Investment Analysis

Difference Between Defined Benefit and Defined Contribution Pension Schemes

Pension is a fund that is built during the working life of the employee and then used to secure the income after retirement. These funds can be operated by employer (occupational pension) who invests over time or alternatively employee can invest in a fund of their choice (private pension scheme). Both of these schemes generate income after retirement.

Pension schemes are of two major types:

  1. Defined Benefit Scheme
  2. Defined Contribution Scheme
1. Defined Benefit Scheme

Defined benefit scheme is a type of pension scheme which ensures a particular level of income/benefit after retirement. Most of the cost of the benefit and risk of the investment is borne by the employer however in the contributory define benefit scheme employees also make compulsory contributions.… Read the rest

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Risks Associated with Derivatives

Although derivatives are legitimate and valuable tools for hedging risks, like all financial instruments they create risks that must be managed. Warren Buffett, one of the world’s most wise investors, states that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

On one hand derivatives neutralize risks while on the other hand they create risks. In fact there are certain risks inherent in derivatives. Derivatives can be dangerous if not managed properly. Numerous financial disasters such as Enron can be related to the mismanagement of derivatives. In the 1990s, Procter & Gamble lost $157 million in a currency speculation involving dollars and German Marks, Gibson Greetings lost $20 million and Long-Term Capital Management, a hedge fund, lost $4 billion with currency and interest-rate derivatives.… Read the rest

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Fama and French Three Factor Model

Capital Asset Pricing Model (CAPM) is the backbone of modern portfolio theory. According to CAPM, the expected return on stock is a function of its relationship with the market portfolio defined by its beta. However, Eugene Fama and Kenneth French (1992) brought together two more factors and found that stock return is based on a combination of not just market beta but also firm size and value. They came up with a new model known as  Three Factor Model  as an alternative to CAPM.

What is Fama and French Three Factor Model?

Fama and French three factor model expands on the Capital Asset Pricing Model (CAPM) by adding size and value factors in addition to the market risk factor in CAPM.… Read the rest

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Arbitrage Pricing Theory (APT)

A substitute and concurrent theory to the Capital Asset Pricing Model  (CAPM)  is one that incorporates multiple factors in explaining the movement of asset prices. The arbitrage pricing model (APT) on the other hand approaches pricing from a different aspect.    It is rarely successful to analyse portfolio risks by assessing the weighted sum of its components.   Equity portfolios are far more diverse and enormously large for separate component assessment, and the correlation existing between the elements would make a calculation as such untrue.   Rather, the portfolio’s risk should be viewed as a single product’s innate risk.   The APT represents portfolio risk by a factor model that is linear, where returns are a sum of risk factor returns.  … Read the rest

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Diversification of Risk in Portfolio Management

Average investors are risk averse. Therefore, they will be ready to invest into securities under the presumption of an adequate compensation for risk taking. The compensation for the risk taken should be in the form of minimal rate of return for the invested financial assets, and the rate is named the required rate of return. It has two components:

  • Delayed consumption compensation (investors could have purchased goods and services with the assets they are to invest) and
  • Risk acceptance compensation.

Diversification is used to stabilize the potential return, and thus increase the value of the investment. Diversification stands for he investment of capital into several different securities or projects, all together called the portfolio.… Read the rest

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Different Types of Stock Beta

Beta coefficient is a comparative measure of how the stock performs relative to the market as a whole.  It is determined by plotting the stock’s and market’s returns at discrete intervals over a period of time and fitting (regressing) a line through the resulting data points. The slope of that line is the levered equity beta. When the slope of the line is 1.00, the returns of the stock are no more or less volatile than returns on the market. When the slope exceeds 1.00, the stock’s returns are more volatile than the market’s returns.  The beta coefficient is a key component for the  Capital Asset Pricing Model  (CAPM), which describes the relationship between risk and expected return  and  that is used in the pricing of risky securities.… Read the rest

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