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International Financial Market

An investor is always interested to invest in such an investment which is risk-free but at some point of time the risk not only the matter but the asset in which the investor invests is itself a risky asset, in this case the investor would always prefer to borrow or lend at risk-less rate of return wherein the return in fixed and do not fluctuate with the prevailing market conditions. The following sections discuss about the model that well describe the situation and also various reasons of why the pricing of risky assets may depend on the existence of opportunities to borrow and lend at the riskless rate of return (Gollier, C. (2001). Risky Assets: An investment with a return that is not guaranteed. Assets carry different levels of risk. For example, an investor investing in a corporate bond would have a less risky situation than the one who is investing in a government bond. Risk-less rate of return: The return on any investment with as minimum or low that the risk is considered to not exist. The risk-free return exists in order to recompense the investor for their investment of capital, even though it is not put at risk. Body: The capital asset pricing model is the basic measure of financial performance of a firm. For any given investment, the cost of capital is the minimum risk adjusted return required by investors for undertaking an investment. The investment project has to generate sufficient surplus to repay the loans of creditors. It should also earn sufficient return which the shareholders might have obtained in some other investment. If the surplus earned by the investment project does not cover

the return payable creditors and shareholders, the value of the firm is jeopardized. It is imperative, therefore, that the net present value of the future cash flows of the project exceeds or at least be equal to, the projects cost of capital. This cost is used a discount rate. Alternatively, the yield from the project should be equal to or exceeds this cost. The reasons for pricing of risky assets may depend on the existence of opportunities to borrow and lend at the riskless rate of return, may be explained taking in account the CAPM model that is Capital Asset Pricing Model. This is explained as follows: Ri = Rf + i (Rm - Rf) (Giovanis, E., & Giovanis, E. (2010). The approach to determine the cost of equity and risky assets for a particular investment project is based on the Capital asset pricing model. By taking the risk-free rate, the expected return of the risky asset and the expected standard deviation of returns, we can develop another equation in the form of Y = a + bX, which is known generally as the Capital Allocation Line (CAL) and explains asset allocation at a basic level. The slope of the CAL, b, is the portfolio's risk premium divided by its standard deviation: Slope = b = [E(r) - r*] S. The Y intercept (a) is the risk-free rate (r*) and X is the standard deviation (S) of any feasible portfolio that can be constructed by blending the risky and risk-free assets (quoted from: Gollier, C. (2001). The CAPM assures that the total variability of an assets pricing and return can be attributed to two sources: Market-wide influences that affect assets to some extent, such as state of the economy and, other risks, which are specific to a firm, such as strike. The former type of risk is usually termed systematic or non-diversifiable risk. The latter is unsystematic or diversifiable risk. The latter is largely irrelevant to the highly diversified holder of securities because the effects of such disturbances cancel out in the portfolio. On the other

hand, no matter how well diversified a portfolio or investment is, systematic risk cannot be eliminated. Hence the investor should be compensated for bearing the risk. This distinction between the systematic and unsystematic risk provides the theoretical foundation to the evaluation of risk in the multinational corporation (Bailey, R. E. (2005). The holders of equity capital claim that portion of profits which remains after the payment of interest to the lenders and dividends to the preference shareholders. The equity share holder face the risk of variable cash flows and expect a higher return that the internal rate of return on the capital invested by them. This internal rate of return would equal the discounted value of all future income streams accruing to them equal to the net worth of shareholders. One can alternatively, also look upon the required rate of discount as the average return of all returns are available on the various activities of the firm. This latter view of the required rate of return gives a better of cost of equity capital of a firm from the conceptual point of view. However it may not be suitable as a convenient choice of a discount rate to evaluate the firms foreign investment project. Thus, the better approach seems to take a project specific required rate of return, which will give a better idea of the riskiness of the particular project. Although, CAPM states that only a systematic component of the risk will be rewarded by a risk premium, this does not mean that the total risk (the combination of systematic and unsystematic risk) is unimportant to the value of the firm. In addition to the systematic risk reflected in the premium on the appropriate discount rate, the total risk may have a negative impact on the firms cash flows. The inverse relation between the risk and the expected cash flows exists, because financial trouble arising out of high total risk will hurt the interests of customers, suppliers and employees. For example, potential customers will be nervous about purchasing a product which they may have difficulty in getting serviced if the firm goes out of business. Similarly, a firm 3

which is trying hard to survive can get suppliers only at higher than usual prices. If the projects cash flows are volatile and uncertain, the management may be unable to take a long-term view of the firms prospect. It will lead them to adopt hit-and-run strategies making most of the current opportunities. For instance, in a situation where returns and the financial structure of a new investment are likely to be similar the ones selected at some point of time in past, the companywide cost of equity capital can be used as a discount rate to evaluate the new investment. Where the returns and the financial structure of the new investment are not similar to those of other projects, a project specific discount rate has to be used. The risk-free return is known. If we look into the future, we should know the risk premium, which is excess of the return expected. Therefore, in this case investors depend on the past patterns and the prevailing opportunities in the market (Bianconi, M. (2003).

Conclusion: From all the studies and research, we conclude that due the risk in the assets the lender or the borrower would always like to take advantage of the opportunities of the risk-less returns. Since, the level of risk in such lending or borrowing might be high, so the investor might choose to invest in such a proportion where even in risky assets they could have risk-free returns on investment that is in proportion of their wealth with the remainder in cash-earning interest at the risk free rate (or indeed may also can borrow capital to finance his or her purchase of risky assets in which case there is a negative cash weighting). It is therefore possible to attain aq particular or required return in two ways out of the following: 1. Investment of ones wealth in a portfolio that is risky,

2. Or diversifying the investment in a risky portfolio and the remainder in cash (either

borrowed or invested). (Bailey, R. E. (2005). Thus the conclusion says, that a person who is planning to invest in a risky asset would always take the advantage of the situation and would not miss the opportunity to invest in a risk-free return portfolio, where at least his returns are fixed and would not fluctuate over the period of time with variations in market conditions. Reference: 1. Kapoor, V., management, H. o., & Bank, S. (n.d.). Investing in risky assets| ET Slide Shows. The Economic Times: Business News, Personal Finance, Financial News, India Stock Market Investing, Economy News, SENSEX, NIFTY, NSE, BSE Live, IPO News. Retrieved August 3, 2011, from 2. Modern Portfolio Theory Part Two | Hedge Fund Writer. (n.d.). Eric Bank | Business Writer. Retrieved August 3, 2011, from 3. Bianconi, M. (2003). Financial economics, risk and information: an introduction to methods and models. Singapore: World Scientific 4. Bailey, R. E. (2005). The economics of financial markets. Cambridge: Cambridge University Press.

5. Fabozzi, F. J., & Markowitz, H. (2011). The theory and practice of investment management: asset allocation, valuation, portfolio construction, and strategies (2nd ed.). Hoboken, N.J.: Wiley. 6. Gollier, C. (2001). The economics of risk and time. Cambridge, Mass.: MIT Press. 7. Giovanis, E., & Giovanis, E. (2010). Application of Capital Asset Pricing (CAPM) and Arbitrage Pricing Theory (APT) Models in Athens Exchange Stock Market. Munchen: GRIN Verlag GmbH