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FIN200 Corporate Finance Assignment: Management Assignment

   

Added on  2020-05-28

11 Pages1990 Words89 Views
Running head: CORPORATE FINANCE MANAGEMENTCorporate Finance ManagementName of the StudentName of the UniversityAuthor Note

1CORPORATE FINANCE MANAGEMENTAnswer to Part AThe Capital Market Line (CML) depicts a risk- return relationship as well as ameasure of risk for the efficient portfolios. On the other hand the Security Market Line(SML) shows a relationship between the expected return and beta of a portfolio. The CapitalMarket Line takes into account only the efficient portfolios that are available whereas theSecurity Market Line depicts the individual as well as the inefficient portfolios that are notincluded in the Capital Market Line. In the Capital Asset Pricing Model the concept of SMLis used. The risk associated with a portfolio is measured in terms of variance or standarddeviation in case of CML and that with volatility in case of SML. Both the concepts of CMLand SML are discussed thoroughly in the answer along with the graphical analysis. There are two types of securities namely the risky securities and the risk freesecurities. The portfolio of all the risky securities is called the market portfolio M. All theinvestors who are investing will hold combinations of the two assets namely the risklesssecurities and the market portfolio. All the above said combinations will always lie along thestraight line which represents the efficient frontier. The line drawn or formed by the action ofall the investors mixing the risk free asset with the market portfolio is known as CapitalMarket Line (Brooks and Mukherjee 2013). All the efficient portfolios of every investor willlie in this Capital Market Line. The relation between the risk and return associated with aportfolio is shown in the following equation,Re=Rf+[Rm−Rfσm]σeWhere, Re = the expected return on the efficient profileRf = rate of return on the risk free assetsRm = expected return on market portfolio

2CORPORATE FINANCE MANAGEMENTσm = variance of the market portfolioσe = variance of the efficient portfolioThe term[Rm−Rfσm] is the slope of the Capital Market Line as well as the riskpremium. The slope measures the increase in return due to one unit increase in the risk. Whereas the Security Market Line is valid for all the inefficient as well as theindividual portfolios which do not lie in the efficient frontier. These points are not included inthe Capital Market Line. The equation of the SML is provided below,Ri=Rf+βi(Rm−Rf)Where, Ri = expected return of stock iRf = rate of return on the risk free assetsRm = expected return on market portfolioβi = volatility of ith assetThe slope of the SML is β which represents a measure of the security sensitivity withrespect to the fluctuations in market returns (Antoniou, Doukas and Subrahmanyam 2015). βis represented in numeric terms. The main difference between CML and SML is this term β.The risk in case of CML is represented by variance and that for SML it is represented byvolatility that is β. The graphical representation of both the markets are provided below.

3CORPORATE FINANCE MANAGEMENTReturnReturnRiskβCMLEfficient Portfolio1SMLFigure 1: SML vs CMLSource: By the AuthorAnswer to Part BIn order to identify the minimum variance portfolio the Modern Portfolio Theory needto be understood. The Modern Portfolio Theory (MPT) is an investment theory that is basedupon the idea that the risk averse investors can maximize or optimize the expected returns onthe basis of the given level of the market risks in order to construct portfolios (Swamy 2013).Risk is always associated with higher rewards. The MVT is one of the most influentialtheories.Consider that there are two assets namely A and B. Consider that both of these havea variance of 5 percent. A portfolio consisting of both these assets will have a lower risk than5 percent if these assets are uncorrelated. However, if these assets are correlated then the riskassociated with the portfolio will be higher than 5 percent. Therefore it is very important tochoose portfolios with minimum amount of risk associated with respect to the expectedreturns. The main aim of minimising the risks is attained by allocating varying weights to thecorresponding portfolios. These portfolios are called mean variance portfolios as any othercombination of such portfolios do not have such low risks and level of expected returns.

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