Efficient Market Essay: Inefficiency Of Capitalization.

Investment in Treasury Bonds and Energy Stocks

Discuss about the Efficient Market Inefficiency of Capitalization.

Troy a venture capitalist founded a hedge fund foundation known as Northwest capital management. The main aim and objective of such organsiation is to minimise the trading risk while infusing money in the market securities. Both public and private money is invested in the hedge fund. Analyst in the present case study discussed about the expectation of Troy regarding the declining housing market with an expectation about growth in the oil market in the future terms.

As in general treasury bonds are the fixed income bearing securities issued by the government department for the long range of period. However such type of securities can be freely transferable in the indirect market at the value prevailing at the certain period of time. These are risk free securities. Reviewing upon the direct and indirect nature of treasury bonds it totally depends upon the fact from where the investor has purchased such bonds. Venture capitalist Troy through his hedge fund group Northwest capital management can bid in the primary market or can purchase at a reasonable price in the secondary market (Haugen & Baker, 1991). To hedge the risk the asset management company should also invest in some sort of indirect and direct investments. In the present case where the AMC is looking forwards to invest in a debt fund it is sort of direct debt investment with a fixed range of returns. However as far as energy stock is concerned if the AMC is investing in the individual energy stocks with its individual screened name then he is certainly investing in the direct securities. But in the case structure if the Troy is investing in the pool of energy stock through foundation trust or mutual funds related to relevant sector then he is investing in the indirect securities (Guercio & Reuter, 2014).

The AMC Northwest capital management formulated a common pool of securities where he himself and certain investors place their contribution that is to be invested in accordance with a stated objective. The ownership of complete fund is joint and mutual in the particular case. The entry load and management fees of such funds are subdivided among the number of units that are sold in the external market. Troy in the present case faces issues with selecting the fund in the portfolio (Fama & French, 2010). He has to regularly switch his investments while viewing the external market opportunities and the current prevailing conditions in the external market. For instance in the present case, the AMC is exiting from the housing group stocks due to future forecast of financial downfall in the particular sector. Alternatively Troy is wishing to invest in the energy segment companies as in the future period certain stock will create a hike as witnessed by external current market situations.

Diversification of Portfolio

Apart from growth prospect, the Asset management company is working out towards the hedging the security risk while diversifying the complete risk among the debt and equity stocks. To work out in the particular area the Northwest capital management group has invested the total pool of funds in the treasury funds which sustains the feature of risk free returns and certain part of money in the energy stocks (Manek, 2016). To further reduce the risk to acceptable investor appetite the fund manager can work out in the direction of investing the funds in the indirect energy securities rather than in direct particular stocks. Indirect security investment in the present task makes sense that fund manager invest in the pool of sartorial securities in certain proportion while reviewing the market Beta factor. Analyst can also trade in the energy sector index funds to work out more effectively and efficiently. It is reviewed that while hedging the risk while utilising the hedge funds might reduce the returns to certain level in the short run but seeking the long term portfolio investment approach and making a risk benefit analysis it has been worked out that investor is in ultimate profitability position at the reduced risk level (Authority, 2015). The analyst has also need to consider the entry and exit load as the frequent switch between the investments might enhance the cost associated with the complete portfolio which ultimately puts a great affect on the overall portfolio returns (Avramov, et. al., 2011).

As in the current case scenario investor while infusing his funds in the portfolio of the current AMC suffered loss due to which initial funds invested got reduced to considerable level. This position comes into fact when the investor has placed its complete fund in the particular direct security and not diversifying its portfolio. An investor is advised to not keep all his funds invested in a single security to minimise the investment loss (Arouri & Nguyen 2010). Additionally the AMC has not placed the certain portion of investors fund in the risk free treasury bonds. Although these bonds do provide the returns at lower level as comparison to the direct funds but it saves the investor to get his funds eaten up.

Northwest capital management should utilise the approach of diversification in its portfolio with overall reference to overall fund management, this makes sense that the fund manager should work out with the number of securities for the purpose of spreading and reducing the risk that sustains in all the financial securities. The risk of portfolio (indirect securities) is considerably lesser than the individual securities (direct securities). Combining security assets in the AMC portfolio should be done in an appropriate manner subject to the degree of correlation between the assets. Troy Dexter needs to minimize the risk by investing the money of the investor in different sector to reduce the risk of loss of money of the investor. The Troy Dexter to minimize the risk of the investor needs to invest in derivative marker t where in future and option minimum lot are fixed.  The buying in future and option minimum lots are fixed. The buying in future involves rutting up the margin money and minimizing the risk by keeping low margin than the assets value. These contracts are for hedging, arbitration and speculation and for this the investor must open a derivation trading account with a derivative broker.

Hedging Strategy to Reduce Market Risk

The northwest capital management needs to adopt various hedging strategy to reduce the market risk depending upon the portfolio or the assets which the company is planning to hedge. The Northwest capital management can make the use of the various tools to reduce the market risk which includes constructing the portfolio, volatile hedging and by making the use of the option. These tools are more effective to reduce the risk of the investment.

The Northwest capital management company can make the use of modern portfolio theory which diversifies the assets among various groups to reduce the volatility of the investment. The method uses the statistical approach to identify the expected amount of return from the defined amount of risk. The technique identifies the correlation between the various assets and identifies the volatility of the investment for the purpose of creating optimal portfolio to deliver the best result to the investor. Many of the financial institute use the modern portfolio theory for the purpose of risk management practices and provide the curved linear relationship between the risk and the return which the company is earning.

The Northwest capital management company can use option which is the other powerful tool for reducing the risk of the investor. For the purpose of hedging the stock with reasonable liquidity can put buy put option for the purpose of protecting against the of downside move. The index option helps in tracking large stock indexes for the purpose of maximizing the return (Manek, 2016).

In the above report analyst has discussed about the Venture capitalist Troy who behalf on his personal Asset management company ‘Northwest capital’ invest the certain amount of funds for his individual and external investor purposes. Depending upon the external market situation and different risk attitudes of his fund investors he switches his funds in the different proportion among the direct and indirect securities. The analyst in the above report detailed about the particular case in which while investing the funds in the direct fund he ends up his total investment amount.

Payback period method – The method is the most effective and easiest way of measuring the risk associated with the investment. The payback period measures the duration within which the company will recover the cost made over the investment. The between the two or more project is made on the basis of the project having shorter payback period. This method is easy to use and involves less complexity as it reduce the evaluation to the simple number of year which provide clear picture of the investment (Storesletten, 2003). It helps in identifying the project which delivers faster return and is important of the company possessing limited cash to recover the cash as quickly as possible. It helps in evaluating the project with the smaller investment and avoid conducting the rigorous economic analyse.

Modern Portfolio Theory

The method ignores the time value of the money which is one of the major disadvantages of the project and the cash flow may be irregular as most the return occur well until the near future. The project may have expected return but many of the time fail the company minimum requirement of the minimum payback period.  The method also doesn’t consider the cash flow after the payback period which also plays a critical role on investment.

Payback period of Lathe A- 4+16000/450000 =4.0356 years

Payback period of Lathe B- 4+56000/486000 =3.6512 years

Analyse- after analysing the above two method using the payback period it was identified that Lathe B is much better in comparison to that of Lathe A as it is having shorter payback period.  But the method doesn’t consider the cash flow after the payback period which is higher in the case of Lathe A.

Net present value – The method compares the investment which was made today with the present value of the future cash flow and consider the time value of money at the time of measuring the investment. The method considers the cash flow throughout the life of the project thus consider effective over the other method. In the method profitability and the risk of the project are given high priority and it also helps in maximizing company value. The major disadvantage is that it requires lots of complexity at the time of applying the method. The method does not give the adequate result if the amount of the investment is different in the two projects (Olawale, et. al., 2010). Also it creates complexity due to not availability of the adequate discount rate and may not give the correct decision when the project has uneven life. The project with the higher NPV is considered better at the time of decision making.

Analyse – from the consideration of the NPV method Lathe A is better in comparison to that of lathe as it is providing higher return to the company. This is because the total cash inflow from the project A is higher than that of project B.

Internal rate of return- it is the capital budgeting measuring which helps in making choice between the various investment and is the interest rate at which net present value of the investment is zero. If the IRR exceed the company rate of return than the project should be accepted on the other hand if falls below the project should be rejected. The method makes the perfect use of the concept of the time value of the money and provides importance to all the cash flow (Bhattacharya, 2014). The method doesn’t require calculating cost of capital and helps in attaining maximum profitability of the shareholder. The method creates difficulty in the case of two mutually exclusive projects and involves unrealistic assumption.

Lathe A = 113280 +142506 + 115038 + 102984 + 243900 /660000 = 1.0874

Lathe B = 77880 + 93960 +66528 +52718 +112194 / 360000 = 1.1202

Analyse- The IRR of the Lathe is better so should be considered for investment.

Recommendation – By applying above capital appraisal technique it was identified that from the point of view of NPV Lathe A is better, on the other hand from the point of other two methods Lathe B is better.

Arouri, M. E. H., & Nguyen, D. K. (2010). Oil prices, stock markets and portfolio investment: evidence from sector analysis in Europe over the last decade. Energy Policy, 38(8), 4528-4539.

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