Question

Use the $80,000 to invest evenly in the two stocks which you have selected based on a 50% margin (currently stock margin is 50%) which give you a leverage of 2 to 1, meaning you can invest up to $160,000 in both stocks. The following are some more requirements:

Prepare a brief profile of each corporation in which you have invested your client's fund.

You may take a long or short position in each stock or long position in one or short position on the other.

Justify your investment decisions based on the health of the firm such as profitability based on the income statement, debt to equity ratio based on the balance sheet, expected cash flows, innovations, and some other variables you may consider are important.

Justify your investment decisions based on the health of the industry. For instance, if the housing market is in trouble, hedge fund managers may take short positions in some stocks of this industry.

Justify your investment decisions based on the health of the economy. For example, when the economy is growing and the job market is healthy, most stocks are rising and investment managers take long positions in many stocks.

You may also justify your investment decisions based on monetary or fiscal policies taken by the policy makers.    

Select the two stocks which have negative correlations or a weak correlation for your portfolio for risk management purpose.

Calculate your return for each investment and your portfolio return.

Answer 1

INVESTMENT DECISIONS

Investible Funds = 80000

Ratio = 50:50

Share of Each Stock (evenly) = 40000

Leverage = 2:1

Amount invested in each stock = 80000

1. In case the price of stocks to be invested are expected to rise in future, then the position to be taken is Long. On the other hand, if the stocks are expected to decline in future, then one must go short on such stocks.

2. If one of the two stocks is expected to rise (bullish) and the other is expected to fall (bearish) in future, then the investment will be as follows =

Stock ABC (bullish) - Long - 160000

Stock XYZ (bearish) - Short - (80000)

Total Investment = 80000

3. Stock Prices can be predicted by considering the effect of following variables -

a. Profitability - Net Profit after tax is a vital factor to make a judgement on the financial stability of the company. One must compare the Net Profit of current year with previous years. Comparison can be done Amountwise, percentagewise and by trend analysis.

b. Debt-Equity Ratio - The ideal Debt-Equity Ratio is 1:1. If this ratio is adverse in case of certain company, then investment in such a stock will not be profitable in long run.

c. Expected Cash Flows - Expected CFs from new projects or existing projects give necessary information regarding the sustainability of the project.

4. In case a certain industry is facing problems, then the companies in such an industry will hav decreasing trend in stock prices. In such a situation, investors go short on such stocks as the expected prices are much lower.

5. Policies - Investments decisions depend alot on the Monetary and fiscal policies prevalent in the country of investment. For example - Foreign Direct Investment policies. Govt. Policies change the stock prices drastically. Considering those, one must take a proper position, either long or short, on a particular stock.