Merrill Finch Inc. Case Study Essay

Merrill Finch Incorpo arrayd is a large financial services corporation. As a newly hired financial planner for the company, I suck up been assigned the task of expendment funds $100,000 for a client. The investing alternatives have been restrict to five options T-Bills, advanced tech, Collections, U.S. Rubber, foodstuff portfolio, and a 2-Stock portfolio.The economic forecasting lag for Merrill Finch developed probability estimates for the state of the sparing, and the security analysts have developed softw ar to estimate the set up of rejoin key on from each unrivaled of these alternatives under each state of the economy. A map showing the results of the analysis is in supplement A of this report.Section 1 of this report begins with a wrangleion on the concept of Return. The calculations of each of the alternatives judge rate of revert atomic number 18 alike compute and discussed. Section 1 then continues with the concept of Risk. Three diametric timements o f insecurity be discussed and calculated for each of the investment alternatives. The hazard measurements discussed are the Standard Deviation, Coefficient of Variance, and genus genus Beta Coefficient.Section 2 discusses some scenarios of distinguishable investment options. The first off is of a 2- buy in portfolio consisting of the investment of $50,000 into both High Tech and Collections. The pass judgment return, standard warp, and coefficient of variance are then calculated and discussed for this option. The second scenario is of a portfolio consisting of hit-or-missly selected stocks. The element concludes with a discussion of the chance involved with this random portfolio and how the addition of more than random stocks to the portfolio would affect the risk.Section 3 discusses the auspices Market Line (SML) Equation and how the SML would be affected if inflation expectations were to show by 3 percentage points. Appendix B shows this equation and its exercise to calculate the required returns of each of the investment alternatives. The section is then cerebrate with a discussion of these calculations and how they compare to the judge returns calculated in section 1.Due to time constraints, probability distri bution graphs for High Tech, U.S. Rubber, T-bills, and a portfolio of haphazard selected stocks has been omitted from this report.ReturnReturn is defined as the income that an investment provides in a year. When deciding on what type of commercialise to invest in, it is wise to first look at each grocery stores expected rate of return. The expected rate of return of an investment is the weighted total of the probability of all practical results. The expected rate of return of various investment options are shown in Appendix A of this report on page 6. For each option, the expected rate of return is calculated by multiplying the probability of the state of the economy by the corresponding estimated rate of return for that groce ry store, then taking the congeries of these values.One of the invested alternatives for Merrill Finchs client is exchequer Bills, or T-bills. These are a form of treasury securities issued by the United States Treasury. T-bills are said to be a risk-free investment, but in realty, there are no true risk-free securities. In regards to default risk, T-bills are risk-free because the Treasury must redeem them. Being that they must be redeemed, also shows that they are independent of the state of the economy. They are, however, susceptible to otherwise forms of risk.If the rates were to addition or decrease, T-bills would then be susceptible to reinvestment rate risk, the risk that they might non be able to be reinvested at the same rate. For this investment, the expected rate of return on T-bills is calculated to be 5.5% .High Tech and Collections are two other investment alternatives for the client. The expected rate of return is 12.4% for investing in High Tech and 1.0% for Col lections. Investors might choose to invest in one of these two depending on how well they predict the economy forget do. High Tech has a direct relationship with the movement of the economy. If the market is expected to increase, then this would be a good investment. Collections, however, moves in the icy direction of the economy. If a dec identify is expected, then investors would use this as a hedge against the negative movement of the economy.The remaining alternatives for this client are to invest in U.S. Rubber, a market portfolio, and a 2-stock portfolio of High Tech and Collections. The expected rates of return are 9.8% in U.S. Rubber, 10.5% in a market portfolio, and 6.7% in the 2-stock portfolio.RiskAs we have already discussed above, no securities are truly risk-free. Depending on the nature of the investment, the type of investment risk will vary. The following sections discuss some of the different types of measurements that can be used to determine the measurement of risk in an investment.Standard Deviation. The standard deviation () is defined as a statistical measure of the variability of a set of observations. The littler the standard deviation, the lower the risk of the investment. It is calculated by taking the weighted average of the deviations from the expected value. This provides an idea of how far above or to a lower place the expected return the actual return is likely to be. The type of risk mensural by the standard deviation is complete Risk, which measures the undiversified risk of holding an exclusive asset. For this investment analysis, the standard deviation for T-bills is 0% , 20% for High Tech, 13.2% for Collections,18.8% for U.S. Rubber, 15.2% for a market portfolio, and 3.4% for the 2-stock portfolio.Coefficient of Variance. The Coefficient of Variance (CV) is a standardized measure of the amount of risk per unit of return. It is calculated by dividing the standard deviation by the expected return. The larger the CV, th e riskier the investment. It is a better measurement of Stand-Alone risk than the standard deviation. This is because it includes the effects of both risk and return and allows for a closer evaluation of situations where investments have substantially different expected returns. This investment analysis shows the CV for T-bills to 0, 1.6 for High Tech, 13.2 for Collections, 1.9 for U.S. Rubber, 1.4 for a market portfolio, and 0.5 for the 2-stock portfolio.Beta Coefficient. The Beta Coefficient a measurement of Market Risk. It shows the extent to which a given stocks returns move up and down with the stock market. The Beta of an average stock is 1.0, but most have betas in the range of 0.5 to 1.5. Beta coefficients are calculated as the slope of a regression line, which represents the difference between a given stock and the stock market in general. The expected returns of a market are directly related to each alternatives market risk. In other words, the higher(prenominal) the rate of return of the alternative, the higher its beta coefficient. The estimated betas for each of the clients investment alternatives are shown in the chart in Appendix A. Considering the beta coefficients provided in this chart along with the other information that we have calculated, we do not yet have bounteous information to choose among the various alternativesWhen considering whether or not to invest in a particular alternative, one thing to consider is portfolio diversification.An investors view of risk in an investment can be greatly affected by the diversification of their portfolio. The risks that can affect an undiversified portfolio may not be the same as those of a diversified portfolio. An undiversified investor may get to be more aware of the stand-alone risk and, therefore, closely admonisher the alternatives Coefficient of Variance or standard deviation. These, however, may not be as relevant to a diversified investor because they are more concerned with the feign that a stock may have on theriskiness of their spotless portfolio rather than on its stand-alone risk. Aside from having higher risk, another drawback to having a portfolio containing only an individual stock is that you would not be compensated for your higher degree of risk.SECTION 2 Investment Alternatives2-Stock PortfolioOne of the investment alternatives for the client is a 2-stock portfolio. An option with this alternative would be to invest $50,000 into both High Tech and Collections. The chart in Appendix A contains the calculations of the various measurements of risk. The expected return on the 2-stock portfolio is 6.7%, the standard deviation is 3.4%, and the CV is 0.5. The riskiness of this alternative is different than that of the individual stocks if they were apart from one another. A major difference is in the measurement of the stand-alone risk. The stand-alone risk of the individual stocks is greater than that of a stock portfolio. This is because the two stocks h ave opposite reactions to the market. As the risk of one alternative increases, the risk of the other decreases, reducing the everyplaceall risk of the portfolio. ergodic Stock SelectionAnother investment alternative to consider might be to separate a portfolio with one randomly selected stock, then randomly adding more and more stocks to this portfolio. Initially, the portfolio would have significant risk because it only contains one individual stock. As more stocks are added, the expected rate of return would remain the same, but the risk would be reduced due to the diversification of the risk done the various stocks.SECTION 3 Security Market LineThe Security Market Line (SML) equation shows the relationship between risk as measured by beta and the required rates of return on individual securities. Appendix B shows this equation and the calculations of the required returns for our various investment alternatives. give an estimated risk-free rate of 5.5% and market return of 10 .5%, the required rates of return were calculated at 5.5% for T-bills, 12.1% for High Tech, 1.15% for Collections, 9.9% for U.S. Rubber, and 10.5% for a market portfolio. These returns compare closely to the estimated returns in the chart in Appendix A. The required returns are bear on to theestimated returns for the Market Portfolio and T-Bills, showing that they are fairly valued. Required returns are greater for U.S. Rubber and Collections, showing that they are overvalued. The required return is lower for High Tech, showing that it is undervalued.The required return of a portfolio with 50-50 High Tech and Collections is calculated at 6.63%. For a 50-50 portfolio of High Tech and U.S. Rubber, the required return is 11%.If investors raised their inflation expectation by 3 percentage points over current estimates as reflected in the 5.5% risk-free rate, the SML would result in an up(a) shift of 3 percentage points. The required returns of both high and low-risk securities would a lso result in an increase of 3 percentage points. If investors risk offense increased enough to cause the market risk premium to increase by 3 percentage points, the SML would then result in an upward rotation about the y-axis and the required returns of high-risk securities would increase.