Economic Factors Contributing to Changes in the Required Rate of Return for Investments - Assignment Example

Name Instructor Course Date 1. What macroeconomic and microeconomic factors contribute to changes in the required rate of return for individual investments and investments in general? Explain each of them. Macroeconomic factors are the exchange rate, time value of money, inflation, financial risk, liquidity risk and country risk. The exchange rate reveals the differences between current consumption and future consumption. The pure interest rate is influenced by market forces such as a country’s economic status. The time value of money represents the difference paid by people for current borrowing and their savings surplus. Inflation affects the value of future payments and is influenced by external factors such as the exchange rate. Business risk refers to income flow uncertainties caused by a business such as volatility of sales (Reilly and Brown 18). Financial risk refers to uncertainties that are caused by debt financing. Stockholders experience this uncertainty to their income from borrowing. Liquidity risk refers to the uncertainty from the secondary market that affects the pricing and time value of money. Country risks refer to uncertainties caused by political differences or changes to the economic environment (Reilly and Brown 18). Microeconomic factors are personal risks such as insurance. The rate of return is influenced by risks such as insurance. 2. Explain the purpose and function of a capital market? A capital market facilitates resource mobilization and redistribution based on the economic needs of a real economy (Reilly & Brown, 2011). The capital market helps corporations, banks and governments with budget deficits to increase their long-term funds for making long-term investments. The function of a capital market is to provide investment opportunities for business firms to and investors earn return on their investments without engaging in economic activities. The capital market provides capital for infrastructure development and equity to governments for socio-economic benefits. 3. Explain in detail the characteristics that determine the quality of a capital market? The characteristics of a quality of a capital market are accurate information, liquidity and price continuity and efficiency of transaction costs (Reilly and Brown 96). The ability to access accurate and timely information is important because investors need information on historical transactions before making buy/sell decisions. Information on the historical transactions would need to provide accurate details on the volume, prices, outstanding bids and any offers. Liquidity is important because it influences how quickly investors can purchase or sell assets at known prices. This ability to sell an asset quickly is influenced by marketability and certainty of the expected price given transaction history and bid quotes (Reilly and Brown 96). Price continuity means that the prices do not significantly change between transactions (Reilly & Brown 96-97). A quality market experiences a large change in transaction price when new information is introduced. The introduction of new information should be rapid to ensure the fairness of the prevailing price. A good market is influenced by the transaction cost. The lower the transaction cost (such as brokerage costs), the more efficient the capital market (Reilly and Brown 97). This efficiency is called internal efficiency. 4. What is the difference between a primary and secondary capital market and how do these markets support each other? Explain in detail. The primary capital market allows trading of securities without any liquidity to owners of the securities. The primary market supports the secondary market by allowing owners to trade their securities (Reilly and Brown 101). The secondary market facilitates this by providing liquidity to the owners of the securities, which eliminates the need for investors to compensate for the high rate of return on bonds or stocks. The secondary capital market allows trading on outstanding issues (such as stocks that have been publicly sold) between potential and current owners of a security (Stowell 45) Earnings from sales in this market are transferred to the security’s owner and not to the issuing company or government (Reilly and Brown 101). Secondary markets comprise of national stock exchanges that are differentiated by time zone and geography. The secondary market provides liquidity to the primary market and benefits from the sale of securities in the primary market (Stowell 45). 5. Explain the specific factors that contribute to an efficient market? Efficiency of a market is influenced by accuracy of information and the transaction cost. The accuracy of information on a security affects the market price as well as supply and demand aspects. Informational efficiency refers to the availability of all information about an asset affects the market price of an asset (Reilly and Brown 97). Transaction costs determine the internal efficiency of a market. An efficient market is one where the transaction cost is low compared to the value of the trade. 6. Given the overall efficient market hypothesis, what are the three subhypotheses and what are the implications of each? Explain. i. Weak-form efficient market hypothesis (EMH) makes the assumption that stocks in the market represent the entire security market information such as rate of return, odd-lot transactions and volume data trade (Reilly & Brown 151). It implies that there is no relationship between historical market data and rates of return and the expected/future return rate. ii. Strong-form efficient market hypothesis (EMH) makes the assertion that the release of public information such as stock splits or announcements on dividends influences rapid changes in the prices of a security (Harder 6). This implies that investors cannot obtain risk-adjusted profits at above-average from transactions when they use public information having considered the trading costs (Reilly & Brown 152). iii. Strong-form hypothesis makes the assertion that stock prices are a reflection of all public and public sources of information (Harder 6). The implication is that an investor cannot obtain an above-average rate of return that has been adjusted to risks (Reilly & Brown 152). 7. What specific ratios help determine a firm’s internal liquidity, operating performance, risk profile, growth potential, and external liquidity? Explain each with example. The current ratio is a measure for internal liquidity. Current ratio is given by current assets divided by current liabilities (Reilly and Brown 280). Example: Current ratio= =  = 1.87 The measure of operating performance is fixed-asset turnover. Fixed-asset turnover is given by ratio of net sales to fixed asset value. Example: Turnover =  =  = 2.0. One measure of risk profile is the debt to total capital ratio. This is a measure of the total debt divided by the total capital where total debt includes current and long-term debt while total capital is given by total debt plus stockholders’ equity (Reilly and Brown 280). Example: Debt to capital =  =  = 0.21 The measure of growth potential is sustainable growth rate. The formula is retention rate divided by the return on equity. Example: Growth =  =  = 26. Measure of external liquidity is the value of traded shares in dollar amount or the number of shares. Another ratio is gross external financing divided by foreign exchange reserves plus current account receipts (Falzon 184). 8. How can the DuPont analysis help evaluate a firm’s return on equity over time? Explain The DuPont system helps investors assess the financial status of a firm by considering three elements: the capital structure, asset management and operating management (Reilly and Brown 289-290). This analysis helps an analyst to determine the return on equity by multiplying net profit margin and the return on equity. This determination helps an analyst determine processes that are successful and those that requirement improvement in a firm. Works Cited Falzon, Joseph. Ed. Bank performance, risk and securitization. New York: Palgrave MacMillan, 2013. Print. Harder, Sebastian. The efficient market hypothesis and application to stock markets. Munich: GRIN Vertlag, 2010. Print. Reilly, Frank, and Brown, Keith. Investment analysis and portfolio management. 10th ed. Mason, OH: South-Western Cengage Learning, 2012. Print. Stowell, David. Investment banks, hedge funds and private equity. 2nd ed. Oxford: Academic Press, 2012. Print. Read More