Sample Economics Paper on Economics of Money, Banking and Finance

Investment success is dependent on several pre-investment decisions that are essential to an investor. The investor considers factors such as their appetite for risk based on their investment, the purpose of the investment, whether income-generating or wealth creation, and the market and business environment. The UK market has one of the largest and most efficient securities markets in the world; the London Stock Exchange. This bourse presents an avenue for trading equities, debt, commodities, and even exchange-traded funds. However, the decision regarding which instrument to buy rests with the investor. An investor with a risk tolerance is likely to opt for long-term investments and prefer riskier instruments such as start-ups. An investor with a medium-risk tolerance opts for medium term investments lasting for approximately 5 years and opts for established growing companies. Investors with low-risk profiles opt for blue-chip companies and stable funds including mutual funds and debt securities. The main difference between these three types of investors is their returns. A risky investor takes more risk, and thus, stands to lose a lot in the case of a market downturn. However, this position allows them to also earn huge rewards since high risk equals high rewards when the usual business cycle is maintained.

A beginner investor may want to take a low-risk investment and concentrate more on wealth generation than earning income. Since this cannot be achieved through a single investment instrument, an investment portfolio comes in handy. The portfolio can be tailor-made to ensure that risk is spread out and that the investor is exposed to both wealth creation and income generation. A beginner investor in the UK securities market can opt for a portfolio containing stock, cash, bond, electronic-traded fund, and a cash equivalent instrument like a money market fund. Ideal instruments in the LSE include; Ashtead Group Plc stock, the Financial Times Stock Exchange 250 index ETF, the T68 Treasury bond, a 5-year RCI Bank fixed rates savings plan, and the Sterling Short-Term MMF offered by investment giant Vanguard Group. The stock instrument exposes the investor to wealth creation as Ashtead stock was ranked as one of the best shares to invest in for wealth creation by Yahoo Finance. The cash and cash equivalent instruments serve as money for precautionary motive. The bond instrument is a cushion against adverse stock market returns. Lastly, the ETF ensures that the investor is exposed to another portfolio of assets and owns a part of the 250 companies monitored by the FTSE 250 index.

Investment instruments are heavily dependent on the UK’s economic and monetary policy outlook. Economic turmoil expected by the UK includes the effects of the Brexit. Various markets are adversely affected including labor markets. The government’s monetary supply policy is also affected as some business may pull out of the UK as factors of production are expected to increase with the introduction of new tariffs and an increase in inflation rates. The UK government may have to increase money supply to boost local production. The Brexit poses an adverse impact on the portfolio of assets aforementioned. All assets, except the 5-year fixed rate RCI Bank savings plan, with be negatively affected. The savings instrument may only suffer from the effects of inflation which are a reduction in the purchasing power of money.

Individual Holdings

Ashtead Plc Stock

The decision to buy each of the assets in the portfolio is supported by relevant traditional investment theories. Foremost, we will determine the intrinsic price of Ashtead’s stocks using the Gordon Growth model. This model highlights whether the stocks are overpriced, underpriced, or fairly priced.

Latest Ashtead divided payment was £2.25

The 10-year government growth rate of 1.4% will be used as the annualized rate of growth for Ashtead stocks.

To obtain the WACC of Ashtead stock we will use the Capital Asset Pricing Model as shown below:

re = rf + β(rm – rf)

Where re is cost of equity, rf is the risk free rate, rm is the market return, and β is the beta of the asset.

The 10-year Treasury fixed maturity bond with a rate of return of 0.46 will be used as the risk-free rate.

Ashtead group has a beta of 1.87.

The market premium, as per the Gurufocus website, is approximated to be 6.46% (Ashtead Group WACC).

Cost of equity = 0.46 + 1.87(6.46 – 0.46)

Cost of equity = 0.46 + 11.22 = 11.68%

Ashtead’s cost of debt as per 2019 was as follows:

Interest expense was 192.8385m while total debt value was 4,369.7291m (Ashtead Group WACC)

Cost of debt = 192.8385/4369.7291

Cost of debt = 0.044131 = 4.413%

WACC = E/(E + D) * cost of equity

WACC = 2.801/(2.801 + 3.745)* 11.68

WACC = 5%

Sp = D1(1+g)/(k-g)

D represents the dividend payments; the annual payments the company will pay to its common equity shareholders. G stands for the growth rate; the rate at which the dividend payments per share increase from one year to another. K stands for the weighted average cost of capital; the minimum rate of return that investors are willing to accept for the risk they are undertaking.

Sp = 2.25/(5-1.4)

Sp = 2.25/0.036 = £62.5

The price of Ashtead’s stock is trading at approximately £23 representing a premium. This shows that the stock is undervalued thus making it a prime asset for buying. Undervalued stocks are preferred because of the following three reasons. First, their prices tend to return automatically to the intrinsic value thus assuring investors of profits. Secondly, they present investors with an opportunity to invest in blue-chip companies at low prices. Thirdly, the risk associated with such stocks is low since the fluctuation in price is cyclical, and with time, prices will return to the real value of the stock.

The Gordon Growth model is better poised to evaluate the intrinsic value of a stock based on the future stream of dividends growing at a constant growth rate. The model assumes that the firm will pay dividends per year that increase at a constant rate. It also assumes that the company will be in existence forever.

Holding a large share in Ashtead’s stock can assure the investor of wealth creation. Moreover, the company pays dividend, hence assuring the investor of a continued flow of income. However, the better position would be dividend reinvestment. Here, the investor uses the dividends to buy more stock hence capitalizing their investment. The purpose would be primarily wealth creation and the use of both dividend reinvestment and capital appreciation to ensure that the investor’s stake grows considerably in the company.

The risk taken by investing in Ashtead stock is compensated using the risk premium as posited in the Capital Asset Pricing Model. This figure is obtained by multiplying the difference between the expected market return and the risk free rate by the beta of the asset. The CAPM assumes that, at the risk- free rate, the investor has assured returns since he has taken a zero-risk position. For the investor to take additional risk, he/she will have to be compensated using the risk premium. Different degree of risk carries different risk premiums, with larger risks having larger risk premiums and vice versa.

Treasury Bond

Government debt investment instruments have the inherent disadvantage of having very low returns compared to the stock market. However, they have two primary advantages that make them ideal for portfolio optimization. First, they offer very minimal risk since the default rate of governments is almost zero. As such, the investor can be assured of returns. Government instruments also promise assured incomes in terms of coupon payments (T68 Treasury 0 1/8% Il Treasury Gilt 2068). Secondly, government assets have a tax advantage; the interest earned on bonds is often income tax exempted. These two reasons make the Treasury bond an ideal instrument to diversify against the risk taken in the stock market. Selling the bond in the secondary market also gives the investor an opportunity to make a return by selling it at a premium.

The T68 Treasury 0 1/8% IL Treasury Gilt 2068 was issued in the year 2013, with its maturity projected to be in the year 2068. The bond pays semi-annual coupons at a coupon rate of 0.125% and a present value of £284.87 with a required yield of 0.04% (T68 Treasury 0 1/8% Il Treasury Gilt 2068). The price of the above bond can be calculated as shown below:

PV=C/(1+i)t + Par Value/(1+i)N

C stands for Coupon payments; i represents the required yield; t represents the number of coupon payments; while N represents the number of years to maturity.

Par Value = PV(1+i)N

Par Value = 284.87(1.04)54

Par Value = £2,368.4

The PV of the bond is £297.8. The bond should be selling at a premium.

Cash Investments

Investing in cash involves the use of savings plans offered by banks. Unlike investments in equity and debts, cash presents a liquid preference for investors to meet emerging needs if and when they arise. The Keynesian demand preference for money posits the need of cash for precautionary motive. Cash is also needed for the preservation of capital. Apart from inflation, cash is a safe investment in preserving capital. Cash also helps investors to avoid selling off their shares and bonds (Cash Investments 2010). Lastly, cash can also be used easily to increase one’s holdings in stock and debt. However, cash suffers from the disadvantage of having minimum to zero returns over time. The risk involved with cash is minimal thus translating to minimal returns. Cash investments include; certificates of deposit, money market accounts, high yield solutions, and money market mutual funds (Cash Investments 2010). The investor in any of these instruments can quickly and easily transform their liquid assets into cash to meet their upcoming needs. The Sterling Short-Term Money Market Fund offered by Vanguard in the London Stock Exchange is an ideal cash investment that can achieve the aforementioned merits. The Sterling short-term MMF is a good investment that can stabilize unstable investment earnings due to exposure to a portfolio comprising of assets earning differently from each other (Sterling Short-Term Money Market Fund). The fund also provides the investor with a steady flow of income in terms of the interest yields earned on a daily basis.

Per the Vanguard group, the Sterling short-term MMF is not ideal for long-term investments over 5 years. However, for investments less than 5 years, the fund is ideal. The fund is completely invested on low-risk instruments including commercial papers, certificates of deposits, repurchase and reverse repurchase agreements, and UK Government treasury bills. This Sterling short-term MMF is required in the portfolio to provide a cushion against adverse fluctuations in returns in the stock market. The fund can also be used to meet arising issues without diluting one’s position in the other holdings constituting the portfolio. The fund has managed to outperform the Short-Term GBP Money Market making it an ideal low-risk asset (Sterling Short-Term Money Market Fund).

Exchange-Traded Funds

An exchange-traded fund is an agglomerate of securities traded as a single unit of assets at a securities exchange. These stocks are often tracked by an index. These funds often contain multiple types of securities including bonds, stocks, commodities, and a mixture of these (Exchange-Traded Funds2020). Their prices fluctuate throughout the day as the ETF is bought and sold. Unlike individual stocks, ETFs offer lower brokerage fees and a wide portfolio of assets. The changes in demand and supply of the EFT lead to changes in its price in the market. ETF’s can be limited to specific sectors of the economy such as banking-focused ETFs. They can also be limited to a single market like the U.S. market or several foreign markets like the Asian market.

The ideal ETF for our aforementioned portfolio is Vanguard’s FTSE 250 UCITS ETF. This ETF was introduced at a price of £25 with a transaction cost of 0.1% (FTSE 250 UCITS ETF). This fund adopts a passive management investment, also known as indexing approach, by physically acquiring the securities. The company uses the FTSE 250 Index. This index comprises of mid-size companies in the UK. Per the Vanguard Group website, the FTSE 250 UCITS ETF is aimed at accomplishing two prime purposes: track the performance of the FTSE 250 Index and remain fully invested in these companies except for scenarios whereby the political and market environment is completely unsuitable for investing. Per the iShares website, the FTSE 250 ETF had a total return of 8.72% against a benchmark rate of 9.21% at inception (iShares FTSE 250 UCITS ETF). In 2019, the fund’s total return of 28.36% was also close to the benchmark rate of 28.88%.

Cash Equivalent Instruments

Cash investments are financial investments whose value is determined directly by markets. There are two types of cash instruments: securities and others cash instruments including loans and deposits. The difference between these two is that while the former are easily transferable, the latter is only transferable upon the agreement of both the borrower and the lender (Cash Instruments Law and Legal Definition). Cash investments offer an investor total capital security but introduce him/her to credit risk. Fluctuations in interest rates do not affect the capital value of investments. Investments in cash should be made in accordance with expected immediate cash flow needs for meeting short-term liabilities. The ideal cash investment will be the RCI Bank 5-year fixed deposit with a rate of interest of 1.7%.

Portfolio Composition

Portfolio formulation should follow the Modern Portfolio Theory (MPT) forwarded by Harry Markowitz. The theory posits that investors can construct their investment portfolios optimally at a given level of market risk and maximize returns (Modern Portfolio Theory2020). The theory encourages investors to assess the risk and return of an individual asset with regards to its effect on the portfolio’s risk and return. The MPT theory holds that given a certain level of risk, an investor can construct a portfolio that will maximize their returns.

The investment portfolio will comprise of a much greater stake in equity as wealth creation is a primary objective of a long-term investor’s investment profile. The income earned as dividends will be reinvested to earn more stake in Ashtead Group. The company is involved in the leasing and renting of industrial and construction equipment. As the industrial and construction sectors grow, the company is also going to grow. The company has a presence in the U.S., UK, and Canada. As such, the expected negative effects of the Brexit can be mitigated by strong performances in the other two countries, especially the U.S. which seeks to strengthen its industrial sector so as to avoid firms from opting to produce in rival China. The company’s equipment handle pumping, digging, heating, support, ventilation, generating, lifting, compacting, moving, digging, and powering, among others. These products diversify the company’s total risk. The company, therefore, has a huge potential for growth even after the Brexit when Britain looks to strengthen its domestic industrial and construction capacities following the possible exit of foreign companies. Ashtead will constitute 40% of the investment portfolio.

Secondly, cash will constitute 25% of the investment portfolio because cash can be used to meet any expected and uprising immediate monetary obligations. Given the expected successful Brexit talks, expected returns in the equity market are likely to deviate to a lesser amount. As such, any expectations of using the equity investment for income generation may not be successful. The cash investments will instead be used to meet any requirements and needs of the investor. A 25% stake will also allow the investor to earn some substantial interest on the cash investment. The debt investment will take a 15% portion of the portfolio. This asset is necessary to diversify the risks expected in the equity market as aforementioned. The relatively minimal risk involved means that the investor can almost be certain of receiving returns from this instrument. Lastly, the ETF and CMMF assets will each get a 10% stake in the investment portfolio. This decision is pegged on the fact that they are both instruments where the investment has been spread across several assets in the market. The CMMF instruments involve an array of investments in several other short-term instruments in the market. The ETF asset involves an investment in the 250 mid-level companies in the FTSE (iShares FTSE 250 UCITS ETF). As such, these two instruments provide a wide degree of diversification. The portfolio is as shown in Figure 1 below:

Figure 1: Investment Portfolio

Source: Self

Portfolio Performance

Portfolio performance was assessed using an online Portfolio Visualizer. The above portfolio had a dismal performance compared to the Vanguard 500 Index Investor. The former had an expected return rate of 8.98% while the portfolio had an expected return rate of 3.99%. The optimization goal was to minimize asset variance within the portfolio. The portfolio performed well in its best year, with a 20.1% return against the benchmark of 21.67%(Portfolio Visualizer). However, the portfolio had a worst year performance of -10.15 against a benchmark of -4.52. This presented a huge underperformance. The portfolio also underperformed in both the Sharpe and Sortino ratios. The portfolio ex-ante Sharp ratio was 0.35 against a benchmark of 0.76, its ex-post Sharpe ratio was 0.34 against a benchmark of 0.73 while its Sortino ratio was 0.47 against a benchmark of 1.11 (Portfolio Visualizer). The portfolio, however, performed well in terms of maximum drawdown. It had a maximum drawdown of -13.08% against the benchmark of -13.55.

The portfolio performed below expectations as outlined. The factors that led to this under-per performance are expected risk levels and a low compound annual growth rate. The portfolio was expected to have diversified the high risk in the equity market using the bond, ETF, and cash equivalent instruments. However, the risk level was still high. Minimal variances would have been achieved by a larger investment in the debt instrument than the stock instrument. Secondly, the expected growth of the portfolio based on the stock instrument did not happen as expected. The drawdown period had a huge adverse effect on the portfolio’s expected annual returns.




Reference List

GuruFocus. Ashtead Group WACC. [Online] Available at: <> [Accessed 9 May 2020].

Investopedia, 2020. Exchange-Traded Funds-ETF. [Online] Available at: <> [Accessed 9 May 2020].

Investopedia, 2020. Modern Portfolio Theory (MPT). [Online] Available at: <> [Accessed 9 May 2020].

iShares. iShares FTSE 250 UCITS ETF. [Online] Available at: <> [Accessed 9 May 2020].

London Stock Exchange. T68 Treasury 0 1/8% IL Treasury GILT 2068. [Online] Available at: <> [Accessed 9 May 2020].

Money-Zine, 2010.Cash Investments. [Online] Available at: <> [Accessed 9 May 2020].

Portfolio Visualizer. Portfolio Optimization. [Online] Available at: <> [Accessed 9 May 2020].

USLegal. Cash Instruments Law and Legal Definition. [Online] Available at: <> [Accessed 9 May 2020].

Vanguard. FTSE 250 UCITS ETF (VMID). [Online] Available at: <> [Accessed 9 May 2020].

Vanguard. Sterling Short-Term Money Market Fund – Income. [Online] Available at: <> [Accessed 9 May 2020].