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Unit Reference Number R/615/3236

Unit Title Investment Analysis

Unit Level 7

OTHM Level 7 Diploma in Accounting and Finance (RQF)

Accounting and Finance Level 7 - Unit 1 - Investment Analysis Introduction

This assignment ("Investment Analysis") is part fulfilling qualification of accounting and finance - level 7. The assignment considers two investment proposals for two different companies. In light of this, the assignment has looked at ten diverse strategic options for the companies to evaluate and they are as follows:

1.   Understand different types of securities 

Bonds

 

Bonds are debt security or loans that are made by organizations. They borrow bonds in order to increase finance from investors who will lend them for a limited time period. If the bond is bought, it means, the money is borrowed by issuer. The prices of bonds fluctuates (Amadeo, 2017).

Types of bond 

Following are the five types of bonds. They all have different buyers and sellers, objectives and returns or risks.

• Treasury bills, bonds and notes: Treasury Department issued them in order to set the prices or rates for longer period. These are sold at auctions in order to provide funds to the Federal government for the operations.
• Saving bonds: Treasure Department issues in affordable prices, and investors can purchase it.
• Quasi-governmental agencies: Organizations sell them after having guaranteed from Federal Government.
• Municipal bonds: Different cities issued as these are free from taxes, but these have lower rates of interests than corporate bonds.

• Corporate bonds: Various companies issued them. They have high rate of return because of more riskier, and available at banks for sell (Amadeo, 2017).

 

Pricing bonds 

Pricing of bonds is influenced by the coupon rate and market rates. If the yield is lower than the coupon rate, prices will be set at premium or above par value. But if the yield is greater than the coupon rate, prices will be set at discount or below par value (Investopedia, 2017).

Bond yields

 

It is the return on amount which investor receives. These are the amounts that issuer use in order to attract investors. There are different types of bond yields like, nominal yield, where paid interest divides with face value. Current yield, where earnings of a year divided by the market price.

Term Structure of Interest Rates

 

This is also known as yield curve, which is a graph in which yields of bonds are plotted against the maturity time. It must be in ascending order from shortest to the longest. This represents the different yields that are currently issuing with bonds. It helps investors in comparing different yields and maturity period (Malkiel, 2015).

Theories of term structure

 

There are three main theories;

 

• The Expectations Theory: It is assumed in this theory that bonds buyers have no preference of bonds of ne maturity over other, so there will not be any quantity of bonds on hold in case of less return expectancy than other bonds with different maturity.
• Segmented Markets Theory: it is assume that there is a completely segmented market for various maturity bonds. Supply and demand of bonds will determine the interest rates for every bond with different maturity and

have no impacts of the returns that were expected form other bonds. Bonds that have longer maturity are associated with interest rates and inflation risks.

• The Liquidity Premium Theory: This consider the bonds with different maturity as substitutes instead of perfect substitutes. Shorter bonds are mostly preferred by investors instead of longer bonds because there is no risk of interest rates or inflation, and so they are willing to pay liquidity premium. For longer bonds, buyer will require the compensation for bearing the high level of risks (Zaheer, 2013) and (Munasib, 2017).

Types and measurement of Bond risk 

• Interest rate risk: Prices of bonds fall, when interest rate rise and vice versa. Bonds selling prices may fall if the bonds are sold when interest rates are high and before maturity.
• Market risk: This risk declines the market of the bonds. The prices may fall before the maturity period ends.
• Inflation risk: The risk of earning return does not adjust inflation. When bond matures, principle amount will received back. Longer the bod kept, higher will be the interest rates.
• Credit risk: Losing money risk will be greater if the bonds are bought from no reputable organization (GSAM, 2017).
• Rating Downgrades: Bonds that have downgrade ratings, prices may fall because of requiring high yields by buyers (learn bonds, 2017).

Bonds risk can be measure from duration method. It consider maturity time length and also difference of the yield to maturity and the coupon rate. Duration reduces as the frequency of payment increases (Benz, 2011).

Equities 

Equity refers to the ownership of small portion of a specific company (Hovakimian, Opler and Titman, 2001).

Types of equity

 

• Common stock: it accumulates the overall funds paid to the company for the shares.
• Additional paid-in capital: this determine the additional amount paid for the shares.
• Treasury stock: this reflect to the amount paid for buying back shares.

• Retained earnings: this contains the earnings of the company without considering the dividends (Accountingtools, 2015).

Measures of equity performance 

• Internal Rate of Return (IRR): this metric is used to identify the performance of private equity.
• Modified Internal Rate of Return (MIRR): this is the modified version for IRR by considering reinvestment in performance.
• Multiples of Invested Capital: this measures the performance by dividing the value of return with investment (Weidig, Born, and Kemmerer, 2005).

Equity pricing and valuation 

Equity price set to which shares are traded. Whereas the valuation of equity is used to identify the asset's market value. It is the process that identify the securities market value (Bodie, 2013).

Securities and characteristics

 

These are traded in the secondary market as these are the investments. (Amadeo, 2017).

There are certain characteristic of securities;

• Liquidity: these can be easily converted into cash.

• Security: Marketable security have the benefits of satisfying as a financial security.
• Intent as a characteristics of marketability: securities bought with short term goals are marketable more than the longer term goals (Ross, 2015).

Types of Security 

• Equity Securities: these are corporation's shares, and broker can sell the securities. Stock market is the secondary market for this.
• Debt securities: these are the loans and known as bond. Repayment wl be decided by the issuer.
• Derivative securities: these are depends upon the stocks that underlie. Traders get the highest return than purchasing it (Amadeo, 2017).

Synthetic securities - swaps, bundled and unbundled securities

Synthetic securities are developed by the combination of securities in order to mimic the qualities of other securities. The mimicked security does not actually exist (moneyterms, 2017).

Swaps are the based on index securities that are narrow and include interests. It is also a loan and security. It has an occurrence and non-occurrence of an event for single issue (Risk, 2017).

Bundling and unbundling securities are the development of the securities with the combination of both derivative and primitive securities in one hybrid into assets (finance, 2017).

The Key Characteristics of Different Types of Securities 

On reflection, no security is totally risk free; that's even the government bonds as some government defaults on loan and defers interest payments. However, in a stable political economic environment, government loan stocks or bonds is about the nearest that can be risk free but returns from investment could be eroded by inflation due to lower interest rates paid. All securities have potential to earn good returns and appreciated values and at the same time could be exposed to risks; due to market volatility and economic uncertainties.

Government securities: Since these two concepts (inflation and market volatility) are associated with investment, investors have to choose the right securities that best suit their investment portfolio. However, some securities are more prone to risks than others for example; most governments issue an array of bonds or treasury bills, which the interest rate is lower. Yet, it's guaranteed to be paid at stipulated date unlike ordinary shares' dividend, which may not be paid due to poor profitability of the company (Pike and Neale 2007; Watson and Head 2004).

Ordinary shares: Ownership of ordinary share gives rights to ordinary shareholding on both individual and collective basis. From a corporate financial perspective, some of the benefits are: to receive a share of any dividend agreed to be distributed. Also, will be entitled to receive a share of any assets remaining after the company has been liquidated. On the other hand, ordinary shareholders are the ultimate bearers of the risks associated with the business activities of the company they own.

Preference shareholders: This investment is less risky than ordinary share, even though they are legally owners of the company but, their dividends are paid before ordinary shares and the shares have potential to appreciate in value and wealth creation. However, they carry a high risk than debt stocks for several reasons: they cannot be paid until interest payments on debts are fully paid and in the event of liquidation, preference shareholders will not be paid off until the claims of debt holders have been satisfied.

 

Debentures or loan stock: This security has significant difference from equity finance; the interest paid on long-term debt finance is allowable deductions from profit chargeable to tax, whereas dividends for ordinary and preference shareholders are not allowable deduction from profit. Interest must be paid to providers of debt finance; whereas ordinary shareholders' dividends are paid only if managers elect to do so.

Eurobond: This instrument is bonds which are outside the control of the county in whose currency they are denominated and they are sold in different countries at the same time by large companies and governments. Eurobonds typically have maturity of 5 to 15 years and interest on them is payable gross and may be at fixed or a floating rate. However, interest rate tends to be lower than those of comparable domestic bonds. Some investors may find this attractive because it offers both security and anonymity (Reilly and Brown 2011; Watson 2004).

Is Covered Interest Arbitrage Worthwhile? 

The advantage of forward contracts is that they can be tailor made with respect to maturity and size in order to meet requirements of the firm while the company gains protection from any adverse interest or exchange movements, the biding nature of a forward contract remains that the company must forgo any potential benefit from favourable movements in exchange rates and interest.

In practice, many exchange rates exist; not only the buy and sell between different currencies but also the same currency over a different time horizon. Thus, spot rate refers to the rate of exchange if buying or selling immediately. Forward rates can be at either a premium or discount to the current spot rates. These contracts are generally set up through banking. The agreement enable a company to fix in advance, future exchange rates on an agreed quantity of foreign or domestic currency, for delivery or purchase on an agreed date, based on nominal principal amount, for a given period.

As the contract in this case is based on £9,000,000.00, which is to be paid in 6 months' time, the profile calculations to effect this is as follows:

A). Spot rate € v £ = €1.4876 x £9,000,000.00 = €13,388.400.00

 

B). one year rate € v £ = 1.4906 x £9,000,000.00 = €13,415,400.00

 

Variance: spot minus forward contract: €13,388,400 - 13, 415,400.00 = €27,000.00

 

C). One year € interest rate @ 4.10 x 13,415,400.00 ÷ 100 = €550,031.4 (£369,000) D). one year £ interest rate @ 3.55 x 9,000,000.00 ÷ 100 = £319,500.00

Variance: one year € minus one year £ interest rates: £369,000 - £319,500 = £47,500

 

The calculations shows that overall, the company will be worse off with forward euro- currency contracts. The variance between spot and forward contact meant that it will cost more to engage in forward contract (€27,000). Equally, the company will be paying more interest rate in one year's time in € compared to £ contact (£47,500.00). Therefore, it will be worthwhile for the company to borrow the money in sterling rather than euro currency.

In this context, the company can hedge interest and exchange rate risks by using the money markets and the euro-currency market. Thus, the company can use the money market to borrow £9,000,000.00 or euro-currency spot (13,388,400.00) now for one year and then deposit this on the money market for six months. The interest yield within this period will be used to up-set part of the interest rate for the forward contact therefore, minimise potential future cost of borrowing (Watson and Head 2004; Reilly and Brown 2011).

2.     Understand the regulation of security trading and new issues in world markets

Review the Regulations, Policies and Procedures Used When Trading 

Investor confidence in the working of the stock market is paramount, if it is to operate effectively. The approach for regulating the market was established by the Financial Services Authority Act (1986), which provided structure, based on self-regulation within the statutory frameworks. This legislation has been amended severally in anticipation to forester transparency of trading and roots out bad practices in the

market. This perspective has helped to uphold the London Stock Exchange and financial services industry's reputation for clean and fair market. The FSA has introduced new powers, effectively from the year 2000; to deal with insider dealings who attempt to distort prices hence, it is a criminal offence to undertake investment business without due authorisation (Pike and Neale 2007; FSA 2012).

A recognised investment exchange (RIE) provides delegated authority to members and that exempt members from needing authorisation to carry out investment business in the market. Based on this policy, the FSA empowers the stock exchange to discharge its responsibilities by:

• Vetting new applicants for membership and trading in the market
• Monitoring members' compliance with its rules
• Providing services to aid trading and settlement of members' businesses
• Supervising settlement activities and management of settlement risks
• Investigating suspected abuse of the markets.

 

The Act ensures effective regulation rules on consent, trust and confidence from the public, including consumers and the regulated. Those powers are used consistently, transparently and proportionately. To achieve these, it set: 1). clean rules and standards. 2). Authorise firms and individuals. 3). Seeks to ensure, it promote clean and competitive markets. 4). Ensures effective access to traders.

The FSA regulatory frameworks have also given the Stock Exchange; responsibility to regulate both the admission of companies to the official list and their on-going compliance with the listing requirements. The aim was to improve efficiency and reduce cost by automating trade and narrowing the spread between buying and settling prices. It has achieved this by the automatic matching of orders placed electronically by prospective buyers and sellers. This measure has enhanced trading procedures by allowing investors to maximise the markets' potential.

Thus, an investor wishing to trade will contact his/her broker and agree a price at which the investor is willing to trade. The broker enters the order is in the order book, which is then displayed to the entire market along with other orders. Once the order is executed, the trade automatically report to the exchange (Reilly and Brown 2011; Watson and Head 2004).

Identity, Analyse, and Review Issues in Global Markets 

The global stock exchange markets are being influenced by multiplicity of factors but, the major hypothesis is; a priority on short-term profitability and dividends at the expense of research and development and other innovative long-term investment plans. This means pressure to perform well has not only led fund managers to increase their activity regarding capital investment. Pike and Neale (2007) as well as Beechey et al (2000) asserts that fund managers focuses on short-term performance of companies in arriving at a valuations of their worth, placing excessive emphasis on current profit performance and dividend payments. Thus, markets' behaviours have two consequences:

1.      Management, in order to keep up with prices of its stock, will tend to focus on producing short-term results that it thinks the market want to see. This results in management failing to undertake important long-term investment decisions.

2.      The volatility of short-term corporate results will be exaggerated in security markets, producing undesirable fluctuations in stock prices.

March (1990) identifies managerial short-termism as a key force behind irrationalities in the stock markets in the UK and around the globe. He claims, when it comes to making plans for the future, fund managers' participation are influenced by their organisational systems and contexts, including the way they are remunerated and rewarded, their time-horizons within the jobs, the role played by the internal performance measurement and management accounting systems; and the internal capital budgeting and projects appraisal systems.

Besides pressure on fund manages to perform well in the markets, Ferguson (1989) highlighted some other underlying factors that are unique in the market, which tends to create market uncertainties; economic performance and political factors around the globe, which includes; companies' inadequate profits reports, inflation and unemployment. These condition have the propensity to affect markets' behaviour in trading on stocks and shares of which, the London stock exchange is not exempted.

However, Megginson (1997) narrates that in an efficient market hypothesis, rational investors will always approve any long-term investments that make sound economic sense. Investors and fund managers will not rush to sell the stocks of a

 

fundamentally sound firm that undertakes long-term investments that promise remarkably high future cash flows; just because that company has reported one bad trading period.

Therefore, for as long as stock exchange markets relies on short-term wins, owing to publicly available information such as government statistics on economic outputs or indicators for example, inflation or unemployment; markets volatility will remain. Equally, the release of information from companies for example, reversed profit forecasts; always have profound influence on market behaviour around the world of which the UK stock exchange is inclusive.

3.            Be able to apply principles of investment theory, securities and market analysis

The Principle of Investment Theory and Use of Securities 

The efficiency market hypothesis (EMH) is based on the assertion that rational investors rapidly absorb new information about a company's prospect, which is then impounded into the share price. Any other price variations are attributed to random "noise". This implies that the market has no memory, it simply reacts to the advent of each new information extract, register it accordingly and settle back into equilibrium. In other words, all price sensitive events occur randomly and independently of each other. Peter (1991) contends that stock markets are chaotic in the sense.

He analyse that markets have memories, are prone to major price swings and don't behave entirely random. For example, in the UK, Peter asserts that today's price movement is affected by price changes that occurred several years ago. The most recent changes however, have the biggest impact. In addition, he claims that price moves were persistent, i.e. if previous move in price were upwards; the subsequent price move was more likely to go up than going down. Yet chaos theory suggests that persistent upwards price trends are also more likely to result in major reversal effects.

Investment in securities has the propensity to assure balanced portfolio for most investors. Some securities provide a buffer between good and risky investment, given the volatility of the markets as well as political, economic and environmental factors. Investment in securities could serve binary benefit; it can be a source for

 

raising liquidity in times of need such as new projects. On the other hand, some securities appreciates in value (for example ordinary and preferential shareholdings), at the same time earns dividends therefore, creating wealth for investors. Some securities such as government bonds could be used as collateral for short-term financial needs to resolve immediate financial pressures that could endanger potential investment.

Similarly, long-term debts such debenture provides financial security, income, liquidity as well as the opportunity to own shares in the company depending whether it is a convertible bond or straight bond. Convertible bonds can be attractive because they usually, like ordinary bonds pay fixed interest, making financial forecast and planning somewhat easier. Companies, issuing long-term debt allows them to pay lower rate of interest than it would otherwise pay if it were to issue straight bonds of similar maturity (Reilly and Brown 2011; Pike and Neale 2007; Watson and Head 2004) .

Demonstrate the Underlying Concepts of Market Analysis and Efficiency 

Market does not necessarily mean a place where people physically gathered to exchange good and services. Technological advancement has facilitated the opportunity for market transactions to be conducted from anywhere in the world without face to face meetings; and the stock exchange markets have embraced this innovation. However, trading on stocks and shares are not isolated from market fluctuations, given political, economic and environmental dynamics. In light of this, Megginson (1997) states, in a real would, perfect and efficient market will have the following characteristics:

• The absence of factors that inhibits buying and selling securities such as taxes and transaction costs.
• All participants have the same expectations regarding securities' prices, interest rates and other economic factors
• Entry and exit from the market is free
• Information has no cost and is freely available to all market participants
• A large numbers of buyers and seller, will dominate the market.

 

In contrast, Dixon and Holmes (1992) advanced that there is no perfect and efficient market in the world. Though companies and investors do not need markets to be perfect, rather they need capital markets to be efficient and to offer fair prices so they can make reasoned investments and financial decisions. Investor's expectation is to have markets that have the following features:

• Operational efficiency; transaction cost in the market should be low as possible and required trading should be quick and effective
• Price efficiency; the prices of capital market securities are fully and fairly reflect all information concerning past events and all events that the market expects to occur in the future.
• Allocation efficiency; the capital market information, through the medium of pricing efficiency and allocate funds to where they can best be used

 

Therefore, market efficiency refers to the speed and quality of price adjustment to new information, bearing in mind the underlying market concepts as below:

1.              Weak form efficiency: Markets are weak form efficient if current share prices reflect all historical information such as past share price movements. This mean it is not possible to make abnormal returns in such a market by using technical analysis to study past share price movements.

2.              Semi-strong form efficiency: Markets are semi-strong form efficient, if current share prices reflect all historical information and publicly available information, and if share prices react quickly and accurately to incorporate any new information as it becomes available. This means abnormal returns cannot be made in a semi-strong form efficient market by studying publicly available company information.

3.              Strong form efficiency: Markets are said to be strong form efficient, if share prices reflect all information, whether it is publicly available or not. If markets are strong form efficient, no one can make abnormal returns from share dealing, not even people who are able to act on insider dealing information. (Megginson 1997; Beechey et al 2000).

 

4.              Understand the principles of taxation Identify indirect and direct taxes

Direct taxes covers the taxes that cannot be transferred or shifted to another person, for instance, the income tax an individual pays directly to the government. In this case, the burden of the tax falls directly on the individual who earns a taxable income and cannot shift the tax to others.

There are various types of Direct Taxes like:

• Income tax
• corporate tax
• Wealth tax
• Gift tax
• Estate duty
• Expenditure tax
• Fringe Benefit Tax

Indirect Tax:-

Indirect taxes, on the other hand, are taxes which can be shifted to another person. An example would be the Value Added Tax (VAT) that is included in the bill of goods and services that you acquire from others. The primarily tax is levied on the manufacturer or service provider, who then shifts this tax burden to the consumers by charging higher prices for the commodity by covering taxes in the final price.

There are various types of Indirect Taxes like:

• Service tax
• Excise duty
• Value added tax
• Custom duty
• Securities Transaction Tax(STT)
• Stamp Duty
• Entertainment tax

Characteristics of direct and indirect tax

Income Tax

The income tax is defined as the tax which is often imposed by the governmental authorities in correspondence with the income of people. The tax is usually generated by the people themselves by giving their tax return statements at the end of every financial year (John, 2016).

Capital Gains tax

This type of tax is imposed by the government when people exchange money for the sale and purchase of their assets. The capital gain is calculated by the total capital which is gained for an asset which exceeds its original price when being sold (John, 2016).

Inheritance taxation

This type of tax is defined as the last duty of the tax payer in different countries. The tax is usually imposed on the heir and different beneficiaries of dead people who inherit their property after their death (Garber, 2016).

The Corporate Taxation

Systems are the principal which is applied on different businesses in any country. This type of taxation system implies the owners to calculate their entire earnings from the goods. The earnings include the business and firm's cost production, depreciation and sales and hence calculate their owed taxes. The corporation tax allows the business to run efficiently while availing different services from the government.

Sales tax

Different as compared to the other forms. This type of tax is usually implied on the end user of any product which has been sold off. The customers who buy different things from the retail shops are obliged to pay their sales tax. The tax is added to the original cost price of the item and hence sold off to the customer (Kristy, 2015).

Value added tax system

It is also another type which is mostly dependent on the consumer of different services and products. The value added is at the initial stages of the product and sometimes at the last stage. The customer is liable to pay the VAT when

 

he avails the products in order to fill the deficit of the VAT paid by the manufacturer (Kristy, 2015).

Progressive taxation

This system is the most abundant system being followed all over the world. The tax systems propagate how the taxes would be distributed amongst the people according to their relative income. This system allows balance in the country where high income people pay more taxes because of their properties and assets.

Regressive taxation

It is a systems works in a complete opposite way. This system allows for leveling out of taxation where high income people do not pay higher taxes. The tax is mainly calculated depending on the assets in terms of property and consumption of people (Kirchhoff, 2012).

The principle of Direct and Indirect Taxes

 

By definition, tax is a compulsory levy made by individuals, corporations, and pubic authorities to the government (OECD 1976). Taxes are therefore, transfers of money to the public sectors for the good of the economy.

Direct and Indirect taxes: this split depends upon the nature of the past and present administrative arrangements and collection of taxes. If the tax is actually assessed on and collected from individuals and corporations who are intended to bear it, it is called "direct tax". This tax is deducted at source and paid directly to the HM Revenue and Customs. In contrast, "Value Added Tax" (VAT) is collected from all the businesses involved in the production and distribution of a good for a final consumer. To an extent, the tax will cause the price to the consumer to rise therefore, this tax on consumers is collected from businesses; and it's called "indirect tax" (James and Nobes 2012).

Taxes may be based on stocks of something (capital taxes) or on a flow of something (current taxes). However, there is ample room for definitional problems. Income tax and corporation taxes are current taxes on income or profit (in case of companies). In principle, capital gains tax is a form of tax on current income, despite the confusion that its name might lead to. The tax base on capital gains is the increase in value which accrues to an investment over time. This income is not taxed

 

until it's realised at the time of sale of the investment therefore, it might be called a postponed current tax.

Value added tax and excise duties are current taxes on expenditure and that affect all stakeholders. Inheritance is a tax on capital, although it has facet, which has the characteristics of a tax on income, in that the tax is only borne when the capital is inherited. VAT and excise duties being indirect tax cannot operate on the bases of a changing rate for those who spend different amounts. However, they can be progressive or regressive, as income changes by applying different rates of tax to different goods.

In addition to this transfer of resources, taxes may distort consumers' choices between goods or produces choices between factors and so impose an additional burden on the taxpaying community. The income effects arises because, when a tax is imposed or increases, the taxpayer's spending power is reduced (Lymer and Oats 2013; James and Nobes 2012).

5.            Understand the laws and regulations controlling the financial services industry

The Laws and Regulations of the Service Industry Markets

 

The mechanism for regulating and controlling the whole UK financial markets system was established by the Financial Services Act (1986), which provided a structure based on self-regulation with the statutory framework. Its objectives were to sustain confidence in the UK financial services' industry and monitor, detect and prevent financial crime. This involves the regulation of the financial markets; promote greater efficiency, investment managers and investment advisors. The hope was that by having a single regulator covering all financial markets, will facilitate greater efficiency, lower costs, clearer accountability and single point of service to customer enquiries and complaints.

In the UK, the Financial Service Authority Act (2012) has been the main pillar that control and regulate the financial services industry. The Act, amended and strengthened the Bank of England Act (2009), the financial services markets Act (2000), and the Banking Act (2009). Equally the Act amended Section 785 of the Companies Act (2006), to make provision, enabling the directors of saving markets

 

to provide services to other public bodies. This policy framework minimise disruption to the community of financial services' industry and core financial services. Thus, the FSA Act defines three core services: 1). To protect the consumers. 2) To protect and enhance the integrity of the UK financial systems. 3) To promote efficiency and competition in consumers' interest.

The laws and regulations have one common purpose: to improve the resilience and resolvability of banks and stock exchange markets including, making changes to their structure. In the UK the Prudential Regulation Authority is required under the Act (2000) as amended (Banking Reforms) Act (2012) to make rules and to implement the ring-fencing of core UK financial services; in line with Her Majesty Treasury (2010 to 2015) government policy on functionalities of the financial services industry.

The changes are intended to mitigate future financial crises therefore, the rationale for ring-fenced bodies are to facilitate systemic risk buffers, which applies to the ring- fenced banks and large building societies. The Act recommend that; the Prudential Regulatory Authority (PRA) should seek to ensure that systemic buffers apply at different levels of organisation, to ensure there is sufficient capital within the consolidated groups and distributed appropriately across the group as to address both global and domestic systemic risks (FSA 2012).

Techniques which are helpful in mitigate the risk

 

Techniques to mitigate the risk:

 

1.   Risk Transfer and contracting:

 

Risk allocation is to transfer the responsibility of risk to the others. Someone is ready to take risk in exchange of rewards that one is getting in exchange of risk. If business has risk factor then it is necessary to divert that risk on to the others so that risk can be reduced and keep the back up plans to transfer that risk. There are many contractor who are ready to the risk but they take reward in therm of money or in term of interest in the company.

 

2.   Risk Control:

 

Risk control is to mitigate and eliminate the risk factor exist in the project so that better result in term of growth and success can be achieved. There are many factors that are available to control the risk as internal control,external control, risk avoidance method. Like in Tesco, risk exist in term of development of new product and redevelopment of product then solution to accelerate the project must be their to reduce the market risk at considerable cost. Risk can be control by beating the competition exist in the market. Risk control also covers technological development in market and to adopt updated technology available in the market(Vaara, 2010).

Practical risk mitigation methods

 

Managing risk is a crucial component of successful long-term investing. If we can effectively mitigate risk, we may have a better chance at staying invested through market's ups and downs as well as achieving our long-term goals.

Here are four simple ways to mitigate risk that have been remarkably effective over time.

1.   Allocate Your Portfolio for Potential Growth & Stability

 

Many investors believe that if they intend to be invested for many years, they should only own stocks because stocks have historically had the best returns over time. But few investors can stick with a portfolio that is 100% in stocks over the long term because stocks are so volatile. We recently spoke with an investor who wanted to put all of her portfolio in stocks because, as she explained, she wasn't going to need the money for a couple of decades. But when she learned about the frequency of market corrections --that the S&P 500 has averaged a 10% pull back every year and experienced a 20% sell-off about every 3 to 3.5 years -- our caller changed her mind. When she considered the emotional gut punch she might feel if her portfolio lost more than 20%, the potential buffer that bonds can provide started to sound appealing.

It can also be risky to keep too much of our portfolios in cash or bonds. Inflation erodes the purchasing power of cash over time, and bonds aren't likely to generate enough return for most of us to achieve our long-term goals.

 

2.   Diversify Your Portfolio with Funds

 

A client once came to us with a retirement portfolio that was entirely invested in Bank of America stock. He didn't think this was particularly risky since Bank of America is the second largest bank in the country. But even the most well-established companies can experience major sell-offs and even bankruptcies. Lehman Brothers had been in business for over 100 years before it filed for bankruptcy in 2008. Enron was one of the world's leading energy companies before it was undone by an accounting scandal. Enron stock lost 99% of its value in 2001.

Owning a diversified portfolio of stocks can help mitigate the risk that any one stock declines dramatically. If we owned 10 stocks, and two of those stocks went down to zero, our portfolio would decline by 20%. But if we owned 100 stocks and two of those stocks went to zero, our portfolio would decline just 2%.

Mutual funds offer additional diversification since most of us can own more stocks through a mutual fund than we would on our own. With S&P 500 index fund, for example, we can own 500 stocks in one fund purchase. And we can further diversify by owning a portfolio of funds.

The built-in diversification of mutual funds can also help stem losses. If a single position in a diversified mutual fund files for bankruptcy, it's unlikely to have a major impact on the fund as a whole. While investors who owned Enron lost almost their entire investment in 2001, investors who had exposure to Enron through diversified funds lost far less, and investors who owned a portfolio of funds lost even less.

3.   Mitigate Risk in Your Fund Portfolio

 

Different funds have different risks. Some stock funds are broadly diversified and subject to market-level risk, while others are concentrated in a single sector and may have above-average risk. Bond funds also have different risks: lower-quality bond funds, for example, are more susceptible to credit risk, while longer-term bond funds have more interest-rate risk.

Some investors opt to avoid riskier funds altogether, but these funds have the potential to add tremendous value at times, and investors who exclude these funds from their portfolios risk missing out on good returns.

 

We use riskier funds but we limit exposure to these funds and use them as part of a well-constructed fund portfolio. In the Flexible Income Fund (INCMX), we can invest in lower-quality bond funds, but we cap exposure to these funds. In the Upgrader Fund (FUNDX), we limit exposure to stock funds that invest in a single sector. We also diversify our exposure among leading sector funds and pair these funds with a core allocation to broadly diversified funds.

6.   Be able to plan, manage and review client portfolios Portfolio Management In Relation to the Investment

Given the objectives of Air UK, it is imperative to consider balanced funds investment in a combination of bonds and stocks of various sorts within the airline industry and beyond. Over any given period, the risk of holding stocks and shares are to receive dividend s or interests as well as appreciation in values and, or the final payments on maturity of bunds. However, stocks and share prices goes up or down, on the other hand, returns on bond could be affected by inflation than expected, which makes the realised return risky. Normally, securities' values and returns go up or down because of some markets' bulletins relating to: 1). Firms-specific news is good or bad and news about the company itself. 2) Market wide news; is news about the economy as a whole and therefore, affects all stocks of all sorts in the market.

Thus, fluctuations of a stock return that is due to firm-specific news are independent risk or unsystematic risk, of which Air UK tends to avoid in order expand its business. In light of this, Air UK can eliminate firm-specific risk for free by diversifying its portfolio and will not require a reward or risk premium for holding it. However, diversification does not reduce systematic risk. Even holding a large portfolio, Air UK will be exposed to risks that affect the entire economy and therefore, affect all securities.

Because the firm is risk averse, it will demand a risk premium to hold systematic risk; otherwise it would be better off selling their stocks and investments in risk free bonds. The reward for holding equity risk will be smaller in the future. The economic environment is less volatile, given the current-day regulation of the markets in the UK and more stable monetary policy worldwide. For strategic portfolio allocation, management and modelling purpose, Berk and DeMarzo (2010) define the equity

 

risks premium as the expected return for holding a well-diversified equity portfolio minus the risk free rate. They profess that there is a premium for long-maturity bonds and fixed income securities with credit risk, which could be between 3 to 6 % given markets or share price trends

Active portfolio management focus on idiosyncratic risk, which is normally measure as the standard deviation of a portfolio's returns relative to the benchmark index. Most established a risk budget that sets targets for this risk and then seek to generate the highest return possible within that band of risk. In light of Air UK's aims and objectives, the risk can be viewed in two ways: 1). It can invest in the industry (airline industry) or economic sector and overweight its portfolio to that industry or it can take a broader view and hold most economic sector at roughly market weight.  2). Picking specific stocks in sectors that outperform in the market. Generally, a larger number of small stocks/bonds are better than a few large holdings. Spreading the sector over many sectors gives a greater chance of some working and balancing out the ones that don't. (Berk and DeMarzo 2010 ; Atrill 2011).

Justify Appropriate Types of Savings and Investments for the Hypothesis Expansion

With regard to types of savings and investment portfolio, Air UK should be mindful of risks and returns and invest in instruments that potentially minimise risks and maximise returns on investment. Therefore, securities portfolio must be completely diversified on both international and domestic instruments, so risks and returns are spread consistently with the world's market. Portfolio is completely diversified and structured for the desired risk level, excessive transaction cost that do not generated added returns. In light of this, the following types of savings and investments are considered for Air UK:

Fixed-income savings: A small proportion of funds should be invested in fixed- income savings account hence, this has a contractually mandate payment schedule. The investment contract promise specific payment at predetermined date, although interest rate is low in comparison to some other investment, but it is assured to be paid when due. The investment retains its value, liquidity and steady income and investment can be withdrawn at the end of investment term.

 

Capital market instruments. Air UK should also consider a percentage of investment in secured bonds. These instruments have fixed-income obligations that trade in the secondary market, which means the firm can buy and sell them to other firms and institutions. Capital market instruments fall into four categories:

1.      UK treasury securities; bonds mature in one year or less however, long-term bonds can be bought if preferred to hold that than one year term. This instrument is essentially free from credit risk, because there is little chance of default and they are highly liquid.

2.      Government agency securities; although these instruments are not directly issued by the government, but it is considered to be default free because it was believed that the government would not allow them to default. Interest is paid when due and capital redeemed at face value in comparison with ordinary share.

3.      Local government securities; these securities are tax exempt and capital invested retains its value and interest paid when due. There is no chance of default as local authorities are funded by local taxes and rates from businesses; this provides continuous income and cash flow from various sources.

4.      Corporate bonds; are fixed income bonds issued by some national corporations of which investment is free of risk from default, although returns may be lower than comparable instruments.

Loan stock debts/debentures: these are investments that promise to pay interest and principal as and when matured. Some securities are secured against the company's asset and that asset could be foreclosure for any default. Debenture owners usually have first call on the firm's earning and assets in case of liquidation. Some debentures could either be bought as; converted bonds, subordinated bonds or fixed bonds.

Equity Investment: This type of investment is different from fixed income-bonds because their returns are not contractual. As a result the investors can receive returns that are much higher or worse than what would have been received on bonds. The shareholders are the owners of the company and shareholding can either be; preference or ordinary share. However, preferential shareholders have

 

preference over the ordinary shareholders. Their returns are heavily influenced by the performance of the company and other variable in the market. Thus, both capitals invested and returns could be lost if the company goes into bankruptcy. These shareholders are the least to receive firm's benefits in case of liquidation.

International bond investment: Instruments in this category includes for example, Eurobonds, the US dollar bonds and the yen bonds. These instruments are denominated in a currency not native to the county where it is issued. They have potential to maximise returns as well as retaining value however, returns are lower, the capital and interest received could be affected by the exchange rate as well as transaction cost (Reilly and Brown 2011; Berk and Medarzo 2010; Atrill 2011).

Issues relating to portfolio management

 

Difficulties Faced by PPM in an Organization

 

1. The management does not know what to expect from the project so that it could be grouped under the right PPM. Failure to identify the right project makes it a liability for the PPM in the long run.

2. Team members feel queasy about the constant monitoring, which PPM requires, to have a thorough knowledge of the project progression. It seems to most as micromanagement, and it negatively impacts the work culture.

3. Improper staff understanding about the dynamic changes made by PPM leads to resistance to adoption.

4. The project management of the organization is not mature enough to be in favor of PPM. The more mature the project management is, the easier it is to implement PPM.

5. The senior management is not ready to absorb the purpose, benefits, and value of PPM.

6. Management cannot control the employees who are resisting the change.

 

7. Adequate budget for PPM is not present, as well as the tools to implement it, since there is no executive sponsorship towards the cause.

 

8. There is resistance to adopt a common approach for project management by teams because they have evolved their own methodologies.

9. Risks are not identified at an early stage. Possible Solutions

1. Project managers can adopt the 5-question model (pictured) of PPM at the start of the project to know if the project is suitable under PPM.

2. The organization should know its own capabilities. The PPM best practices might be very popular, but those have to suit the organization's infrastructure and protocols.

3. Necessary knowledge-sharing with relevant teams about the benefits and values of PPM and how it will provide higher returns by frequent evaluation of the process will lessen the resistance.

4. The senior management needs to be encouraged to come to an agreement about using the same protocols when their projects are under the same portfolio, so that the process can be institutionalized faster.

5. The management has to create a platform for an open dialogue where the people resisting the change can come up with risks and concerns. External consultation can be sought, if needed.

6. Prepare proper documentation of premeditated risks, concerns, and solved issues for future reference.

7. Usually, those projects are prioritized that already have allocated budgets. However, the budget has to be assigned based on how the project influences the portfolio and the organization in the end.

8. Work should be done in phases rather than in one shot so that new trends and customer demands in the industry can be incorporated in the development.

9. Instead of depending solely on the PPM tools, manual supervision can be leveraged to have a better outcome.

 

References

 

Atriii, P (2011); Financial management for decision makers (5^th edition), Prentice Hall

Beechey, N, Grunen, D and Vickery, J (2000); The efficient market Hypothesis; Resern Bank of Australia

Berk, J and Demarzo, P (2010); Corporate finance - Pearson international edition; Addison Wesley

Dixon, R and Holmes (1992) Financial markets: An introduction, London Chapman

 

Ferguson A (1989) Hostage to the short-term markets today; journal of international economics

Financial Services Act (2012) chapter 12 - Banking Reforms Regulations

 

James, S and Nobes, C (2013); The economics of Taxation (12^th edition); EP Fiscal Publications

Lymer, A and Lynne Oats (2014) Taxation policy and practice (20^th edition) EP Fiscal Publications

March, P (1990) Short-Termism on trial international fund managers association Meggison, W.L (1997); Corporate finance theory reading; Addison Wesley

Organisation of Economic Corporation and Developments (1976) Revenue statistics, (OECD) Paris Part 11

Peter, E (1991) Applies Chaos Theory to stock markets; journal of international economics

Pike, R and Neale, B (2007); Corporate finance and investment - decision and strategies; Prentice Hall

Reilly, F and Brown, K.C (2011) Analysis of investment and management of portfolio (10^th edition); south-Western Cengage Learning

The Financial Services and Markets Act (2000, 2012, 15) Banking and Pensions Reforms) Regulations

Watson, D and Antony Head (2004) Corporate finance principles and practice; Prentice Hall

 

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