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Finance Theory

Diversification is the process of investing unrelated assets or activities to achieve a stable performance of a portfolio. Promoters of the modern portfolio theory argue that with an efficient diversification investors will obtain the highest return for any risk level. According to Markowitz, the risk in a portfolio of diverse, unrelated stocks will be less than the risk in holding any single stock. Hedging, on the other hand, is a strategy aimed at neutralizing the risk of an investment by engaging in offsetting contracts that would cancel potential gains and losses.

Financial derivatives allow for the efficient transfer of financial risks, and allow managers to focus on improving on areas not subject to volatility. Derivatives, despite calls for asset diversification, are still widely used because of their ability to modify the risk and expected return of existing investment portfolios. Futures and options allow hedging of the risk of a portfolio beyond those of diversification. One drawback of diversification, which involves not putting eggs under one basket, is that not all assets are diversifiable.

The subprime market crisis and the near-collapse of Fannie Mae and Freddie Mac for example, affected nearly the majority of the stocks in the market. Hence, no matter how highly uncorrelated the assets are in the portfolio, investments are still subject to these types of risks. Assert diversification, in addition, requires more capital in order to spread the wealth and minimize risks. Hedging is effective in reducing risk exposures by transferring the risks of price volatility to other parties.

However, this requires companies to pay prices above the current spot prices. It also exposes firms to counterparty risks. In addition, as future prices are subject to speculations, people may increase the agency costs and risks of derivative securities. Derivatives, specifically expose investors to risks – while derivates allow investors to earn large returns, they could also cause large losses if prices moves against the invested assets. Hedging is subject to speculations thus may be subject to artificial demand, and may instead subject traders to unnecessary risk.

Procter & Gamble and Orange County (California) filed for Chapter 9 bankruptcy because of speculation in derivatives. Nick Leeson, a trader at Barings Bank, made risky investments poor judgment in index futures, resulting to a collapse of the bank. Derivatives control a large notional amount of assets and may lead to distortions in the equities markets and real capital markets. Hence, compared to asset diversification, where the risk is spread, derivatives are subject to more risks due to speculations and notional value. Question 2

Describe the ways in which the psychological idea of over-confidence has been used to explain systematic deviations from the economic model of rational maximizing decision making which have been illustrated by such studies as that of Basu on the PER as a predicator of returns and that of De Bondt & Thaler who used the cumulative average residual methodology to show the persistence of under and over pricing of securities. Traditional ? nancial and economic theory is based on the notion that individuals act rationally and consider all information in making decisions.

However, researchers like Basu and De Bondt & Thaler have discovered that this is not the case. According to Basu’s earnings conservatism principle, earnings re? ect bad news quicker than good news. Regulations, for example, mandate the prompt recognition of expected losses, but delay the recognition of gains until they are realized and earned. During the subprime lending crisis, banks like Citigroup and Merill Lynch immediate wrote off its investment in mortgage securities even though not all mortgagors have defaulted on their loans, or collateral haven’t been foreclosed.

Because investors are excessively pessimistic after a series of bad news and earnings reports, companies with high Earnings/Price may be undervalued, resulting to an anomaly. De Bondt and Thaler discovered that investors overreact to dramatic and unexpected news events resulting to the volatility and inefficiency of stock. They found that companies facing consecutive periods of bad news tend to earn high subsequent returns due to low expectations and vice versa.

In light of that, they determined that companies with low book-to-market ratio — book value of the company’s assets over the market value of its equity — have earned lower returns than those with high ratios. Question 3 Critically examine and explain the proposition that mergers and acquisitions activity is not only of a phenomenon of a rising market but that a rising market is indespensible for the success of such activity and that the M & A activity is a prime factor in sustaining a rising market.

An indicator that a country’s economy is improving is rising share prices and improving profits by majority of firms. An improving economy also reduces interest rates because of the reduction in default risks. These factors push for mergers and acquisitions because, among other things, (i) firms will be able to get cheap financing to fund their mergers, (ii) shareholders would usually approve expansions during a good economy, and (iii) firms doing well will use earnings not distributed to shareholders to fund expansions.

Rising prices of a firm’s stock enable it to (a) obtain financing by issuing new shares or (b) use the shares as consideration for the acquisition. Prior to the great depression, the economic boom allowed company to issue equity to fund mergers. After the stock market collapse, however, when there was no value in the stock market, mergers did not occur. In the 1970s for example, as the economy rose, profitable firms obtained large cash flows and use their extra cash to acquire competing firms. Question 4

Explain and discuss the proposition that “Beta is Dead” with references to the Arbitrage Pricing Theory and the suggestion by Fama & French that the Book-to-Market ratio could replace Beta as a prime determinant of returns. An offshoot of the capital-asset pricing model, Beta measures a stock or portfolio’s relative volatility to the aggregate stock market. Eugene Fama and Kenneth French, of the University of Chicago, inspected the returns on the New York Stock Exchange and other markets from 1941 and 1963 to 1990, and found that Beta did not appear to explain the performance of various stocks.

They were able to see a trend though when measuring the ratios of (i) firms’ book value to market value, and (i) price to earnings. They then concluded that B/M and P/E may be a better measurement for riskiness. They have determined that firms with high book-to-market ratio have higher returns than firms with low book-to-market ratio. The B/M ratio group’s firms into – value firms (having high B/M ratios) or growth firms (low B/M market ratios).

Fama and French’s results dispute the usefulness of the CAPM. However, economists’ study of statistics from the 1930 to 1960 showed that average return of stock was directly correlated to the Beta of those stock and portfolio. Detractors also argue that the result of Fama and French may be due to a statistical bias or selective use of data. An analysis for a longer period of time, and not just 50 years of data used by Fama and French, showed that Beta continues to be positively related to actual returns.

Barra, however, observing Standard and Poor’s 500 and other indexes data for January 1975 – September 2002, and taking cue from Fama and French, determined that the B/M pattern was absent for large firms or firms with above average market capitalization. Accordingly, Barra and other economists have determined that Fama and French’s results are pushed by: (i) low returns by small and new growth firms and (ii) a strong seasonal B/M, because of using monthly data instead of annual data.

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