Investment and Portfolio Management

Question: Discuss about the Investment and Portfolio Management. Answer: Introduction Portfolio management is a strategy of selecting the precise investment policy by individuals or organizations to earn maximum return at minimum risk. It represents the best and appropriate investment plan to the investors according to their income, budget and capability to accept risks. There are generally two types of portfolio available for investors- Market portfolios and zero investment portfolios. Market portfolios involve investments in every kind of assets that are accessible in the financial market whereas zero investment portfolios are a group of investments that create nil net value. Zero investment portfolios incorporates lower risk as well as lower return because of simultaneous buying and selling of similar securities (Stettina and Hrz 2015). Most common and significant component of portfolio management is investment in securities that are assets with some financial values. Debt securities and Equity securities are two types of securities available to the investors. Debt securities are the assets having defined terms and conditions with respect to the principal amount, rate of interest, rate of returns and maturity date. Accordingly, interest-bearing securities are a part of debt securities such as bonds, debentures, certificates of deposits that disburse regular interests (Rank, Unger and Gemnden 2015). Discussion Interest- bearing securities being the essential component of portfolio management are majorly tradable in the money market and capital market. Most common interest-bearing securities that are available majorly in the money market are cash investments in the form of certificate of deposits and money market instruments. Cash investments are short-term securities that bear fixed interest rate usually with maturity of 90 days generate low returns (Kock, Heising and Gemnden 2015). Certificate of Deposits are the common interest bearing securities traded in the money market issued by commercial banks at higher rate of interests than that in savings account. These securities can be issued at any denominations with a maturity period of either three months or six months (Edirisuriya, Gunasekarage and Dempsey 2015). Certificate of Deposits restrains the access of funds until the date of maturity of the investment asset. For example, Federal Deposit Insurance Corporation (FDIC) insures the issuance of certificate of deposits by bank up to the value of $250,000. On the other money market instruments are also short-term investment securities that provide decent rate of return in the form of interest with a maturity period of six months or less. These securities are highly liquid in the money market with low and affordable denominations to invest at a stretch. There are different types of money market instruments available for short-term investors, which are Treasury Bills, Federal Agency notes and commercial papers. U.S. Treasury bills are the instruments that provide reasonable interest return with extremely low risk element (Ibrahim 2015). Australian treasury bills with maturity period of 2 years yields approximately 1.46 % and coupon rate @ 3.25% in the current money market while the historic yield around in the year 2000 was 6.38% at coupon rate of 7.00% (approximately). This shows that the value and return on these bills have declined in the period of sixteen years, yet for short-term investors having limited cash fund are keen on invest ing in these securities. Moreover, the commercial papers are short-term unsecured debt instruments issued by the organizations with fixed interest rates, to finance their current assets and liabilities. These instruments are issued at discount rates on the face value and carries rate of interest at the current market rate. Merrill Lynch Finance (Australia) Pty. Ltd issued commercial papers valuing around $ 800 million that is rated F1+ by Fitch IBCA. This issue reflected the strong profitability and level of interest coverage, well-diversified revenues and well utilization of asset resource as per the current economic scenario, current yield of 3months commercial paper is around 0.90 percent while the same was 0.20 % in the past year 2013 (Rahman 2015). Further, capital markets are the markets where trading of debt and equity securities take place. Common debt securities that are traded in the capital market are government bonds, corporate bonds, debentures issued by the organizations and other collateral bonds. These instruments carry fixed interest rates according to the market rate and corporate policy that are traded over the counter. In recent years, Australian Securities and Investments Commission (ASIC) require issue of debentures with an offer of security over the issuers tangible properties in proportion to the number and value of issued securities (Jackson and Victor 2015). Risks on investment and return on investments are parallel to each other. Higher the risk, higher is the return. For instance, fixed interest rate bonds or securities provide less return while the securities with variable interest rate fetch little higher return. On the other hand, securities that do not come with interest rates like equities fetch highest return and are invested with the long term perspective (Perez, Hodge and Le 2016). Figure 1: Risk vs. reward (Source: Westpac. 2016) Westpac Banking Corporation, one of the big four banks in Australia, specialize in issuing a wide range of both long term and shot term securities. It provides the facility to invest in government and corporate bonds, which yields higher return than cash investments at the rate 2.45% approximately for 12 months bond with denomination between $5,000- $2,50,000. The company also issue hybrid securities as well as tailored deposits with minimum deposit of $500,000 or $100,000 and maturity period of 1 year to 10 years (Westpac. 2016). However, investors need to review the performance of organizations and measure its issue price, interest amount with the current yield before investing in any securities. For instance, a perpetual bond of face value $1,000 and coupon rate at 4% is presently trading at $972. Current yield of similar securities in the market is 6% then investor should determine the intrinsic value of the bond before making investments. It can be derived as coupon amount/market yield rate i.e. 4% of $1,000/6% = $666.67 but the actual price of the bond is $972, which is overpriced. Hence, the investor is not advised to buy this bond (Westpac. 2016). Apart from the investors benefit, the instruments of money market influence the economic activities as well. Government regulated the measures in monetary policies either by themselves or through corporate by managing the supply of fund, credit and rate of interest. The budget of the financial year 2008-09 in Australia projected strong surplus amounted to around $21.7 billion to ensure the strong economical and financial position of the country. Incorporation of interest bearing securities for trading was a step by the government to strengthen the financial position of Australia through risk balance, fiscal flexibility to cover up the diminished global conditions (Rezende 2015). In case of Lehman Brothers, investments bank whose bankruptcy marked a serious interruption in the financial markets across the globe. This issue affected the industrial markets, stock markets with low index price, high interest rates and high level of risks. The considerable development in financial position in the Australian economy started in the year 2008. During this year government started issuing interest bearing securities with lower rate of return and low level of risks which improved the financial position raising GDP (Nainggolan, How and Verhoeven 2015). Therefore, investors have to be very cautious while managing their investment portfolio to incur maximum returns. Asset allocation means allocation of savings at right time and in a right way to maximize the return on investment. Each investment element is to be evaluated with respect to the duration, market yield, expected and actual return and issue price to have a profitable investment portfolio (Chalmers 2015). In order to choose optimum portfolio, investors can use matrix approach that involves three criteria for example, Target return 7% Target Standard deviation or risks 3% Number of days to disinvest and get back the fund, which is target in 5 days Portfolio Woolsworth with expected return 8%, risk 4% and number of days to disinvest 6 days Portfolio Bentley with expected return 5%, risk 2% and number of days to disinvest 3 days Score of return computed as portfolio return/ target return *100 Score of standard deviation or risks = Target Risk/ portfolio risk*100 Number of days score= Target days/ portfolio days *100 The optimum portfolio would be having highest total score: Score portfolio Woolsworth portfolio Bentley Expected return 8/7 * 100= 114.29% 5/7 * 100= 71.43% Risks 3/4 * 100= 75% 3/2 * 100= 150% Number of days 5/6 * 100= 83% 5/3 * 100= 166% Total score 272.29% 387.43% Table 1: Optimum portfolio (Source: Created by author) Hence, portfolio Bentley is preferable to invest because has the highest total score. Similarly, analysis of duration is also an essential factor to make invest in the right and profitable securities. For all interest bearing securities and bonds, duration is less than maturity except for zero coupon bond where duration is equal to the maturity. Accordingly, as maturity rises, duration increases at a decreasing rate and tends to limit the value. Hence, if the yield or interest rate is lower, duration of a security is higher (Fajar Pasaribu, Si and Ridwan 2015). Another significant factor of investment in interest bearing securities is a measurement of convexity, which is a curve to define the relationship between the price and yield of bonds. It is a risk management tool that reflects the change in duration of bonds with the change in interest rate. This means when yield of a bond falls price rises at a higher rate whereas if the yield rises, price falls at a lower rate. This positive feature is called positive convexity (Bengtsson and Hsu 2015). Figure2: Convexity (Source: Westpac. 2016) In the graph it is clear that even the price of two bonds is equal, bond A has a greater convexity due to the change in interest rate that shows the investors will have to pay more for securities or bonds having higher convexity. Therefore, analyzing the bond duration and risk of interest rate investors can immunize their investment portfolio to equalize it with the time horizon to fetch expected and maximum return (Chalmers 2015). Recommendation Therefore, if the investor is risk averse and not willing to invest in risk bearing securities, then it is recommended for them to invest in interest bearing securities. In this type of investment, there is a fixed amount of return in the form of interest will be incurred apart from the expected return of the securities. On the other hand, if investors are willing to take on risk and earn more return then they should invest in equity securities of listed companies or in mutual funds. Conclusion In view of the above discussions it can be said that the management of investment portfolio is critical and involve analysis of significant factors to incur maximum return at minimum risk. However, interest bearing securities are the optimum investment option for investors who are risk averse because these securities provide fixed return for a fixed duration with a maturity date. The issuance of these securities by government and corporate also contribute to the economic growth and industrial market in the country. Securities issed by companies like Woolsworth, Laserbond, Seafarms group and many more provides market prevailing interest rates and return rates. Economic growth of Australia has been in favorable with the incorporation of fixed interest rate securities and risk free bonds, which was a major step taken by Australian government since 2008. Therefore, interest-bearing securities with low risk and short-term duration are profitable for the investors. 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