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FIN/711 v7 Risk and Return Analysis Mr

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FIN/711 v7 Risk and Return Analysis Mr. Tom Silverman invests in stocks, bonds, mutual funds, and other financial assets. Tom knows that investing in stocks is risky and he has about $3MM dollars to invest. He would like to play it safe, so he plans to invest $1MM in U.S. Treasury Bonds with 10-year maturity. He plans to invest the remaining $2MM in the stocks of 2 companies, Cinplat Inc. and Solvay Inc. Cinplat Inc. is a software company, which has been in business for more than 10 years. Solvay Inc. is a distributor that has been in business for nearly 20 years. Solvay Inc. has distribution centers, warehouses, and trucking companies in the U.S. Tom believes that if he invests in stocks of companies in 2 different industries, he can reduce his risk. The financial situation in the U.S. is not very stable, and the stock market has taken quite a few extreme swings in the past several months. Before Tom invests his funds, he wants to assess the returns and risk of investing in U.S. Treasury Bonds versus the 2 stocks. The economic experts have specified 5 possible scenarios at the end of the year. For each scenario, they have estimated the probability of the scenario occurring and the impact on returns from U.S. Treasury Bonds and the 2 stocks. Given this information, Tom has calculated the rate of return on a 10-year zero coupon for each scenario. The probabilities and returns are shown below for each scenario. Write a 700- to 1,050-word risk and return analysis in which you address the following: Bonds 1. What is the return on investing $1,000 in U.S. Treasury Bonds if selling it after 1 year for $1,088? 2. Graph the probability distribution for the 5 scenarios during the next year for the 10-year zero coupon Treasury Bonds. Copyright 2020 by University of Phoenix. All rights reserved. Risk and Return Analysis FIN/711 v7 Page 2 of 4 Return on a 10-Year Zero Coupon Treasury Bond Scenario Probability Return Worst Case 0.15 -18% Bad Case 0.25 -3% Most Likely Case 0.35 6% Good Case 0.15 19% Best Case 0.10 28% Note: The total in the Probability column must equal 1. Calculate the expected return on this bond given the probability distribution. Stocks Calculate the expected returns for the 2 stocks, Cinplat Inc. and Solvay Inc., given the historical returns for the past 10 years. Stock Returns Year Market (S&P 500) Cinplat Inc. Solvay Inc. 1 36% 28% 55% 2 17% 16% -45% 3 17% -12% 17% 4 -29% -18% 8% 5 -16% 4% -30% 6 10% -14% 48% Copyright 2020 by University of Phoenix. All rights reserved. Risk and Return Analysis FIN/711 v7 Page 3 of 4 1. 2. 3. 4. Year Market (S&P 500) Cinplat Inc. Solvay Inc. 7 25% 42% 16% 8 -11% 28% -20% 9 -5% -28% -5% 10 40% 32% 65% Estimate the risk of each of these stocks. Which stock is riskier and why? If Tom invests $1MM in each of these stocks, what is the risk of the portfolio? If Tom invests 75% of $2MM in Cinplat Inc. and 25% in Solvay Inc., what is the risk of the portfolio? The graph of the returns from Cinplat Inc. and Solvay Inc. are shown below. What inferences can you derive from this chart? Copyright 2020 by University of Phoenix. All rights reserved. Risk and Return Analysis FIN/711 v7 Page 4 of 4 Submit your assignment. Copyright 2020 by University of Phoenix. All rights reserved. Risk and Return Risk is basically the possibility of losing your invested capital due to various unfavorable conditions whilst return is the reward you get for taking a risk. Risk and return have a positive relationship thus the higher the risk the higher the return. Mr. Tom’s investment plan is a good one as it involves the principle of diversification since he is looking into investing two different stocks and also some treasury bonds which spreads his risk. Treasury bonds are generally considered to be risk free as the government would never fail to pay its domestic debt since they easily pay their debt through raising taxes or considerably printing more money. On the other hand, he will be looking to purchase stock of two different companies which are Clinplat Inc. which has been around for more than ten years which means at least the business has tried and tested business processes which reduces their operational risk, and the other one is Solvay Inc. which has also been in business for nearly twenty years meaning they also have tried and tested business processes. However, the US economy is not very stable and the stock market has been taking extreme swings which makes it a very risk market to invest in. Return on Treasury Bonds $1,088 - $1,000 = $88 $88 / $1,000 * 100 = 8.8% The return on $1000 US treasury bonds will be 8.8% and this will be regarded as a risk free rate and will be used to determine risk premiums and the market rate for other bonds. This is however a high rate and represents a good return. Expected Return Scenario Worse case Bad case Most likely case Good case Best case Probability 0.15 0.25 0.35 0.15 0.10 Return -18% -3% 6% 19% 28% Expected Return -2.70% -0.75% 2.10% 2.85% 2.80% 4.30% The return on the 10-year zero coupon treasury bond will be equivalent to the expected return of 4.30%. This will be considered the risk free rate in theory meaning purchase of these bonds would not warranty any risk to Mr. Silverman on his $1MM investment. This would be a wise investment considering the current unpredictability of the US economy, only limited risk investments would be advisable at the moment. Expected returns on stocks Cinplat (28 + 16 – 12 – 18 + 4 – 14 + 42 + 28 – 28 + 32)% = 78% 78% / 10 = 7.8% Solvay (55 – 45 + 17 + 8 – 30 + 48 + 16 – 20 – 5 + 65)% = 109% 109% / 10 = 10.9% The expected return of Clinplat is 7.8%, whilst that of Solvay is 10.9% and this indicates Solvay yields more returns than Clinplat and this could be because of the higher risk it also poses on investment. Risk of the stocks Cinplat ∑ (x - ?)2 / n – 1 16.4 / 10-1 16.4 / 9 = 1.82 Solvay ∑ (x - ?)2 / n – 1