Question 1
In order to properly understand the constructs of Capital Asset Pricing Model (CAPM) we need to understand the various types of investment risk. According to the CAPM the total risk of a security portfolio of securities can be split into two specific types – systematic risk and unsystematic risk. Total risk = Systematic risk + Unsystematic risk.
Systematic Risk cannot be diversified away. It is the risk which arises from market factors and is also frequently referred to as undiversifiable risk. It is due to factors which systematically impact on most forms, such as general or macroeconomic conditions. Systematic risk can be diversified away by creating a large enough portfolio of securities. It is often called diversifiable risk or company-unique risk. It is the risk which relates, or is unique, to a particular firm. Factors such as winning a new contract, an industrial dispute, or the discovery of new technology or product would contribute to unsystematic risk (Mcmenamin 1999).
In CAPM it is assumed that all investors have homogenous expectations of returns, risks and correlations among the risky assets. It is also assumed that investors behave rationally, meaning they all hold optimal mean-variance efficient portfolios. This implies that all investors have risky assets in their portfolio in the same proportions as the entire market. Hence, CAPM promotes passive investing in the index mutual funds (Schmidt 2005). The CAPM argues that since investors can purchase a diversified reference portfolio (called the market portfolio), the risks of individual securities can and should be assessed in terms of their contribution to the risks of that market portfolio. According to the CAPM, this means that the market required rate of return on a given security is
E(rX )=rf +βX [E(rM )−rf ]
Where E(rX ) is the expected return on the security in question, rf is the risk free rate, E(rM ) is the expected return on the market or reference portfolio, and βX is the volatility of the security in question. Intuitively, βX measures the sensitivity of changes in the expected return on the security to changes in the expected return on the reference portfolio. Using the variance of return as a measure of risk, the CAPM establishes formally that βX =COV(rX, rM )/σ2(rM ) where βX is the market price of risk for asset X, rX is the rate of return on asset X, rM is the rate of return on the market portfolio, COV(rX, rM ) is the covariance of returns on X and M respectively, and σ2(rM ) is the variance of returns on the market portfolio (Neave 1998).
The CAPM is based on the following assumptions:
Utility maximization – investors try to maximize their own utilities; they are risk-averse
Decision basis – investors make their decisions only on the basis of risk and return
Expectations – investors have homogeneous expectations regarding return and risk of the assets
One-period time horizon – investors have identical time horizons of one period
Information efficiency – information is free and simultaneously available to all market participants
Risk-free asset – investors can borrow or invest in an unlimited amount of risk-free assets
Market without friction – no taxes, transaction fees, restrictions on short positions or other market restrictions exist
Capital market equilibrium – the sum of all instruments is given and in possession of the investors. All instruments are marketable, and the assets are divisible to any degree. Supply and demand are not influenced by anything other than price.
Distribution – the CAPM is based on the normal distribution of returns or quadratic utility function
The Beta Coefficient (β)
The Beta coefficient (β), is used to measure part of a share or portfolio’s risk, namely the part that cannot be reduced by diversification, that I the systematic or market risk of an individual share or portfolio of shares. Systematic risk can be further subdivided into business risk and financial risk. Business risk arises from the nature of the firm’s business environment and the particular characteristics of the type of business or industry in which it operates. For example the competitive structure of the industry, its sensitivity to changes in macroeconomic variables such as interest rates and inflation and the stability of industrial relations all combine to determine a firm’s business risk. Financial risk in contrast represents the risk which arises from a firm’s level of gearing or leverage and is a variable which is directly under management’s control. Basically the more debt a firm has, the greater the level of financial risk (that is, the risk of the firm not being able to meet its financial obligations).
As the level of debt increases, the greater will be the firm’s burden of interest and principal payments and the greater the return the equity shareholders require to compensate for the additional financial risk.
Beta is a measure of the sensitivity or volatility of an individual security’s or portfolio’s return (capital gains plus dividends) in relation to changes in the overall capital or stock market return. In the capital asset pricing model, market return is the return (capital gains plus dividends) from the market portfolio.
The market portfolio is a theoretical concept which, in theory, should include every conceivable security traded in the capital market in proportion to its market value. It may help to view the market portfolio as a giant weighted average of the market values of all the possible investment assets available in the capital market. It is important to note that beta can apply in the context of an individual share or a portfolio of shares. The beta coefficient is like a share’s market sensitivity indicator.
Categories of Beta
Shares or securities can be broadly classified as aggressive, average or defensive according to their betas. Shares with a beta > 1.0 are described as aggressive; they are more risky than the market average, although they will tend to perform well in a rising or bull market. Consequently investors would require a rate of return from the share which is greater than the market average. Shares with a beta=1.0 are described as average or neutral as their rate of return moves in exact harmony with movements in the stock market average return; they are of average risk and yield average returns. In contrast, shares with a beta <1.0 are classed as defensive. A defensive share does not perform well in a bull market but conversely it does not fall as much as the average share in a falling or bear market.
Question 2
Asset diversification means purchasing a number of investments or securities within an asset category or class in order to reduce investment or unsystematic risk (Bresnan and Gelb 1999). Diversification involves investing in a significant number of securities within each asset class in order to minimize investment-specific risk. Diversification focuses on minimizing risk. Diversification is not underscored by the trade-off between risk and return. Rather, it is understood by the concept that adding more securities with similar risk-and-return policies will result in lower investment-specific risk in the overall portfolio. The goal of diversification is to minimize investment-specific risk, thus leaving a portfolio with only market risk. As an investor add more securities to his or her portfolio, the total risk declines. A portfolio with 20 or more securities is said to be diversified. Only those securities with essentially the same risk-and-return profile should be used. Otherwise, the risk-and-return profile of an investor’s overall portfolio will change.
Question 3:
Background of the Business
Cathay Pacific Airways in an international Hong Kong based airline that offers scheduled passenger and cargo to 118 destinations in 37 countries and territories. The company has earned the reputation as one of the world’s leading airlines and Asia’s biggest and most regarded airline. The company was founded in 1946 in Hong Kong. Cathay Pacific is committed to uplifting Hong Kong’s airline industry and invests in making Hong Kong one of the world’s aviation hubs. In addition to Cathay Pacific’s expanding fleet of aircraft, the company has invested in other related businesses such as catering, aircraft maintenance and ground-handling. Cathay Pacific owns Hong Kong Dragon Airlines Limited (Dragonair) and partners with Air China Limited. In addition, the airline is also a major shareholder in AHK Air Hong Kong Limited which is an all-cargo carrier offering scheduled express-freight services within Asia (Cathay Pacific Annual Report 2007).
The company together with its subsidiaries employ almost 20,000 people in Hong Kong. In 2007, Cathay Pacific recorded a total profit of HK,023 million. The key driver for this profit was strong passenger demand, helped by a weak dollar, fuel hedging gains and the profit contribution from its associates such as China Air. In 2007, the company also faces problems especially the rising fuel prices. The company gained from the strong passenger demand especially from first class and business class passengers (Cathay Pacific Annual Report 2007).
However, the gains in 2007 were not maintained in 2008. Cathay Pacific’s Interim Report for the first half of 2008 reveals that the company has lost HK3 million for the first six months of 2008. The main reason for this was the exorbitant fuel increase. In line with the company’s commitment to the environment and in order to cut fuel price, Cathay Pacific constantly updates its aircraft fleet, making sure to operate the most modern, fuel-efficient fleet possible.
Relationship between the Business and Its Environment
The business is affected by a variety or environmental factors. Political, Economic, Social and technological factors affect Cathay Pacific. In order to succeed in the airline industry, Cathay Pacific changed its strategies in accordance with the changes in its environment.
Political
The company is subject to government policies and regulations. The company must also follow the standards and procedures set by governing bodies. Policies on climate change affect the company’s operations and strategies.
Economic
Hong Kong remains the financial hub of Asia. There is minimal rate wars in this side of Asia as there are few direct competitors. Cathay Pacific joins alliances and partnerships with other airlines in order to minimize competition and to avoid price wars. Hong Kong has codesharing partnerships with Dragonair, giving both airlines more capabilities to enter markets that are risky to do on their own. Perhaps one of the challenges that Cathay Pacific faces in the economic sphere is the fluctuating fuel price.
Social
There has been a steady demand among business passengers. As Hong Kong continues to be on the center of Asian economy, an increase in demand in business flights is expected. However, passengers are also exploring other affordable alternatives.
Technology
Technological advancements are introduced in a breathtaking speed. Airlines spend considerable amount of money in order to keep up with the trends. There is an expansion of wireless technology.
Integration to Risk Management
Cathay Pacific moves in an industry where risks abound. Competition is very stiff and there are numerous threats. In this section, I will discuss the various risks that the company is facing or may face in the future.
1. Operational Risk – this is the risk that failures in computer systems, internal supervision and control, or events such as natural disasters will impose unexpected losses in a firm’s derivative positions (Culp 2001). There are environmental disasters that Cathay Pacific cannot control such as typhoon, storm, earthquake, and others. These disasters can cause operational risks for Cathay Pacific. Another possible source of operational risk is system failure. Being an organization that relies heavily on technology, system failure can cause severe losses for the company. Management failure also poses as a major risk.
2. Regulatory Risk – this is the risk that actions take by regulators constitute events that can unexpectedly raise costs and risks for market participants. There are two forms of regulatory risk. First is procedural regulatory risk, which is the risk that legal uncertainties and financial losses will result from ill-conceived and costly changes to statutory or administrative regulations. The second type of regulatory risk is judgmental regulatory risk. This risk stems from inadequately informed examiners and regulatory auditors who attempt to review the derivatives of a firm based in incomplete information (Culp 2001).
3. Customer Loss Risk – this is risk that the business loses its customers, either because a competitor attracts them away or because they no longer demand the products and services that the company is selling. If either the demand curve shifts in for exogenous reasons or available substitutes for the good or service being sold become relatively more attractive, the business will find itself in great difficulty (Culp 2001).
References
Culp,C. (2001). The Risk Management Process: Business Strategy and Tactics. New York: Wiley.
Mcmenamin, J. (1999). Financial Management: An Introduction. London: Routledge.
Neave, E. H. (1998). Financial Systems: Principles and Organization. London: Routledge.
Schmidt, A. B. (2005). Quantitative Finance for Physicists: An Introduction. Academic Press.
Credit:ivythesis.typepad.com
0 comments:
Post a Comment