Significance and Importance of Risk Management for Investments and Capital Markets - Term Paper Example

 Topic: Developments in the assessments of market risks Significance And Importance Of Risk Management For Investments And Capital Markets. How important is risk management to investment and capital markets? Recent economic events have shown the importance of risk management and manifested challenges that must be met for sound economic policies of an institution. Market risk is defined as “the risk that the value of an investment will decrease due to moves in market factors.” (Wikipedia) These market risk are chances that stock prices, currency, interest rate and commodity prices will change are considered as standard market risk factors. In simple term, market risk is the probability of a business to a profit or loss. Fundamentals of risk management. The purpose of risk management is to reduce the impact of different risks related to a purpose. It may be caused by risks posed by the environment, technology, organization or politics. But in financial management, risks can be managed using traded financial instruments and therefore there is a need to understand the importance of fundamentals in risk management. Risk management fundamentals are governance and risk control, risk identification and measurement and liquidity risk management. Governor Randal S. Kroszner, speaking before the American Bankers Association, Spring Summit Meeting in Washington, D. C. held on March 11, 2008, spelled out the importance of fundamentals in risk management. He stressed that there are fundamental issues that must be addressed by financial institutions in the light of economic disruptions and points out to sound risk management practices. Governor Kroszner cited an example as one of failures of bank’s policy is risk concentration, and cited an example of “putting all eggs in one basket”, and that by concentration, he said, “losses could occur at one time.” Gov. Kroszner noted that as concentration of banks to its functions of basic lending, holding of securities, trading of complex instruments, providing liquidity instruments, engaging in off-balance sheet transactions and other financial activities, banks are treading on a new market where there are information and unidentified data which form hidden risks, and manifests its presence only during times of problems. An example, Gov. Krozzner said, is the market- wide demand for liquidity experienced by US recently. (Governor Randall S. Kroszner, 2008) The Importance of Fundamentals in Risk Management The importance of understanding the relation between the risk concentration and capital is relevant in risk management as it affects the capital that should be held against it. Impact of information management In governance, information is the key for control and this lies in the hands of senior management who are entrusted to do this function. Gov. Kroszner stated why information is important link taking into consideration recent events in the US.. He said that when information is kept “in silo” and not distributed “vertically and horizontally within firms” a segregation prevents managers from knowing the extent of risks of the different activities undertaken by the firm and thus managers are unable to correlate it in events of stress. Specifically Gov. Kroszner said most managers are not aware of the relations of the firm’s mortgages and its relation to the US sub-prime mortgages as well as other exposures to mortgages and complex securities. As such, senior managers must have proper understanding of the risks assumed by their firm and that adequate information should be disseminated from senior managers up to the business line, and information should be presented in an unbiased analysis, Gov. Kroszner stressed. In a similar fashion of understanding key information, in press release of the SAS on October 10, 2006, in Ireland, said that result of their survey showed data quality and management are the biggest setback in the implementation of the Enterprise Risk management system. The survey was conducted globally among 339 financial service executives. SAS proposes "To deliver an enterprise view of risk that meets all stakeholders' requirements, institutions have to start with what they have in common: information. That means lifting data out of the organizational and technological silos, cleaning it up, and integrating it into financial and customer decisions to enhance business value and manage companywide risk." (SAS 2006) Anticipated rewards of financial institutions from centralized data system are reduction is capital allocation system and a reduction on cost of credit losses. Banks have realized the importance of credit risk managements as a method to manage their loan portfolios. Nomura Research Inst., in their study of Regional banks and credit concentration risks in Japanese financial institutes reported information as a problem in extending relationship banking. The problem of regional banks, as pointed out in this report, is the credit risk concentration. Regional banks are allowed to expand services to other wider areas of loan borrowers, but are hindered by availability of information. Transactions such as credit loan swap or loan participation has been objected because of difficulty of obtaining information on the borrower. (Nomura Research Institute 2006) 2. Risk Identification and Measurement The second fundamental of sound risk management relates to risk identification and measurement. Correct and up to date information are significant to sound risk management. A good risk-management structure must take into consideration risks affecting not only the firm, but should gather and process information on an across enterprises basis in real time. In short, Gov. Kroszner said, “you cannot manage your risks if you do not know what they are.” Analysts must have foretold knowledge of stock prices, currency, interest rate and commodity prices and other financial information to mange risks. Tools commonly used to identify risks In finance, analysts and financial institutions use various tools to measure risks in any investments. Liquidity, Working capital, Performance, and Solvency ratios and VAR are used to analyze are often times employed in measuring risks in financial investments a. Liquidity ratios answer the question on “Can the company continue to pay its liabilities and debts?” The article for Stock Market for Beginners said accepted rule in liquidity ratio says the higher the value of the ratio, the larger the margin of safety that the company possess to cover short term debts, and stated, “Anything over 1 is acceptable.” The commonly used liquidity ratios are the current ratio and the quick ratio b. Working capital rations.. Investor ratios provide information on how the company uses its funds, compare company performance year by year and make comparative study on the company standing with that of its competitors and the industry. Price earning ratios, dividend yield and growth, debt to equity ratios of a company are commonly used ratios in comparing performance with the industry and competitors, and comparison of yearly performance of the company. 1. Debt to equity. A debt to equity ratio measures the level of borrowings the company has used in proportion to stockholders’ equity to finance its assets. A study said that when a company has more loans, its ability to pay these loans and interests is the key to its survival. According to this study, as a rule of thumb, investors should stay away from businesses “whose debt/equity ratio is greater than 1 (i.e. it is financed more through borrowings than through stockholders’ equity)” (Stock Market for Beginners) However, it has also been rationalized in this study, that capital intensive business tends to have higher debt to equity ratios, and that business with reliable (ie. earnings which don’t fluctuate much through economic cycles) earning can sustain a higher debt to equity ratio. 2. Price earning ratios. P/E ratios determine if one company is better than the other when investing in the stock market. Investors advocate using a P/E of 10, or a P/E of as high as All other things being equal, a stock with a lower PE ratio would provide better value than one with a higher PE. Following the rule of a lower PE ratio is better value than one with higher PE, investors will most likely look at investing in the competitors of Easy Jet (Stock Market for Beginners) 3. Price to sales ratio is “a ratio that compares a firm’s stock price with its sales per share (or its market value with total revenue). It is used by some analysts to find companies that may be temporarily undervalued in the stock market. A low P/S ratio is used to characterize a firm with the potential for a significant turn around because sales has already taken place and improvement need only take place in the margin the firm is able to earn on each dollar of sales.” (Stock market for beginners) Types of market risk. Value at Risk. In market analysis, the most commonly used measure is the Value at Risk technique. VAR is a technique which uses the statistical analysis of historical market trends and volatilities to estimate the likelihood that a given portfolio's losses will exceed a certain amount. (Investorwords) However, it has been noted that there are limiting factors that may affect accuracy in use. First, it assumed that the composition of the portfolio measured is not changed over a single period of time. However, for a longer period of time, many items in the portfolio may change as maturity comes in place, and other intervening factors that may affect fixed options such as fluctuations of interest rates, changes in cash flows and others are not taken into consideration in the single period computation, and thus affect accuracy of data. Specific risk. In contrast with market risk, there is also the specific risk to management. This is defined as “risks that affects a very small number of assets.” (Investopedia). For example, there is a news that would affect the shares of stocks of an investor, or news about changes of policy in the company that would specifically affect investments. Unlike systematic risk or market risk, specific risk can be diversified away. Specific risk is also explained in LSE as ”the variability in the return on a security due to exposure to risks relating to that security in isolation, e.g. risk of losing market share due to poor marketing decisions.” (LSE definition) Equity risk is the risk that one's investment will depreciate because of stock market dynamics causing one to lose money. This has been explained in Wikipedia as “The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods. The standard deviation will delineate the normal fluctuations one can expect in that particular security above and below the mean, or average. However, since most investors would not consider fluctuations above the average return as "risk", some economists prefer other means of measuring it.” Interest rate risk is defined as “the risk (variability in value) borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond's duration.” (Wikipedia) C. Discuss the reasonableness of reviewing corporate activities based on a sound investment of risk. Bank’s activities as well as traded corporation have the responsibility to its stakeholders to report their financial conditions. Securities and Exchange of the US mandates US corporations to report the market risk transactions of the companies in a section of Form 10-K of annual reports. The company should report in detail how results of its operation may depend directly on financial condition to provide investors information on investments done by the company. (Wikepedia). For example, an investor thinks the company is a normal soft drink company, but all the while, same company is doing other activities such as investing in complex investments like “foreign exchange futures. Corporate activities are usually reported in figures in the annual report. It will show the growth of the company which will be the basis for investment. It shows costs and revenues, assets and liabilities and earnings allocated for stockholders. A certain portion of the report indicates the accepted accounting procedures followed in reporting. There are some founded criticisms in usage of accounting system. For example, Risk Glossary article points to the inadequacy and limitations of the accrual accounting system of assets and liabilities. A bank or insurance companies would accept deposits, insurance and annuities and in turn invest these to earning activities such as bonds, loans or real estate at an assumed interest rate for a fixed period of time, and at the same time keeping the record at book value. Report does not disclose the disguised possible risks arising from how the assets and liabilities are structured. (Risk Glossary.com) Let us take a bank that borrows USD 100M at 3% for a year and lends the same money to a borrower at 3.20% for five years. Initially, prospect looks good, because the bank will earn .20 on the transaction for the first year. Now supposing, the interest rates have increased to 6% at the end of the year the bank will have to pay higher interest rate on its loan, while earning a low fixed rate for its own investment. Clearly, this is a picture of a loss which will not be reported as a loss at once, but will be carried on the subsequent years of accrual. There are financial reports that considers market value accounting and recognizes the bank’s predicament and reflects loss or gain on a market accounting stand point. From a market-value accounting view, the bank has lost USD 10.28MM. The market value standpoint recognizes the loss today while accrual accounting recognizes the loss in the duration of four years. Signals of this kind of risk could cripple an organization, lead to capital loss that could end up to bankruptcy if the magnitude of investment is big. Discussions and conclusions Market risks are always evident in any kind of transactions. But risks could be managed and limited by use of financial tools. Foremost among the tools is access to vital information related to the ability of payment of borrower, market condition, volatility of currency and interest rates, technological change and other forces that may signal stress of the situation. Relative to this, Gov. Kroszner is correct in saying “What will you manage if you do not know what to manage” in stressing his key point on importance of information. A data management or centralized data system of information is envisioned to help financial institutions limit their credit losses and reduce expenses. Many banks have subscribed to this idea with the expectations of having reduced costs on access to information. Other tools of measurements used by analysts in measuring market risks and have been found to be traditional tools of risks management. Working capital ratios have long been found effective measure instruments. But although we have all the kinds of measurements, a question could be aptly placed, why is there a financial economic collapse? Has the information machinery failed to bring the needed message to authorities that shape decisions? A thorough study would require an in-depth analysis on a cross-wide, country wide and global perspective to be able to analyze the real situation which is not covered by this report. Total words count: 2454 List of references Definition. Market risk. In Wikipedia. [on line] Available at Retrieved 09, Jan. 2009. - - - Equity Risks. In Wikipedia. [on line] Available at Retrieved 09, Jan. 2009. - - - Interest rate risks. In Wikipedia. [on line] Available at Retrieved 09, Jan. 2009. Investopedia. Specific Risk. Definition.. [on line] Available from Retrieved 09 Jan. 2009 Investorwords. Value at Risk. Definition. [on line] Available from< http://www.investorwords.com/5212/Value_At_Risk.html> Retrieved 09 Jan. 2008. Kroszner, Randall S. 11 Mar. 2008. The Importance of Fundamentals in Risk Management. A speech delivered at the All American Bankeers Association Spring Summit Meetng, Washington, D.C. [on line] Available from http://www.federalreserve.gov/newsevents/speech/kroszner20080311a.htm> Retrieved 08 Jan. 2008 LSE. Specific Risk. Definition. [on line] Available from Retrieved 09 Jan. 2008 Nomura Research Institute. 2006. Regional banks and credit concentration risk.Lakyara Vol. 08 [on line] Available from Retrieved 09 Jan. 2008 Risk Glossary.com. Asset-Liability Management. [on-line] Available from http://www.riskglossary.com/link/asset_liability_management.htm markets.”. Retrieved 09 Jan. 2008. SAS Ireland. Risk Management Survey Highlights Business Benefits as Important as Compliance Goals for Companies. 10 Oct. 2006. Press Release. [on line] Available from http://www.sas.com/offices/europe/ireland/press_office/press_releases/> Retrieved 09 Jan. 2008 Stock Market Investing for beginners. 07 Sept. 2008. [on line] Available from http://beginnersstockinvesting.blogspot.com/2008/09/quick-ratio-formula.html Retrieved 09 Jan. 2009 Wikipedia. SEC mandates US corporation to report market risks in Form 10-K of annual reports. [on line] Available on http://en.wikipedia.org/wiki/Federal_Reserve> Retrieved 09 Jan. 2008 Read More