Comparing Risk And Return Of Five UK Investment Products

Part A

a). Tom is present with two investment scenarios under which he needs to evaluate the best option depending on the payoff. The first option for the payoff is receiving the £1400 bonus this year or receiving the £1600 bonus next year. Tom should evaluate both the case depending on the payoff and the return generated from each of the option. Tom should look upon the discount rate in each of the case so that whether any other investment opportunity case available or not that can generate or yield better return for Tom for the sacrifice of bonus he is going to receive this year (Bowen and Hutchinson 2016). While evaluating the return or the payoff scenario the crucial things he will consider for deciding the best options for evaluation is the yield generated under each of the options. The second option should generate and give return more than the risk free rate of return of 3% for the viability and the selection of the same (De Bondt et al. 2015).

b).Use of Investment Tool and evaluation of the payoffs:

c). The shares option plan, offered to Tom for consideration of receiving bonus this year of £1400 or receiving shares after two year when the shares of the company will float in the market and the expected value, is £3000. However, there are some crucial factors, which should be taken into consideration like the uncertainty in the price, stock and market volatility and the level of risk in this kind of investments(Favilukis, Ludvigson and Van Nieuwerburgh 2017). Tom has preferred the shares option after evaluating the volatility and the probability option scenario for each of the case and he was able to generate better return and yield from the second option that is £1600 in the next year.

d). Tom colleague Cath goes for the second option for receiving the £1600 bonus and for not receiving the £1400 bonus this year taking the 10% annual interest as the future value of the investment then would be around 1540 which is 60 less than 1600 which could be simply earned by considering the second option (Gitman, Juchau and Flanagan 2015).

e). If the inflation forecast for the next year is expected to be around 5% then the investment decision would be affected by the rise in the risk free rate of return or the expected return from the investment would also rise from 10%- 15%. The first option would not be considered as viable that is deferral of the 1400 and getting 1600 as the same would yield around 14.29% instead of the 15%.

Higher returns are associated with higher risks in the investment asset class the phrase depends on the type of exposure the investor is considering for investment. Higher returns comes in the form of higher risk to an investor (Devaney, Morillon and Weber 2016). The return on investment depends on the type of asset class and the investment horizon for the investor. Investors with longer time horizon of investment and willing to take above average risk outperforms in the achievement of return from the asset class. Risk of an asset class depends on the volatility of the asset and the scenario under which the asset class operates. If the market scenario and the volatility of the asset class in the form of return generation is higher, the risk of the asset class is considered risky and the return desired from the investor from such an asset class is higher (Hoque et al. 2015). The five-asset class shown in the table has different characteristics and the return and the risk for the asset class varies as the type of product and the services it delivers. Some of the assets class which are less risky and nonvolatile provides a lower amount of return for the investors. However, it should be noted that on the other hand asset class, which was having volatility in the form of return and was risky is said to deliver better return to compensate investors for the risk undertaken. The evaluation of the different asset class and the products will help us know the different risk and return characteristics of the asset class and the suitability of investment accordingly:

1. Use of Investment Tool and Evaluation of Payoffs

Product 1: The first product evaluated was the savings bank account, which provided an annual interest rate of around 1.5%. The lower risks and return for the asset class is depended on the asset class. The form of investment is in the type of the liquid asset where the amount of risks undertaken by the investor is almost negligible (Jordan 2014). The tenure of the fund is almost negligible, as the funds will not be locked in any kind of investment asset class. Thus, the return from the asset class is low depending on the risk of the asset class (Nicholls and Tomkinson 2015).

Product 2: The annual interest rate offered by the savings account is around 2.5% and the same is higher than the product 1 because the financial regulator, which would regulate the operations and the business of the lenders, does not recognize the social lenders bank. The risk associated with this kind of product is the company risk and the business risk associated with the company that is compensated in the form of extra return given by the bank. Thus, higher return comes with an additional point of risk taken by the investor for investing in the asset class (Saha, Ahmad and Yeok 2016).

Product 3: The third product evaluated was the government bond, which was a £100 face value bond with a coupon rate of 5% the yield from the bond is also 5%. The higher return in this product is due to the tenure of the und and the market and the price risk associated with the product as the bonds will be going through changes in the price as the interest rate in the economy changes.  The higher return is compensated due to the tenure of the investment in the asset class of five year where the investor will be lo0cked down in the asset class and would not be able to evaluate other investment asset class.

Product 4: Annual dividends and the price appreciation of the share price are the two common sources of return for an investor for investment in shares. The investment in the share would provide the investor with an annual dividend of around 3.5% and price appreciation of the company’s share price. The standard deviation is the amount of risks associated with the product, which is around 8%, which shows the level of movement in the share price can be around 8% or more depending the market scenario and the business condition of the company.

Product 5: Investment in the Shares of New Fad would be considered as one of the risky investment asset class out of all the investment asset class as the beta of the asset class is around 1.8. Beta of 1.8 shows that if the market scenario changes by 1% the stock is expected to change by around 1.8%, which shows that the asset class is a high beta stock. The asset class has a higher amount of risks than product 4 as the company in this product 5 is not settled well in terms of profitability and return generated to the investors.

Thus, different asset class has different level of risk and the return from the same is also dependent on the type of investment asset class and the tenure of the investment. The investment horizon, liquidity factor and investor preference towards risk return tradeoff are some of the factors that needs to be considered (Venkatesh 2016).

References

Bowen, D.A. and Hutchinson, M.C., 2016. Pairs trading in the UK equity market: risk and return. The European Journal of Finance, 22(14), pp.1363-1387.

De Bondt, W.F., Muradoglu, Y.G., Shefrin, H. and Staikouras, S.K., 2015. Behavioral finance: Quo vadis?.

Devaney, M., Morillon, T. and Weber, W., 2016. Mutual fund efficiency and tradeoffs in the production of risk and return. Managerial Finance, 42(3), pp.225-243.

Favilukis, J., Ludvigson, S.C. and Van Nieuwerburgh, S., 2017. The macroeconomic effects of housing wealth, housing finance, and limited risk sharing in general equilibrium. Journal of Political Economy, 125(1), pp.140-223.

Gitman, L.J., Juchau, R. and Flanagan, J., 2015. Principles of managerial finance. Pearson Higher Education AU.

Hoque, H., Andriosopoulos, D., Andriosopoulos, K. and Douady, R., 2015. Bank regulation, risk and return: Evidence from the credit and sovereign debt crises. Journal of banking & finance, 50, pp.455-474.

Jordan, B., 2014. Fundamentals of investments. McGraw-Hill Higher Education.

Nicholls, A. and Tomkinson, E., 2015. Risk and Return in Social Finance:” I am the Market”.

Saha, A., Ahmad, N.H. and Yeok, S.G., 2016. EVALUATION OF PERFORMANCE OF MALAYSIAN BANKS IN RISK ADJUSTED RETURN ON CAPITAL (RAROC) AND ECONOMIC VALUE ADDED (EVA) FRAMEWORK. Asian Academy of Management Journal of Accounting & Finance, 12(1).

Venkatesh, R., 2016. Risk and Return in Micro Finance Institutions-A selective study of Micro Finance Institutions in Karnataka. International Journal in Management & Social Science, 4(9), pp.145-156.

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