Finance and Investment : Assignment

FINANCE AND INVESTMENT
1

Table of Contents
Part A.........................................................................................................................................3
Question 1..................................................................................................................................3
Negative externalities and systematic risk.............................................................................3
Reduction of risk in banking system......................................................................................3
Deposit protection..................................................................................................................4
Payday loans...........................................................................................................................4
Behaviour of financial firms and their employees.................................................................5
Question 2..................................................................................................................................5
Characteristics of Auto-enrolment pension............................................................................5
Defined contribution pension scheme and defined benefit scheme.......................................5
Computation of present real value of retirement fund...........................................................6
Advantages and disadvantages of opting out of auto-enrolment scheme..............................6
Draw down of retirement fund or purchasing annuity...........................................................6
Part B..........................................................................................................................................8
Question 3..................................................................................................................................8
Introduction................................................................................................................................8
Investment strategy for adventurous investor............................................................................8
Advantages and disadvantages of putting money in two or three securities rather than one
security.....................................................................................................................................10
Assessment of changes in allocation in case Billie become less adventurous and more
concerned with the preserving capital......................................................................................12
Conclusion................................................................................................................................13
2

Part A
Question 1
Negative externalities and systematic risk
Negative externalities refers the cost of financial transaction which has to be borne by the
third party. The main reason behind the negative externalities is the production or the
utilization of the resources for a good reason by one party, but the cost is paid by other party.
In the business, producers are the first and consumers are the second parties and any
individual, property owner, company, and resources are the third parties those have to suffer.
Systemic risk is a possible risk that occurs at the business and can cause severe volatility in
the business and in the economy. If the company considers the systematic risk, then there is
less probability of the failure. Businesses that are highly unified with others are also a cause
of systemic risk as this form of risk is connected with the whole economy. It is used by the
federal government as a reason to interfere in the financial system. The source for this
interference is the faith that the administration can decrease or reduce the ripple effect from a
company-level event throughout the targeted system and proceedings
Reduction of risk in the banking system
A regulatory capital or capital adequacy is an amount of capital that is required to be reserved
by financial institutions or banks because it is obligated by the financial regulators. Such
requisites are fulfilled to assure that such organizations do not obtain on surplus leverage and
turn out to be as insolvent. Capital supplies preside over the ratio of equity to debt,
documented on the liabilities and equity side of a company’s balance sheet. They must not be
puzzled with reserve necessities, which preside over the assets side of a bank's balance sheet
especially; the number of its assets which are required to be held in highly-liquid assets or
cash. A major part of bank regulation is to assure that firms working in the business are
carefully supervised. The major objective is to defend the firms themselves, their clientele,
the administration and the financial system by originating system to assure that those
organizations do have enough capital to confirm continuance of a secure and well-organized
market and capable of enduring any predictable troubles.
3

Deposit protection
Moral hazard is a condition, where the cost of mistake of borne by another party. It occurs
when both the parties don’t have complete knowledge of each other.
In the economic market, there is a threat that borrower is involved with the actions that are
questionable according to lenders as they create the situation in which they are less interested
in returning the due amount of loan. It happens when the borrower has knowledge that
somebody else will pay back for their mistakes. This in return provides them with the rewards
or incentives to perform operations in a riskier manner. Such financial approach is moral
hazard.
Payday loans
Payday loans are the form of short term borrowing, where the financer will impose the
charges in terms of interest. On the payday loans, the high-interest rate is charged, therefore
in the United States, the government fixed the maximum limit on the interest rate and total
charges that can be charged by the financer. However, the financial regulator noticed that in
the other form of short term credit, the lender charges a higher interest rate and some other
charges. It leads to the major problem for the financial regulator and providers. The
government should make the specific norms for the payday loan as well as short term credit.
A payday loan is similar to the cash advances. However the short term credits are generally
provided one year. Therefore on the basis of duration of advance, the government should
prescribe the interest rate on the borrowing.
The behaviour of financial firms and their employees
Financial institutions and other employees will behave in the regulated ways even in the
situation where external regulators are not present because they have well designed formal
government processes which help them to secure the good regulatory results. Apart from this
other regulatory initiatives gives a great priority to the present culture, customers and the
market. Moreover, financial conduct authority’s plans demonstrate the culture of the
company, its governance which is essential to develop a trust in public and confidence in the
strategies and services of the company. To survive successfully in a competitive environment,
boards build a strong cultural leadership and take liability for setting up and controlling the
precise culture. Hence strong cultural leadership lower down the threat of poor outcomes and
employees will behave in a regulated manner.
4

Question 2
Characteristics of Auto-enrolment pension
Under the Auto-enrolment scheme, it is the duty of the employer to enrol their eligible
employees in the pension scheme. In the above specified scheme, along with the employer,
the employee also makes the contribution in a pension scheme. Auto-enrolment scheme is a
government initiative, which assists in more savings of the employee. There are several
benefits provided to the employee complementary in addition to the auto-enrolment scheme.
Further, the employee also motivated to adopt this scheme as in this employer also made a
contribution. All the features increase the scale of saving into a pension.
Defined contribution pension scheme and defined benefit scheme
Defined contribution scheme is the job-related pension scheme. In this scheme, the employer,
as well as the employee of the company, makes the contribution, and the proceeds are
provided to employees at the time of retirement. On the other hand, under the defined benefit
scheme, only the employer made the contribution and assured the specified amount at the
retirement. The main difference in both the plans is related to the investment risk. In the
defined contribution plan, both employer and employee bear the risk; however in a defined
benefit scheme, only the employer bears the investment risk (Sialm, Starks, and Zhang,
2015).
Computation of present real value of retirement fund
Contribution by Sally (after Tax) =£77
Contribution by employer = £57.75
Total Contribution = £134.75
Interest rate = 5.5%
Inflation Rate = 3.5%
Real value of retirement fund = £32482.19
If the inflation rate = 4%
Then, real value of retirement fund = £29214.57
Due to the rise in inflation rate, the value of retirement benefit reduced.
5

Advantages and disadvantages of opting out of the auto-enrolment scheme
The opting out of auto-enrolment scheme leads to an increase in the gross pay of sally. On the
other hand, if sally opt-out from this scheme, then tax benefit on the contribution made in the
pension scheme can not avail by her.
Drawdown of a retirement fund or purchasing annuity
The rise in annuity cost
It is probable that, risk in the annuity cost influence Sally to select the drawdown option. In
this approach, she can switch her stable portfolio to a profit-making bond portfolio Since
Sally wants to keep amount invested without any withdrawals then there is a high probability
of an increase in value in drawdown option. Therefore, a sharp rise in annuity cost will not be
beneficial for Sally so she may select the drawdown plan.
The risk in drawdown
In the drawdown, the person keeps funds invested and obtain the annual income. As
compared with the annuity, it is much riskier. As in this, it is probable that pension pot may
fall. Therefore those associated with drawdown will also face the problem. Another, risk
associated with the drawdown is the risk of longevity because in this there is no lifetime
guarantee and there is probability to exhaust benefit at the time of retirement. Therefore, sally
for mitigating these risks can opt for the annuity plan, despite the high annuity cost.
6

Part B
Question 3
Introduction
By considering the declining trend of the interest rate at their historic low of 0.5% for the past
six years, it is better to invest in the stock market to attain better return from available funds.
Adventurous customers are very intrepid of nature as they are eager to grasp the ups and
downs of the international stock market in order to boost their long term returns. The
connection between risk and return cannot be perfectly predicted, however, it has been
assessed that the correlation between risk and return does exit. In case an investor wants to
attain higher returns, they have to be willing to accept a higher rate of risk. This is the nature
of an adventurous investor. Though, its main emphasis should be made on taking the right
risk. For instance: holding all cash portfolio could be riskier in case cash is being eroded by
inflation. Present essay emphasizes on investment strategies for Billie, who is an adventurous
investor. Further, the advantages and disadvantages of investing in more than one fund rather
than in just one security have been discussed. Lastly, the manner in which strategy changes
the case to the adventurous investor is more concerned with preserving capital build by the
investor.
The investment strategy for an adventurous investor
Active strategy is most appropriate for the investors who attempt to move up to the efficient
frontier in order to take more risk for attaining more reward. In the present case, as Billie is
interested in taking a higher rate of risk for higher return, the active strategy will be most
appropriate in order to develop the portfolio for investment. The investment will be assessed
on the basis of return and risk related with the same. The type of risks which are assessed
while taking investment decision are capital risk and liquidity risk. Capital risk is referred as
the risk of attaining more or less than expected amount and liquidity risk is not attaining
returns when expected, i.e. risk related of being unable to cash an investment rapidly enough
as they fall due in order to take advantage of better investment opportunities. The securities
from which selection will be made for construing portfolio of Billie are as follows:
7

8

Table 1: Table representing net return of existing securities
Name of
Securities
UK all
companies
Money
Market
Global
Bonds
UK
company
tracker
UK
gilts
Global
Growth
Mean annual
return 8.5 0.16 4.5 2.3 12 17.5
Annual Charge 0.8 0.2 0.25 0.4 0.5 1.5
Ongoing Charge 0.9 0.3 0.25 0.3 0.6 2.1
Net Return 6.8 -0.34 4 1.6 10.9 13.9
Beta 0.9 1.1 1.3 1.1 1.5 1.2
Standard
Deviation 9.5 0.08 3.9 9.5 12.9 12
Sharpe Ratio 0.9 -5.5 1.3 0.6 1.1 1.1
R-squared 75 16.5 84 91 95 85
As Billie is interested in investing in the maximum of three securities, investment will be
made in securities having a higher rate of return as she is willing to take the maximum risk.
In order to ascertain the securities are having highest return, annual charge, as well as
ongoing charge, will be reduced from the mean annual return as cost relating to securities is
also be considered before calculating return attained from securities. Thus, the securities
which are providing highest returns are Global Growth, UK gilts and UK all companies. All
the three securities have a higher return in comparison to other securities available for
investing, i.e. money market, global bonds and UK company tracker. The beta of security
represents systematic risk relating to security. A security which has less than 1.0 beta
represent that it is less volatile in comparison to the market. It means that the portfolio is less
risky in case the specified stock is included in the portfolio. Thus, in present case UK Gilts is
9

having highest beta 1.5 which represent that is more volatile in comparison to other securities
but as Billie is ready to borne risk in order to attain higher return.
R – Squared is referred to as a statistical measure which represents the extent to which the
data are fitted to regression line which is also known as the coefficient of determination. A
lower percentage of R- squared regression line represent that less variability of response data
is around its mean. On the contrary, higher R-squared percentile represents the variability of
response data around its mean. Thus, in above-specified securities in which investment has
been made is having higher percentile which represent that the all the variability of response
data is around its mean, i.e. the model fits the existing data. The portfolio of Billie as an
adventurous investor will be construed after assessing the return as well as the allocation of
the specified securities. The same is as follows:
Table 2: Portfolio of Billie as an adventurous investor ready to take a high risk against huge
returns
Security Name Allocation in
Cash
Allocation in
Equity
Allocation in
Bond
% of
Investment
by Billie
UK all
Companies
3 95 2 40%
UK Gilts 3 0 97 10%
Global Growth 2 98 0 50%
Note: Investment has been made in higher proportions in the securities which allocate their
sources in equities in a significant manner.
Advantages and disadvantages of putting money in two or three securities
rather than one security
Advantages
Reduction in Loss:
The main advantage of investing in two or more securities rather than one security is
reducing the loss to a significant extent which is resulting from investing in one security or
asset. In other words, it can be said that risk relating to loss of cold weather can be decreased
from diversification by investing in a combination of more than one security which is
unlikely to move in the same direction at a same time. Investor applies statistic in order to
10

develop a combination of shares which are most appropriate for diversification. In statistics
when shares are closely associated with each other regarding prices, as they move in the same
manner over time is believed to have a strong correlation. On the contrary, in case they move
in a different manner than the same is referred to as weak correlation. This correlation assist
is constructing a diversified portfolio. Thus, it can be concluded that investor can improve the
balance between risk and return to a significant extent through diversification.
Choices of Asset
Another advantage is that investor can make its own choice to spread out investment in
different securities which comprises stocks and bonds, commodities etc. It is a fact that each
security (asset) has its own quality and strengths and the profitability of the same depends on
market supply and demand. Thus, a good mix could assist in the development of a stable
portfolio.
Lower Maintenance
Every investment requires appropriate attention in order to keep them performed well. In the
present case, as Billie is seeking higher returns and ready to take risky ventures than it will
require investing significant amount assessing markets and dodging financial bullets. Thus, as
a diversified portfolio is less exciting and more stable. Thus, through investing in more
securities an appropriate portfolio can be developed which requires less maintenance
comparatively.
Disadvantages
Missed Windfalls
The disadvantage of being borne by the investor in case of a diversified portfolio (investment
in more than one security) is facing issues in making a huge profit from specific industry to
others. The fact cannot be denied that diversification protects an investor from fluctuation,
but it also restricts the stock capability to enhance to a certain limit. The reason behind the
same is that investment is made in various companies. Investment is done in stock with the
aim of high risk with higher gain or vice –versa. But as an investment is made in more than
one security gains as well as losses are bifurcated in the no. of securities in which investment
has been made.
Spread too thinly
11

In case the market declines as a whole than it is possible that all the securities of the portfolio
will face trouble and investor might assess that the loss is spread too thinly. As an investor in
making an effort to protect from a massive financial exposure and the same could have
missed out on big profit. It can be concluded that as the portfolio is widely diversified, the
extent of relative risk is increased that some part of the portfolio will decline at any point in
time.
Income at a slow rate
Assessment of changes in allocation in case Billie become less adventurous
and more concerned with the preserving capital
The risk-return spectrum which is developed through investing in appropriate investment is
dependent on the attitude of the customer towards risk. In the present situation as Billie is
more concerned towards the capital which has been developed by her; investment will be
made in risk-free or less risky securities to the maximum extent. Standard deviation is
measured by investors in order to assess the amount of expected volatility. The low standard
deviation represents less risk relating to individual stocks as well as that the data points are
closer to the expected range of values.
The investment will be made after assessing the risk level (beta and standard deviation) as
well the analysing the manner of allocation of assets by the specified securities. Thus as the
return of security (UK Gilts) is appropriate and it also invest in Bonds to the maximum extent
which is a risk-free asset; a major part of the investment will be made in same. Further, if the
net return of Global Bonds is assessed with Beta and Standard variation than it can be
concluded that it is appropriate to bear volatility for the specified quantum of return.
Moreover, as the security invests a major part of its sources in Bonds, i.e. 95 %; it matches
with the attitude to risk accepted by Billie too. Thus, change in the earlier construed portfolio
will be made in the following manner:
Table 3: Recon structured Portfolio of Billie
Security Name Allocation in
Cash
Allocation in
Equity
Allocation in
Bond
% of
Investment
by Billie
UK all
Companies
3 95 2 10%
UK Gilts 3 0 97 40%
12

Global Bonds 5 95 50%
Note: A small part of available funds has been allocated to the security as it has the least beta
and highest return in the securities in which investment has been made. Thus, the same will
not affect the capital developed by Billie in a significant manner even though the specified
security allocates its sources in equity (risky asset) to the maximum extent.
Conclusion
It can be concluded that Billie should invest in more than one security. As through
developing a diversified portfolio, she would be able to develop an asset portfolio of her own
choice. Moreover, she would be able to recover the loss borne from one asset against the
profit earned from another asset. The fact cannot be denied that she would not be able to earn
huge profits from single security. But overall she would be able to make a significant profit.
13