FINANCE 301 DR. SHELDON NOVACK CASE STUDY ROTH FINANCIAL ADVISORS PART #1 INTRODUCTION Roth Financial, founded nearly 10 years ago, is a financial services firm which has a diverse base of clients. The founder of this start-up firm, Hugo Roth, developed a reputation for himself and also his associates by the way the financial firm conducts business. As the firm grew, so did the firm’s reputation for honesty and fair dealing. Hugo Roth established a reputation for training and helping his new associates establish themselves in the financial industry.
Steve Johnson was a financial advisor in training for Roth Financial Advisors and was willing to take extra measures in order to learn more about financial services. His most recent task was to develop a presentation in regards to the different types of risks investors may come across when investing their money with Roth Financial. Steve’s task was to break down different types of risk into its simplest components and to figure out a way to show clients how risk was treated in financial markets and when making investments decisions.
Hugo Roth has provided several sets of numbers for Steve to use in his presentation. The first set of numbers was a group of returns from different stocks which was classified by the type of economy. This could give a direction of what these stocks might face in the future and the return each was likely to experience in different situations. PART #2 METHODOLOGIES 1) Beta= [ Cov(r, Km) ] / [ StdDev(Km) ]2 R= is the return rate of the investment Km = is the return rate of the asset class 2) CAPM= ra = rf + Betaa(rm – rf) Ra= is the asset price
Rf = is the risk-free rate of return Beta= is the risk premium Rm =is the market rate of return 3) Rate of Return 4) 5) PART #3 SOLUTIONS 1) Beta of Stock A= 1. 315 Beta of Stock B= -. 557 2) l 3) Rate of Return= 3. 0% 4) Standard deviation= 5) L PART #4 CONCLUSIONS Beta is a measurement of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM) which is a model that calculates the expected return of an asset based on its beta and expected market returns.
Beta is calculated using regression analysis, and you can think of beta as the tendency of a security’s returns to respond to swings in the market. A beta of 1 indicates that the security’s price will move with the market and beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security’s price will be more volatile than the market. Stock A has a beta of 1. 315, so theoretically stock A is 31. 5% more volatile than the market.
Stock B has a beta of -. 557 which means the stocks are a commodity. Beta is more useful when analyzing stocks that are to be placed in a portfolio. Beta is more useful because beta will calculate if a stock is a commodity, a defensive stock, or if the stock will move with the economy. If the beta is over 1. 5 the stock is a high risk stock. From completing a simple beta equation a person can diversify their portfolio to include a mixture of commodities, stocks which move with the economy, and defensive stocks.
So in case of hard economic times a person with a diversified portfolio will not lose all their investments because the economy tanked but instead have some stocks which will strive during a recession while other stocks are losing money. The main difference between beta and standard deviation is Beta measures volatility based on a security’s correlation with the market as a whole, whereas standard deviation determines volatility based on its historical pattern. Risk can be defined two ways: It could be the chance of loss on a single investment or it could be in measured in conjunction with an investor’s portfolio.
Unsystematic risks are fluctuations of stock’s return that are due to company or industry specific news are independent risk. Systematic risks are fluctuations of a stock’s return that are due to market wide news represent common risk. In portfolio management, standalone risk measures the undiversified risk of an individual asset. So, for example, by investing just in Microsoft stock, you would subject your portfolio to standalone risk (standard deviation of returns) of a single company and industry sector. Portfolio risk is the diversified risk of a whole portfolio of assets.
So, if your investment portfolio held 50% large company stocks, 25% international company stocks, 15% small cap stocks and 10% bonds, your portfolio would have an expected risk (standard deviation of returns) to it vs. a different portfolio that had a different makeup of investments. The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time.
The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium. The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).