Finance and Accounting: Financial Markets and Institutions - Assignment Example

? Finance, Financial Markets and s Contents Question 3 Question 2 7 Reference 12 Question A - Every organization irrespective of whatever business they undertake has to take some sort of risk. Risk can be classified into two categories systematic and unsystematic. Systematic risks are those which cannot be controlled by the organization alone like change in interest rate, inflation, recession etc. Unsystematic risk can be controlled by the organization like management problems, industrial relations, business or financial or default risk. Banking organizations also have to face these risks. These risks must be managed well in order to grow and sustain in the market. If these risks are not managed properly then banks can collapse like Lehman Brothers collapsed in the year 2008. Lehman Brothers was one of the largest investment banks in USA. It was established in 1850. During the initial years it operated in the field of cotton trading. Later, it started the business of investment banking. It faced many financial crisis during its long tenure like the great depression in 1930’s but it collapsed and became bankrupt during the financial crisis which occurred due to subprime crisis. The collapse of the Lehman Brothers is the biggest example of inefficient handling of the financial risk. Financial risk can be defined as the risk which arises due to the use of debt in the capital structure of the organization. This risk happens due to increase of financial leverage. If the company uses debt in the capital structure then it is bound to make fixed payments to the creditors. Compulsory payment of fixed charges in turn lowers the earning per share (Kevin, 2006, p.58). The EPS of a company varies due to the financial risk. Apart from this the organization also faces the risk of default which is also known as credit risk, business risk which is associated with the management and the operations of the business, liquidity or short term solvency risk which the company faces while making day to day business transaction. This risk is also associated with the financial risk. All these risks affect the financial position of the organization. The Lehman Brothers faced all these risks which were not managed efficiently as a result the organization collapsed. Lehman Brothers were in the business of investment banking were correct trade-off between risk and return is very important. The investment bank has to decide on the amount of risk it can undertake and whether the return associated with the risk is justified. During 2002 and 2003 the real estate industry was booming in USA. Every investment bank was involved in subprime mortgage loans which were considered profitable during that time. Previously the Lehman Brothers use to purchase assets to sell them in the market but to gain to follow the other investment banks Lehman Brothers abandoned their previous strategy and stared using them for their operation to gain more profit. The main investments of Lehman Brothers were in real estate, equity and loans. The main problem of Lehman Brothers was that they made many investments which were not liquid. The capital structure of the Lehman Brothers consists of more debt than equity. To finance new investment they used more borrowed funds. As the investments made by them were not liquid they were unable to sell them to generate cash for making the compulsory payments which exposed them to the liquidity risk. In order to make more profits Lehman Brothers got involved in the subprime loan that is giving financially risky loans without proper security. This in turn exposed them to the default risk. It conducted various stress tests to analyze the risk but excluded the additional non liquid assets therefore accurate results were not found. Its aggressive risk taking decisions also affected its reputation (Field, 2010). Once the subprime crisis occurred and the real estate bubble burst Lehman Brothers suffered huge losses. It faced liquidity problems as most of the investments were non liquid. The level of default rose to a great extent because of their subprime loans. As the bank was highly levered the fall of the bank could not be controlled as a result in 2008 it filed for bankruptcy. For every bank liquidity and balanced capital structure are very important for its survival. They should be risk averse and make correct trade-off between risk and return should be made before making any strategic decision. Had Lehman Brothers properly managed their financial risk then they would have been in the market today. B - The financial sector of every country is regulated by some or the other regulatory body. The main regulatory body whose actions have a major impact on the financial sector is the central bank. The central bank of every country takes number of steps to control the financial position of the country. If there is inflation or deflation in the economy the central bank takes various steps to control them. Sometime the actions of these regulatory bodies instead of increasing the stability of financial markets decrease it. When the economy faces inflation the central bank takes a number of measures. Some of the measures are to increase the cash reserve ratio, repo rate etc. In USA whenever the economy faces inflation the Federal bank increases the federal fund rate. Federal fund rate is the rate which the central bank charges to banks for lending money. If this rate is raised then the commercial banks has to give more interest as a result they increases their lending rate. Due to increase in lending rate the companies who borrow money from banks pays more interest as result their EPS falls as a result the company’s stock price falls. If the share price of many companies falls, then the index of the stock exchange where their shares are listed will also falls. The increase in federal rate also influences the bond market. The interest of the bond which is considered as risk free security increases as a result people move out from the equity market to the bond market as increase in risk free rate adversely affect the risk premium which one expects to get for taking risk in equity market. Hence in order to control the inflation the measures taken by the regulatory body indirectly makes the market volatile. C - Investments play a major role in the financial markets. Every company irrespective of the sectors they are operating makes a number of investments. Investments can be defined as spending money on something with an expectation to reap profit in future from it. It can be machinery, plat, furniture or any other equipment used in operating the business or any financial instrument like bond, debenture, shares, mutual funds etc which can yield monetary benefit in the future. Thus the main function of investment is to reap some sort of financial benefit. Investment plays a major role in increasing liquidity position of the company. Short term investments are made in order to encash them whenever there is a need of liquid cash. For ensuring the liquidity investments are made in money market. The main money market instruments are trade bill, Treasury bill which is considered as a risk free security, commercial paper, call money etc. The interest in these instruments is comparatively low but the company can turn them into liquid cash whenever it will need it. Maintaining liquidity is very important for every company and investment plays a major function in it. Another major function of investment is increasing productivity. Companies make investment in buying fixed assets and technology for increasing the production. A large amount of investment is made for purchasing the assets to be used in the operations. As the productivity increases the company reaps benefit from the investments in terms of revenue and profit. No company can generate revenue without investing in assets to be used for operations. Investment also plays a major role in improving ones long term financial position. For improving long term financial position people tend to invest in various financial instruments such as share, bonds, debenture, fixed deposits, mutual funds etc. People invest in these assets expecting financial gains in future. Investment plays a major role in long term cash inflow. Nowadays investments are also made in order to hedge risk. Businessmen hedge risk associated with the market condition and exchange rates. Investments are made in forward contract, future contract, swaps and other financial derivative so that they can reduce the risk of changing market condition. Question 2 A - Market efficiency is a term which signifies that whether the stock price is reflecting all the available and relevant information related to the stock. The essential requirements for market efficiency are as follows: 1) The stock prices should reflect all the relevant and available information required information. 2) No predictions can be made using technical analysis that is past performance cannot be used for judging the future performance of the stock. 3) No insider trading happens in the financial market. 4) No investor can take advantage of the financial market continuously in the long run. The concept of market efficiency came from the efficient market hypothesis (EMH) which was developed by Eugen Fama in 1960s. As per efficient market hypothesis the stock price should reflect all the essential information which implies that the stock price is accurate. This means that no trader can make profits continuously (Harder, 2010, p.5). There are three dimensions of market efficiency. They are 1) weak form 2) semi strong form 3) strong form. These are discussed in details below Weak form: The stock prices in financial market which has weak form of efficiency shows all the historical data related to the past performance. In this type of market the stock prices shows all the information regarding the past performance of the stock. Hence in this type of market no trader can earn profit by using the historical data. Therefore in this type of market technical analysis cannot be fruitful in reaping profits. Many empirical tests such as run test can be performed to establish the validity of this type of market. In this type of market the present price changes are not at all related to the future price. Hence the future price of the stock is random. Semi strong form: The stock price of semi strong efficient market reflects all the publicly available information. Some information which is held by some insiders can be used for making profits in the financial markets. Insider trading is a common feature of this type of efficient market. As soon as any new information is available to the public the stock price adjusts automatically. Only those traders who have the inside information can make profit. Hence in this type of market not only technical analysis but also fundamental analysis become futile as the stock prices does not reflect all the relevant information and therefore the stock prices are not accurate. Strong form: The stock price of financial market which has strong efficiency reflects all the relevant and available information regarding the stock. In this type of market there is no chance of making profits from available information continuously ion the long run. Insider trading is strictly forbidden. Hence the stock price in this market is accurate. Accurate stock price does not mean that the stock prices will always be equal to the intrinsic value but it will reflect all the relevant information regarding the company. As it is already discussed in the previous section that the financial market will be declared efficient only when the stock prices will reflect all the relevant information that means trader cannot make profits using insiders’ information. UK has banned insider trading this means that stock prices in UK are free from insiders information (Korczak, Korczak and Lasfer, 2009, p.5). In UK the mutual fund managers were not able to perform at a high level continuously in the long run also the analysis of past performance of the fund was not enough to predict the future performance. Hence it can be said that the financial market of UK is efficient (Blake, Timmermann, 2003, p.42). B - Any individual who invests in the financial markets has to correctly make trade-off between risk and return. Risk can be defined as the uncertainty of getting expected return from the investment. Return in turn is the benefit one expects to get while investing in a particular security. Every investment has two main features, one is risk and the other one is return. The investors decide upon their investments on the basis of the expected return and the variability of that return that is the risk. Generally, the risk adverse investors make investment on that security which is expected to generate high return with less risk. For this many times they go for diversification. That is instead of investing in a single security they invest in a number of security and the risk got divided. Based on the rationality and the utility of the one can find that a relationship exists between risk and return. Every investment has some sort of risk involved in it. Higher the return is expected higher will be the risk associated with the investment. Therefore a rational investor will always try to trade off the risk and return in such a way that he can get maximum amount of return while facing minimum risk. There are two type of risk, one is systematic risk and the other one is unsystematic risk. Systematic risk is the risk which cannot be reduced by diversification like inflation, interest rate risk etc. This risk is not associated by a particular company or industry. On the other hand unsystematic risk is the risk which is associated with a particular company or sector of the financial market. This risk can be reduced through diversification that investing in a number of securities in a number of sector. Hence a rational investor will always try to eliminate this risk. The relationship between risk and return can be seen and measured with the help of CAPM theory. As per this model the investors are rational and they will invest in the assets after analyzing risk and return. A rational investor will undertakes that much of risk for which he is expecting risk premium. Risk premium is the additional return one is expecting for undertaking a certain amount of risk. It is the excess amount of market return one is expecting over risk free return after considering the systematic risk. As per the CAPM model the rational investor will always try to compensate the risk it is taking by the market premium. The formula used in this respect is Risk free rate – beta (Expected market rate of return - Risk free rate) The first part of the formula signifies the time value of money and the second part refers to risk premium one is expecting. Beta is the measure of the systematic risk one is exposed to. The security market line shows the relationship between expected return and systematic risk. If the expected return is less than the required rate of return than the investor will not invest in that investment. The performance of an investment portfolio is also measured comparing the return and risk of a portfolio. For example Sharpe ratio is used to measure the excess return the investment gained over risk free return for every unit of systematic risk it undertook. By using tenor’s ratio a rational investor measures how much excess return the investment portfolio is generating for every unit of overall risk involved in the portfolio. Hence a clear relationship exists between risk and return. C - Every investment has some sort of risk involved in it. Investor assesses the risk involved in the investment and compares it with the expected return and then decides whether he will invest in it or not. The risk taking capacity of every investor depends upon his risk tolerance level. The risk tolerance level varies from investor to investor. A risk adverse investor is an investor who will not invest in that investment which involves high risk. The main characteristics of these types of investors are mentioned below: The main characteristics of adverse investor are they will avoid risky investments. If the investment has the potential of earning more return then also this type of investor will not invest in that type of investment. They have a physiological barrier in making any risky investment. They always avoid risky investments: Risk adverse investor is prone to invest in security which has low rate of return. They are satisfied with low rate of return. As most of the securities which are minimal risk have low rate of return but the risk adverse investor finds it comfortable to invest in that type of security. If the risk adverse investor has to choose between two investment options then he will like to invest in that security which will have less risk irrespective to the return it is yielding. These type of investors will invest in less risky or risk free securities such as Treasury bill, bonds etc. Reference Blake, D. Timmermann, A. (2003). Performance Persistence in Mutual Funds. [Pdf]. Available at: http://www.fsa.gov.uk/pubs/other/pastperf_mutalfunds.pdf. [Accessed on: July 30, 2011]. Field, A. Lehman Report The Business Decisions That Brought Lehman Down. [Online]. Available at: http://www.dailyfinance.com/2010/03/14/lehman-report-the-business-decisions-that-brought-lehman-down/. [Accessed on: July 29, 2011]. Harder, S. (2010). The Efficient Market Hypothesis and Its Application to Stock Markets. Germany: GRIN Verlag. Kevin, S. Security Analysis and Portfolio Management. India: PHI Learning Pvt. Ltd. Korczak, A. Korczak, P. and Lasfer, M. (2009). To Trade or Not to Trade The Strategic Trading of Insiders around News Announcements. [Pdf]. Available at: http://www.efm.bris.ac.uk/economics/working_papers/pdffiles/dp09613.pdf. [Accessed on: July 30, 2011]. Read More