Objectives of Risk Analysis in Financial Market - Essay Example

Number 01 February Objectives of Risk Analysis in Financial Market Financial market is a mechanism that enables buyers and sellers to meet their financial requirements. Buyers are the investors who purchase short term or long term financial assets while sellers raise funds for their short term and long term requirements. The globalization of 1990s made world markets more integrated and more opportunities in overseas investments. This paper deals with financial market, different types of risks that arise in financial market and how buyers reduce the risk. A financial market is a mechanism that allows people to buy and sell financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods). Based on the instruments dealt in the market, we can divide financial market into money market and capital market. Money market deals with short term trading (buying and selling) of financial assets which have maturity period of one year or less. Money market instruments mainly include treasury bills, commercial paper, certificate of deposit and banker’s acceptances. Sellers in the money market try to raise funds quickly for meeting their unexpected requirements. As sellers try to raise funds for their immediate requirements, they have to pay high rate of interest for the amount that they raise from the market. Money market provides liquidity to global financial system. Capital market deals with securities (debt or equity) which companies and governments used to raise long term funds. Usually, the capital market instruments have a minimum maturity period of one year or more. The capital market includes stock (equity and security) market and bond market (debt). So, the main difference between capital market and money market are: Money market is to raise funds for short-term and immediate requirements Capital market is to raise funds for long-term requirements Money market instruments are treasury bills, commercial paper, etc… Capital market instruments are bonds, shares etc… Every buyer in the money market or capital market tries to reap maximum profit. The motto of capital market is buy maximum when the price is less and sell when the price is high. Buyers purchase different kinds of financial instruments while sellers try to raise funds for their requirements. Every buyer in a financial market is an investor. To maximize the profit, buyers are usually ready to take risk. Risk management is a very important concept in both money and capital market. To manage the risk, investors usually diversify it. Risk in the financial market can be divided into two: Systematic risks and Unsystematic risks. Systematic Risks Systematic risk is defined as “The risk that tends to affect the entire market similarly”. (Kidwell et al. 2007) It is also known as market risk or nondiversifiable risk. Systematic risk is the risk that cannot be reduced or predicted in any manner. Systematic risks are those risks which nobody can predict. As you cannot foresee it, you cannot reduce it or protect yourself against it. For example, the recent political turmoil in Egypt sent all the share markets in the world downward. All investors lost a lot of sum. This political crisis was unpredictable and no investor was able to protect his investment against this downfall. Most investors are primarily concerned with systematic risk as they can reduce unsystematic risk through diversification. Economists use the term ‘beta’ to show the relationship between a stock’s return and the general market movement. For example, if you assign beta 1 to general market (index) and 2 to a particular share, it means if the market goes up 20%, the share goes up 40% and if the market goes down 10%, the share goes down 20%. It means, this particular share is twice as volatile as the market index. Shares with betas greater than 1 are called aggressive shares as they carry more risk than the market. In addition, they affect the entire portfolio in a greater degree than the market movement. Shares with betas less than 1 are called defensive shares as their impact on the portfolio is less than the average market movement. Shares of most of the Australian companies have betas between .5 and 1.5. Unsystematic Risks Unsystematic risk is defined as “The unique or security specific risks that tend partially to offset one another in a portfolio.” ((Kidwell et al. 2007)) It is specific to an asset’s feature and can usually be eliminated through diversification. An investor achieves risk diversification by investing in many securities. When the price of some securities goes down, the price of some other securities goes up and the loss of the investor is offset. But sometimes, the price of many securities may go down but in different degrees and the total loss is reduced. It means price of A may go down 10 % and B may go down 20 % then the average loss to the investor is 15%. If the investor has opted only for share B, his loss is 20% instead of 15. So, to reduce the unsystematic risk, investors usually add as many securities to their portfolio as possible. An example for unsystematic risk is news that affects a specific stock such as a sudden strike by employees. Foreign exchange Risk Foreign exchange risk occurs due to changes in exchange rate. This is also known as currency risk. #f dollar must be converted to another currency to make a certain investment, then any changes in the exchange rate of that currency will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency.  For example, if you make any investment in Japan in yen, you need to convert your dollar into yen. Once you sell your shares, you need to convert your yen into dollar. Any change in the exchange rate of yen, affects your earnings in dollar. Australian Security Market. Security market in Australia is controlled by Australian Securities and Investments Commission (ASIC). It was established in 1998 with a view to manage and maintain financial market integrity, protect consumers and maintain investor’s belief in financial market system. Australian Securities Exchange (ASX) regulates the behavior of companies that are listed with it and traded on it. Works Cited: David S. Kidwell, Mark Brimble, Diana Beal, David Willis, 2007, Financial Markets Institutions & Money, John Wiley & Sons, Australia. Read More