation rates, taxation levels, current interest rates, economic growth prospects, future consumption rates, returns on competing assets, and investor perceptions of available assets. Financial theory suggests that investors should be willing to accept an investment’s volatility in return for its expected upside or return.
The following theories are all used by investors to guide their investment decisions:
Capital Asset Pricing Model (CAPM): The capital asset pricing model is the most common framework that explains the relationship between risk and reward in investments. This model suggests that an investment’s required return is determined by its systematic risk, or volatility in returns, rather than its specific risk. This relationship is expressed mathematically using the following equation:
Risk = ƒ(β) x α
Where “Risk” is the total risk of an investment, “Beta” is a measure of how volatile an investment’s returns are relative to that of the overall market, and “α” is the risk premium or required extra return on top of the expected market return.
The CAPM equation requires an estimate for both beta and alpha. Beta estimation can be done using historical returns, which are more reliable when longer periods (e.g., three to five years) are used. The goal of beta estimation is to calculate the historical co-movements between an investment and market returns. Alpha, on the other hand, is difficult to estimate due to its subjectivity, but it can be linked to expected returns derived from valuation ratios.
Mean-Variance Optimization (MVO): The mean-variance optimization theory (MVO) suggests that investors prefer investments with the highest possible expected return and lowest possible risk. The MVO model provides a formalization of the trade-off between returns and risks, thus creating a benchmark for evaluating investment options.
The MVO assumes risk is measurable, which may not always be accurate because it may be difficult to measure or determine the risk associated with some investments. The MVO model also assumes that an investment’s risk can be reduced through diversification, which may not always be true because some investments are highly correlated. For example, stocks in Europe tend to move closer together.
Capital Market Line (CML): The capital market line plots expected returns against systematic risk (beta). The CML assumes that investors can diversify their portfolios at no cost, but this assumption is also subject to criticism because the costs of diversifying portfolios are not always negligible. Additionally, the CML assumes that beta estimates are correct.
Efficient Market Hypothesis (EMH): The efficient market hypothesis (EMH) states that since markets are rational, unpredictable short-term stock price movements should not be exploited by investors. According to the EMH, an investor would be unable to outperform the market by consistently buying stocks that are expected to increase in price or by selling stocks expected to decrease in price. Thus, investors who attempt to beat the market are said to be engaging in a zero-sum game where they can only succeed at the expense of other market participants.
Assignment Task 2: Compare the main categories of financial assets and their role in allocating consumption over time.
Financial assets are financial instruments that can be traded or sold on financial markets. Financial assets include cash, notes, accounts receivable, bonds, stocks, shares in trusts, mutual funds, money market accounts, etc. Assets can also be classified as tangible (physical) or intangible. Tangible assets include land/real estate, machinery/equipment, and inventory/stock. Intangible assets include patents, trademarks, copyrights, goodwill (e.g., brand value), etc.
Financial assets are important to allocate consumption over time because they allow individuals to borrow money in the present if they promise to pay it back with interest by a certain date in the future. Other types of financial assets are investments that provide us with the ability to generate income in the future. For example, savings accounts allow us to save money now and withdraw it later when we need it for consumption without incurring a penalty. Stocks enable investors to invest their money in companies they believe will increase in value over time so that they can sell these stocks at a higher price and make a profit. Bonds allow an investor to lend money to an entity (e.g., company or government) and receive interest payments in return until the bond’s maturity date at which point they will get back the money lent plus interest.
Assignment Task 3: Evaluate the relationship between risk, return, and the covariance of asset returns, and how these contribute to overall portfolio risk and performance.
The relationship between risk, return, and the covariance of asset returns is an important one for investors to understand. Covariance is a measure of how two assets move together. If two assets have a covariance of zero, they are not related to each other. If the covariance is positive, it means that when one asset returns more than the other, the other likely did too (and vice versa). If the covariance is negative, it means that when one asset moves up in value more than expected, the other moves down in value more than expected (and vice versa).
Risk is measured by standard deviation. The more volatile an asset, the riskier it is. Investors generally seek investments that offer the highest returns for a given level of risk (e.g., stocks are risky but provide higher potential returns than bonds). Diversification reduces portfolio risk because it allows an investor to reduce the covariance of their assets. The more uncorrelated assets in a portfolio, the lower its overall risk.
In general, investors want to find investments with low covariances to reduce overall portfolio risk. This is because risk increases (measured by standard deviation) are generally accompanied by decreases in expected return. So by reducing the variance of an investment, we can also increase its expected return. Diversification is a way to reduce the overall risk of one’s portfolio and increase potential returns (at least in theory).
Assignment Task 4: Use financial mathematics to calculate the optimal allocation of investment capital between risky assets.
Portfolio optimization is the process of finding the optimal allocation of an investment portfolio such that it maximizes return for a given level of risk or minimizes risk for a given level of return. There are several techniques used to optimize portfolios including mean-variance analysis and Markowitz’s theory. These calculations can require complicated mathematics. Here, we will focus on the mean-variance approach (since this is what is tested on the exam).
The mean-variance model uses equations to solve for portfolio return and risk. The first step of this process is to identify the set of all possible portfolios. The next step is to calculate each portfolio’s mean and variance (expected return and risk). The final step is to select a portfolio that maximizes the expected return for a given level of standard deviation (risk).
Assignment Task 5: Critique the theory underlying asset pricing models such as the Single Index Model, the CAPM, etc.
In general, investors want to find investments that offer the highest expected return for a given level of risk. To find such an investment, they can use models that help them identify high-performing assets through past returns. However, no current model is perfect and all asset pricing models have some limitations. Two common models used by investors are the single-index model and the capital asset pricing model (CAPM).
- The single-index model is a model that uses past return data on an asset to predict future risk-adjusted returns. The single index model (SIM) states that investors should value a stock based on how well it correlates to the overall market. The theory behind this model is that all assets can be represented as combinations of one or more commonly available publicly traded indices. In other words, all publicly traded assets in the market only vary due to differences in risk and return. This model focuses on the variance of an asset’s excess returns which is calculated using a beta coefficient.
- The capital asset pricing model (CAPM) directly relates risk and expected returns for individual securities. The CAPM states that the expected return on any security is equal to the rate on a risk-free asset (e.g., a risk-free T-bill) plus a risk premium that is proportionate to systematic market risks. The CAPM model requires that all assets are correctly priced which means they should have a linear relationship between risk and return.
These models allow investors to estimate the expected return of each asset and this is useful for them in managing their portfolios. However, these models are limited in their accuracy since they do not take into consideration the effects of risk aversion or taxes. Additionally, other factors affect expected returns including liquidity and time horizon. These limitations need to be considered by investors when using asset pricing models.
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