Explain the challenges of Financial Investment.
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There are different options that are available in the market. The financial products have increased. It is important that suitable buying and selling of the stocks in the portfolio are made based on the different financial products.
The specific challenges that are there in the current stock market that have huge influence and impact on the investor decisions are as follows. The dynamism and uncertainty in the market has increased. In the current scenario the slowdown in the market isn’t high enough to match the inflation rate that is prevailing in the market. This is to say that in the times of high inflation the interest rates were also high
The complexity and the ambiguity in the financial markets has increased. Further after the financial crisis in 2008 the regulatory framework has made it more difficult to manage the investment as impact of these regulations will have to be considered
The investor thus must focus on developing a portfolio that is diversified. Further proper research is conducted on the expected return based on the tools such as CAPM which is one of the most basic tools. Further it is important that portfolio is well diversified so that risk could be managed effectively
The stock that has been selected to be included in the portfolio, as shown above, is Citigroup. The company operates in the financial services industry. It is one of the oldest and largest financial service providers in USA. This is one of the strengths of the company as being in the industry for such a long time and having significant market share lends stability to the business of the company. Further the financial industry is the backbone of any economy. After the financial crisis there was a downfall in the market. However the stability of the economy is returning and the recovery of the economy is backed by strong financial support which is provided by the financial institutions.
The company also has presence across various customers including consumers, corporations, governments, and institutions worldwide. The different services that are offered by Citigroup include traditional banking and commercial banking offering different services which include corporate, institutional, public sector, and high-net-worth clients. This segment provides wholesale banking products and services, including fixed income and equity sales and trading, foreign exchange, prime brokerage, derivative services, equity and fixed income research, corporate lending, investment banking and advisory services, private banking, cash management, trade finance, and securities services.
Considering the above discussion it can be said that the stock has been quite stable having tremendous growth opportunities. Overall it is advisable to purchase the stock as it will benefit the portfolio in maintaining steady growth and at the same time reduced risk as Citigroup has significant market share with good business operations to boost the stock price movement.
Based on the current economic conditions and the strong business portfolio of Citigroup it may be beneficial for making investment in the stock.
The table has been prepared showing the portfolio that has been developed based on the following criteria
|
Portfolio |
Citigroup |
USA High Income Mutual Fund |
USAA SHORT-TERM BOND |
United States Oil Fund (ETF) |
Certificate of Deposit |
Total |
|
Nos. |
100 |
100 |
100 |
100 |
||
|
Price |
$ 51.58 |
$ 8.45 |
$ 9.20 |
$ 17.73 |
||
|
Value |
$ 5,158.00 |
$ 845.00 |
$ 920.00 |
$ 1,773.00 |
$ 1,304.00 |
$ 10,000.00 |
The target of the above exercise is to develop a diversified portfolio. The portfolio signified above, consists of both high growth & stable asset in the form of Citigroup while the corporate bonds that have been selected are aggressive with short term viewpoint. It is important to note that the Citigroup has been considered as a hold stock whereas the certificate of deposits provides stability in the form of low return and risk associated with it. Significant investment i.e. around 10% of the total investment has been made in the CD. Overall the portfolio has the attributes that are required.
Based on the article by Tuchman it can be said that the risk and return have direct relationship. This is to say that as the return associated with the particular investment increases the risk associated with such investment would be high. Investment in single security exposes the investors to such risks resulting in making the investment vulnerable.
The article highlights three ways in which return in an investment can be maximized by minimizing the risk. It is important to note that the risk associated with an investment is linked to the volatility in the stock price. The three ways that have been suggested reduce such volatility. These have been discussed below
Diversification: Investment in a number of portfolios diversifies the risk associated with single security. This is beneficial as with proper balance of securities in the portfolio the return can be maintained whereas the risk associated with the portfolios reduce significantly.
Rebalance: In this the balance of the portfolio is maintained by selling or purchase of the stock based on their ability to generate the return. However it is important that significant and frequent changes may not be made to the portfolio as it will result in short selling and the investor will not be able to take the advantage of compounding.
Compounding: This refers t reinvestment of the earnings from the returns that have been generated. It is important that this may be considered as the investment made with long term horizon. Investors with short term perspective tend to make loss whereas in the long run the investors tend to gain more.
The beta of Citigroup is 1.84. The beta signifies the level of risk and volatility associated with the stock. It signifies the level of risk associated with the stock cannot be diversified. The two possible reasons for such high value of beta of Citigroup are as follows
Firstly considering the size and the market share of the company it can be said that the company is having huge impact on the economy and as well is impacted by the changes in the economy. This is to say that a small change in the economic conditions will have greater impact on the company as the market share of the company is high. Another important factor that may be there for the high beta value of the company is the international business operations. The presence of the company in a number of international locations exposes it to greater returns and risks. The factors that contribute to the performance of the company may be applicable for various international markets. Thus particular factors may be impacting a company having it operations in USA only to a certain extent but will have greater impact on Citigroup due to its presence in many international markets.
The portfolio Beta is calculated by calculating the weight of each of the component of the portfolio. This has been shown in the below table
|
Portfolio |
Citigroup |
USA High Income Mutual Fund |
USAA SHORT-TERM BOND |
United States Oil Fund (ETF) |
Certificate of Deposit |
|
Beta |
1.84 |
1.1 |
1.23 |
1.05 |
0.5 |
|
Weight |
0.52 |
0.08 |
0.09 |
0.18 |
0.13 |
The beta of the portfolio is 1.41. It is significant that beta has been managed and
There are several economic factors that can impact the performance of the security. These include inflation, interest rate, tax, subsidy, income level etc. The two major factors are the inflation rate and interest rates. In both the cases the investment reduces due to reduced demands of the funds. Another impact of inflation can be seen with respect to the return on the investment that has been made. This is to say that in case the return on the investment is higher than the inflation rate, it would be beneficial. In other cases the inflation rate may be higher than return on the investment that has been made, the return will not be there.
Similar is the case with interest rates. In case higher interest rate is provided for the savings, the investment return will not be considered by the investors. At the same time the increase in interest rates will increase the cost associated with the use of funds and thus the demand will be impacted.
The investors with fixed income are impacted most by the increase in inflation and interest rates as the earnings are impacted with these factors. Thus both these factors are hindrance to the investors as inflation reduces the earnings whereas interest rates impacts the cost related to borrowings and mortgage interest payments. Overall investment is reduced in case of increase in interest rates due to higher incentive for saving rather than investing.
In the present case the investment in certain securities in the portfolio will reduce and at the same time the deposits will increase where the fixed returns are there provided the return is higher than the inflation rate.
There are many theories that attempt to explain stock market behavior. There are certain market anomalies that contradict the efficient market hypothesis. These have been mentioned below
Of the above anomalies January effect is associated with the performance of the stocks in the month of January following the underperformance in the fourth quarter. The reason that is provided for such anomaly is that the investors use the losses made in the investment as a result of underperformance by offsetting capital gains taxes. Excessive selling can put the stock in the range of buyers thereby boosting the demand. Thus overall there is excessive selling pressure before January and after January the buying pressure is there due to favorable price of the securities.
Thaler (1987) conducted the study on this anomaly. It was concluded that the average return in the month of January exceeds the average return in other months of the year. This is actually true for many countries that were part of the study. However the relation with the capital gain tax isnt there. For example the capital gain tax isnt applicable in Japan but still the January effect could be noticed there. The study conducted by Tinic and West (1984) highlighted that January effect is more prominent in case of high risk stock and that these stocks have shown higher returns in the month of January in comparison to the other quarters.
January effect is certainly one of the most prominent anomalies. Further its is important to note that in the study by Thaler (1987) it has been shown that it isnt only the statistical phenomenon but has been supported by suitable reasoning.
The financial statement analysis has been performed based on the annual reports for the last two fiscal years of the Citigroup. The three components i.e. profit margin, asset turnover, and leverage have been studied on how these contributed to the change in Return on Assets and Equity of the company.
Firstly the three components are assessed individually. The net profit margin of the company which is the ratio of net profit to net sales made by the company has come down significantly. In the year 2013 this was in the range of 29% but reduced significantly in 2014 to 15% only. Considering the return on shareholders’ funds it can be said that the return has also come down significantly from 6.63% in 2013 to 3.45% in 2014. It is important to note that the return on assets has been significantly low in both the years. Lastly total asset turnover has been considered. In this there has not been significant change
Considering the above discussion the various factors that contribute to the performance of the company are profit margin, asset turnover, and leverage. These aspects broadly provide an insight into the performance of the company. The other factors such as cash flow, liquidity and financial costs are indirectly affected by these factors only.
Firstly considering the profit margin, it has reduced significantly. Profit margin has direct influence on the net profit margin, return on assets and return on equity. Thus the fall in the net profit of the company has deteriorated the performance of the company. Thus the profit margin has significant impact on the performance of the company.
The leverage is another important aspect. It is significant to note that equity employed is quite low in comparison to liabilities of the company which majorly includes the debt. Thus it can be said that the assets that have been developed are majorly contributed by the debt employed by the company.
Three important findings that have been discussed above are that there has been huge fall in the net profit margin, the return to shareholders fund has declined but the asset to shareholdings has not witnessed much change. From these aspects it can be said that the net profit margin and sales have been the major factors that have impacted return on assets and the return on equity. This is because net profit margin is driven to a certain extent by the sales and the return on assets and shareholders equity is directly affected by the net profit margin
The interest rate of 5% is used in discounting. The value of Moody’s Seasoned AAA Corporate Bond is considered. The long term average for this bond is 7.23%. Certain assumptions have been made in order to calculate the value of bond. This includes the value to maturity and the years to value. The value to maturity is taken as $100 whereas the ‘years to maturity’ is taken as 5 years.
The calculations have been shown in the below table
|
Year |
1 |
2 |
3 |
4 |
|
Coupon |
7.23 |
7.23 |
7.23 |
7.23 |
|
PV Value |
6.886 |
6.558 |
6.246 |
5.948 |
|
Total |
103.98984 |
The current value of the bond is being sold at discounted price as the current yield is lower than the value of the bond. The bond value is taken as the coupon payments that will be made and the value of the bond at maturity.
The factors that have an impact on the performance of the bonds are the interest rate and the inflation rate. As the interest rates increase the price of the bonds come down. However apart from this there may be other factors as well. These include credit ratings and inflation. The inflation rate has similar affect as that of the interest rates. On the secondary level exchange rate also has an effect on the bond valuation. This is because as the exchange rate will come down the interest rate will be increased and thus the price of the bonds will come down. Lastly the credit rating means the ability of the company to pay back to the creditors. As the credit rating improves the bond prices increase whereas the fall in rating reduces the bond price.
The five type of risks that have been highlighted are interest rate risks, purchasing power risks, Financial Risk, Liquidity Risk and the Call Risk. It is important to note that all the risks do impact the performance and return of investment. However interest rate risk is one of the major factors that has to be considered. Based on this the target should be to mitigate other risks as well. This is to say that interest rate risk will aggravate the effect f other risks as well. For example, the increase in interest rates will reduce the price of bonds thus leading to liquidity risk whereas the decrease in the interest rates will lead to increase in bond prices leading to purchasing power risks. Thus proper balance will have to be made considering the interest rate risk and thus managing the other risks accordingly.
It is important to note that the inverse will not be there i.e. liquidity risk or purchasing power risk leading to bond volatility or the interest rate risk. Thus it is important to consider this interest rate risk in the investment being made.
The yield to maturity of the most recently issued US treasury for various maturities has been shown below
Based on this the yield curve has been prepared and shown below
The above yield curve shows that in the long run the interest rates have increased in comparison to the short run. This is to say that the 3 month, 6 month and one year yield is lower than 5 year, 10 year and 20 year yield. This is done in order to safeguard the interest of the lenders considering the default by the borrowers.
In case the yield to maturity comes down, the earning of the investors is lower. This will be shown by lowering of the yield to level below the rate based on based on higher return rate. The other case is that of getting closer to the maturity date. As seen above the yield is lower for the shorter period. Since the chances of default be lower the yield will reduce as the bond gets one year closer to its maturity. Lastly in case the market interest rates increase, the chances of default will increase. The interest of the bonds will increase thereby resulting in higher yield as the risk of default will increase.
The Black-Scholes model to Value Options is shown below
According to the above formula with the call premium being function of strike price, it will be dependent on the strike price. Considering all factors to be constant the call premium can be said to be directly related to the strike price. Thus with the strike price increasing the second part of the formula will increase there by reducing the call premium. In other words high value of strike price the premium will reduce.
To conduct the analysis for the future contract Gold futures is being considered. The current value of the Gold future is $1217.40. One year ago the future price of Gold futures was $1287.40. Based on the market conditions suppose the future contract was purchased at $1300. The investment that is made is $1,000. Also the loss that is made is of $12.6. Since there will be 100 shares in one lot, the loss will be of $1260. Considering this it can be said that loss will be made. This is because the future price is reducing. The future contract were purchased assuming that the gold price will go up. However it has come down. But since the contract has been made the future contract will be purchased. However if the same is sold in the market it will fetch only $1217.4. This will result in greater loss. But considering the future contract the loss will be of $1000 and $1260 i.e. $2260.
It can be said that in near future the price of gold will go up. This is because the fall in gold price might be the result of profit booking. However the timing would be a factor and if one buys the future contract the profitability will be there as the markets will recover from the current position. It can be said that there is extensive fall in the prices and that the gold future market will recover.
|
If futures contract value decreases to $1,217.40 an ounce |
($4,540) |
-106.9% |
($1,180) |
– 100% |
In case of the anticipation that the stock in the portfolio will experience a significant decline within the next three months, different strategies can be potentially used to take advantage of to protect portfolio’s value. One of the strategies is to sell the call option. This will reduce the loss made on the stock. This will be beneficial as call option can be used even if the stock is not owned. In such a scenario if the stock price is $32 and the stock price falls to $30. In case of 100 shares call option the gain on call option is $100 whereas loss on 100 shares will be $200. Thus the net loss will be $100. In such a way the loss can be reduced. This is also called covered call option.
The second option that is available is the short put. In case the trading price of the stock s $42.50. In such a case if the strike price is $40 it can be sold for $2.50. This will credit of $250 for100 shares. Thus in the worst case scenario $4000 will be paid but the advantage of $250 will be there. Thus it will assist in minimizing the loss in case share value comes down.
The two strategies that have been discussed above are related to call and put strategies in options. The viewpoint of both the strategies is to minimize the loss that can occur.
There are many factors to consider when selecting mutual funds for a portfolio. One factor is the fees associated with owning the mutual fund. The US High income mutual fund has an expense of 0.98%. Comparing it to the yield and returns i.e. 5.58% and 8.38% respectively it can be said that the expenses are on the higher side. It is important to note that the fee s based on the asset value rather than the returns, So there might be the cases wherein returns are lower and still the fee is paid. In the present case it may not be reasonable to say that the fee is paid as the returns are not high on this mutual fund.
If the fee is a very large 2%, one will still going to pay that 2% even if the fund stays flat. If the fund drops 30%, one will still going to be paying 2%. So, in some sense, one never pay for performance – investors always pay for assets under management.
Thus in the present case it may not be justifiable topay the expense and it may be wise to shift to another mutual fund which is offering high return i.e. performing good or expected to perform good with low expenses due to its low price.
One of the financial service companies has offered to invest in oil related stocks and options. It has been advised that the investment that has to be made in stock to be kept at 50% and in ETF it may be kept to 30%. In this way the investment in the certificate of deposits will not be there.
Considering the above option that is given by the financial service company it can be said that it is the high risk portfolio. The rationale behind this investment is that the oil stocks are trading at low prices and this value is bound to increase in future. However it can be said that in the long term it may be more suitable to invest in stocks that are less volatile. The volatility related to oil stocks is higher in comparison to the banking stocks.
However to gain returns it may be done that the investment in oil options may be done. In the current scenario all the components of the portfolio are quite stable thus selecting the oil stock for investment in ETF will be quite beneficial. This will increase the overall return of the portfolio. In comparison there will be small increase in the risks. However this return will be higher in comparison to the increase in risk.
The stock that has been selected to be included in the portfolio, as shown above, is Citigroup. The company operates in the financial services industry. It is one of the oldest and largest financial service providers in USA. This is one of the strengths of the company as being in the industry for such a long time and having significant market share lends stability to the business of the company. Further the financial industry is the backbone of any economy. After the financial crisis there was a downfall in the market. However the stability of the economy is returning and the recovery of the economy is backed by strong financial support which is provided by the financial institutions.
The company also has presence across various customers including consumers, corporations, governments, and institutions worldwide. The different services that are offered by Citigroup include traditional banking and commercial banking offering different services which include corporate, institutional, public sector, and high-net-worth clients. This segment provides wholesale banking products and services, including fixed income and equity sales and trading, foreign exchange, prime brokerage, derivative services, equity and fixed income research, corporate lending, investment banking and advisory services, private banking, cash management, trade finance, and securities services.
Considering the above discussion it can be said that the stock has been quite stable having tremendous growth opportunities. Overall it is advisable to purchase the stock as it will benefit the portfolio in maintaining steady growth and at the same time reduced risk as Citigroup has significant market share with good business operations to boost the stock price movement.
The table has been prepared showing the portfolio that has been developed based on the following criteria
|
Portfolio |
Citigroup |
USA High Income Mutual Fund |
USAA SHORT-TERM BOND |
United States Oil Fund (ETF) |
Certificate of Deposit |
Total |
|
Nos. |
100 |
100 |
100 |
100 |
||
|
Price |
$ 51.58 |
$ 8.45 |
$ 9.20 |
$ 17.73 |
||
|
Value |
$ 5,158.00 |
$ 845.00 |
$ 920.00 |
$ 1,773.00 |
$ 1,304.00 |
$ 10,000.00 |
The target of the above exercise is to develop a diversified portfolio. The portfolio signified above, consists of both high growth & stable asset in the form of Citigroup while the corporate bonds that have been selected are aggressive with short term viewpoint. It is important to note that the Citigroup has been considered as a hold stock whereas the certificate of deposits provides stability in the form of low return and risk associated with it. Significant investment i.e. around 10% of the total investment has been made in the CD. Overall the portfolio has the attributes that are required.
References
Thaler, R.H. (1987). Anomalies The January Effect. Economic Perspectives. Volume 1. Number 1. Pp. 197-201. Available At: https://faculty.chicagobooth.edu/richard.thaler/research/pdf/seasonal%20movements%20i.pdf
Tinic, S.M. & West R.R., (1984). Risk and Return: January and rest of the year. Journal of financial Economics. Volume 13. Pp. 561-574
Graham, J. (n.d.). The Short Put Strategy – Selling Puts to Generate Income. Available At: https://discoveroptions.com/mixed/content/education/articles/shortputstrategy.html
Petit, J. (n.d.). Applications in Real Options and Value-based Strategy. Available At: https://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/opt3.pdf
Bhattacharya H., (2004), Working Capital Management: Strategies and Techniques
Green, R.P. & Carroll. J.J. (2000). Investigating Entrepreneurial Opportunities: A Practical Guide for Due Diligence. Sage Publications
Reily, F.K., Brown, K.C., Reily, J.R. & Brown, P. (2011). Investment Analysis and Portfolio Management. Cengage; 10th edition
Swensen, D.F. (2009). Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment. Simon & Schuster; Rev Upd edition
Malkiel, B.G. & Ellis, C.D. (2013). The Elements of Investing: East Lessons for Every Investor. Publisher Collins-Wiley
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