Barclays Bank: Viewing Principles of Finance at Work - Essay Example

?Barclays Bank: Viewing Principles of Finance at Work Table of Contents Table of Contents 2 Introduction 3 Portfolio Diversification in Barclays 7 Market Efficiency of Barclays 12 Conclusion 15 References 17 Introduction Barclays plc is often regarded as one of the largest British associations, which provides international investment and commercial services to worldwide client base. It was established in the year 1690. It provides a major monetary service in sectors like private banking, corporate and investment banking, prosperity and asset managing and credit card facilities. It currently operates in more than 50 countries and provides employment opportunities to around 140,000 people worldwide. The bank is also known for providing the public with the first Automated Teller Machine (ATM) service, nearly 40 years ago dated in 19671. Similar to every other large-sized organisation, Barclays has also diversified its investments in various sectors and different assets; thus, developing its portfolio in a diverse manner. In simple terms, a portfolio can be defined as the assortment of different assets owned by a company or an individual or any legal entity, in terms of stocks, mutual funds, cash equivalents, bonds and other funds. The main intention of holding a diverse portfolio, mainly concentrates on the reduction and balancing of risks involved in investments. Correspondingly, the portfolio needs to be managed efficiently, in order to maintain the risk at a lower degree. It is considered to be a set of business procedures that mainly aims in coordinating the collection of strategic processes and decisions, which can most effectively balance any organizational change. It mainly aims in managing the total investment in order to meet the planned objectives. The main work of a portfolio manager is to make the right choice that aligns best to meet the objectives set by the organisation2. In the discussion henceforth, the portfolio construction and management procedures practiced in Barclays will be assessed on the basis of its current performances. In this regard, following a brief of the portfolio owned by the company, various theories will be applied with the intention to analyse the portfolio diversification in Barclays. Correspondingly, market efficiency theories will also be applied to process the risk management techniques and its effectiveness in managing the portfolio effectively. Portfolio Risks of Barclays As stated above, portfolio is considered to be an amalgamation of securities mainly consisting of stocks, bonds and money market instruments. The process of merging together the assortment of assets, so as to obtain optimum return with minimum risk is referred as portfolio construction. It is vital for every firm that proper risk and return analysis strategies are applied efficiently, so that the firm does not face any heavy loss resulting from any mismatch in the portfolio constructed3. It is worth mentioning in this regard that taking into concern its portfolio risk management strategies, Barclays is considered to be one of the best and the largest banks for managing capital market portfolios. After its establishment in the year 1690, the company has been well known for its functioning in the field of managing portfolios of large business houses. Contextually, the different businesses of Barclays include Retail and banking, Barclaycard, Investment bank, corporate banking and wealth and investment management4. On the basis of the above mentioned businesses, the bank can be observed to have applied different risk management strategies. Detailed descriptions for the different risk management strategies applied by Barclays have been explained below. Barclays employs a variety of methods and strategies to mitigate its credit risk to the highest possible extent. Few of these strategies include, netting and set-off, collateral and risk transfer. Theoretically, netting and set-off is a method, which is generally adopted in derivatives and repo transactions with financial institutions. This form of agreement provides the advantage of netting of credit risk by binding the other party to make the payment on the same day and in the same currency at the day of mitigation. Again, collateral is treated as a measure generally taken in situations, where the borrower is unable to pay the money loaned from the bank. Based on the same intention of reducing portfolio risk, Barclays also uses the strategy of risk transfer, which tends to control the risk arising out of non-payment of dues, where two or more parties are involved. With the strategy of risk transfer, the potential uncertainties of the investment are transferred from one party to the other who is more credit worthy than the original counterparty5. It is in this context that Barclays faces three major types of portfolio risks, including market risks, liquidity risks and operation risks. While operation risks and liquidity risks can be affirmed as controllable, market risks are faced by the company as an uncontrollable risk. Market risk is considered to be the risk that may result from trade market fluctuations as well as non-trade market uncertainties and pension risks. The bank thus aims to mitigate such risks by adapting robust management, modifying the functioning by suggesting a transparent risk management framework and by minimizing non-traded market risks. Apparently, these factors can be observed as uncontrollable for Barclays, which also imposes the highest degree of uncertainty risks to the overall performance of the company within the global plethora. Hence, noteworthy and broadly applicable financial strategies are required to be considered by the company, so as to assure its effectiveness in compensating the losses incurred by such uncontrollable risks. Apart from the market risk, Barclays also faces liquidity and operation risks, which can be categorised as controllable risks, as mentioned before. Liquidity risk is primarily accounted as the failure of a company to meet its financial obligations, leading to its inability to support the regular business activities. Correspondingly, Barclays attempts to mitigate this form of risk by withdrawing the necessary funds from the borrower and by dividing the market into groups, i.e. by dividing its risks into various categories or market sectors. Again, operation risk is considered to be those risks, which may arise from unusual human interventions or failures in the continuous. In order to mitigate risks arising from such factors, Barclays have been focused on developing a framework, which comprises a group of top level authority who are liable to continuously monitor the operational efficiencies of the company along with forecast the financial impacts caused by its operational attributes. The company also aims to preserve a high degree of flexibility in its financial strategies so as to adapt change under necessary circumstances when facing operational risks6. Portfolio Diversification in Barclays As can be apparently observed from the above discussion, diversifying the portfolio is considered as one of the prime strategies adopted by Barclays in mitigating the risks it faces in respect of its portfolio management. In this regard, the Markowitz Portfolio theory can be applied. Markowitz Portfolio Theory: Markowitz portfolio theory is considered to be one of the best ways for measuring risk. The theory mainly focuses on combining stocks into portfolios to reduce standard deviation below the level obtained from a simple weighted average calculation of the risk associated with a portfolio. Correspondingly, the various weighted combination of stocks that create the required or estimated standard deviation in order to mitigate the portfolio risks, constitute a set of efficient portfolios7. In order to apply the Markowitz Portfolio Theory in the context of Barclays, three major investments have been selected from the company portfolio, i.e. Stocks, Bonds and Hedge Funds. As per the obtained results, the standard deviation of stocks held by Barclays tends to be substantially higher that the weighted average of the same, for the period of 2009-2013. This reveals that investment in stocks for Barclays is quite risky. In order to mitigate its risks associated with the investment in stocks, the company also invests in less risky options, including hedge funds and bonds. The standard deviation calculated for both hedge funds and bonds were measured to be substantially lower than their weighted average of returns for the same period, i.e. 2009-20138. Thus, the portfolio risk of Barclays, applying the Markowitz Portfolio theory can be diagrammatically represented as below. Figure 1: Showing the indices of Barclys Stock, bonds and Hedge Funds Correspondingly, considering the hyperbola created with the obtained results, it can be affirmed that the bonds and hedge funds investment of Barclays is more efficient than its investment in stocks, although all the three investments can be considered as feasible. The Relationship between Risk and Return Portfolio risk and feasibility can also be measured by evaluating the relationship between risk and return obtained by Barclays through its investment. Theoretically, higher risk is often positively correlated with higher return9. Notably, Barclays also focuses on measuring its portfolio risks, in respect to the returns obtained as well as forecasted to have a better control on its investments10. On the basis of the risks evaluated in respect of the returns obtained, Barclays divides the investment into different portfolios and rates it according to the risk evaluated. It has been viewed that the company has launched a multi-asset index that helped investors to measure the risk on the basis of the segments divided by Barclays. As can be observed from the below diagram, Barclays intends to maintain its risk of incurring loss at a lower degree than the calculated mean loss, which further indicates that the company has been able to remain in a low stress area of its portfolio when considering the relationship of risk and returns. Figure 2: Risk and Return Estimation Chart of Barclays11 Validity and the Role of the CAPM: Capital Assets Pricing Model (CAPM) is considered to be another most important theory applied while pricing assets in a portfolio. It is basically applied to determine the rate of return for an asset. In the CAPM theory, the required return rate for an asset (alpha) should be in a linear relationship with the assets beta value i.e. systematic risks, which cannot be diversified12. It is worth mentioning in this regard that Barclays also pays due attention towards applying the CAPM model to forecast and manage the risks involved in its portfolio with different combinations of assets. Considering nine assets of Barclays’ portfolio, i.e. Cash and Short-maturity Bonds, Developed Government Bonds, Investment Grade Bonds, High Yield and Emerging Markets Bonds, Developed Markets Equities, Emerging Markets Equities, Commodities, Real Estate and Alternative Trading Strategies, as per the CAPM methodology applied by the company, it was observed that Barclays intends to maintain its portfolio risk at estimating a lower expected return than the actual return obtained from the portfolio, in order to have its alpha (denotes the difference between the expected and the actual return obtained from a portfolio) secured at a positive range. As can be observed from the below diagram, Figure 3: Equilibrium excess returns and Barclays’ views* for our nine asset classes13 Accordingly, the efficient frontier of Barclays’ portfolio combination has been generated as follows. Figure 4: The Efficient Frontier of Barclays’ Portfolio14 Apparently, the efficient frontier line tends to be straight upward directed, which indicates that the Capital Market Line (CML) of Barclays’ portfolio gives various investment opportunities to select from high risk to low risk combinations. Hence, the portfolio management strategy applied by Barclays can be affirmed as efficient. Three Factor Model The three factors model is considered to be another method that is adopted by any investment or financial institution while selecting or constructing portfolios. It is a method of estimating the stock return considering three factors, i.e. (a) sensitivity to the market (beta), (b) the size of stocks in the portfolio (size), and (c) the average weighted book-to-market15. Barclays uses this method, considering that it is very important for the firm to estimate the overall market condition before investment. Applying the three factor model, Barclays’ portfolio combination for its assets have been observed to reveal the below illustrated three portfolio combinations and the corresponding utility functions16. Figure 5: Three Factor chart for the year 201217 Market Efficiency of Barclays Random Walk Random walk hypothesis theory indicates the movement in the price of securities assuming those to be unpredictable. As a result, investors cannot predict the market as a whole. This theory states that the main reason behind the concept of price changes for securities and other combinations of the portfolio is that the stock price adjusts to the new information, which is again impossible to be reflected virtually. For a company like Barclays, which mainly functions in large investment portfolio, it is vital that proper decisions are made before any investment decision is taken. It is often viewed that large companies like Barclays often uses the Random walk theory to keep a track of their stock price18. Below, is a graphical representation of the stock price of Barclays’ stock price trends, observed for the period of 1st January, 2009 to 31St July, 2013. Figure 6: Random Walk Hypothesis Chart of Barclays from 1St Jan, 2009 to 31St Jul, 201319 With reference to the above figure, it can be stated that the stock price of Barclays have faced considerable ups and downs, though the negative value of the shares was considered to be less in comparison to the increasing share price of the company. Efficient Market Theory Efficient market theory, also known as ‘Joint hypothesis Problem’, is used by Barclays as another mechanism of measuring its market efficiencies. This particular theory states that the monetary market of a portfolio is “informationally efficient”, which refers that even though the functioning or the movement of the stock price listed in the financial market cannot be tracked, the price listed is accurate. Market efficiency of Barclays, applying the efficient market theory can be measured by dividing the company portfolio into three categories, i.e. ‘Weak form Efficiency’, ‘Semi Strong From’ and ‘Strong Form efficiency’. The weak form of the efficient market theory emphasises that information relating to the past movement of stocks, cannot be used to predict the future movement of the stock price. Semi strong form of efficient market hypothesis indicates that the investment portfolios held by the company is able to change as per the available information in the market, in a flexible manner. Thus, this particular form of efficient market hypothesis rewards maximum options for the investors to select the most suitable investment portfolio, and hence, is much preferred. The strong form of efficient market hypothesis assumes that all information available to the investors is fully reflected in the price. However, from a realistic point of view, as market information cannot be reflected virtually in an all-inclusive manner to the investors, this particular form can be considered as an unrealistic proposition20. Considering the price changes of Barclays’ stocks, since 2008 to 2012, it can be observed that the company pursues a semi-strong form of efficient market hypothesis in managing its portfolio. As can be observed from the below graphical representation, the investments of Barclays maintains a flexible portfolio management strategy, which efficiently reflects all the public information available in the market. Figure 7: Barclays’ Stock Price changes through the curve21 Conclusion Portfolio is referred to the combination of securities such as stocks, bonds, mutual funds and other monetary instruments that can be converted into cash when needed by the company to maintain its financial position at a stable rate. It is very essential that a portfolio is constructed after analysing the market values of the different stocks and its performances in the market. The main motive behind creating a portfolio by any company is to minimise the loss resulting from various kinds of uncontrollable and controllable risks. In case of Barclays, the above discussion revealed that there are mainly three kinds of risks witnessed by the company, i.e. the market risk, the operational risk and the liquidity risk. As observed throughout the discussion, Barclays implements various strategies to manage its portfolio efficiently. In this regard, the results obtained through the Markowitz Portfolio theory application, analysis of the relationship between the risk and return obtained by Barclays through its portfolio, CAPM model application, the three factor model, along with the Random Walk and the Efficient Market theory, reveals that the company had been efficient in maintaining its portfolio at a desirable risk and return margin. References Associated Newspapers Limited, Cashpoint machine celebrates 40th. News, , 2007 (accessed 5 August 2013). A. Frank, ‘Fama-French Three Factor Model’, Forbes.com LLC, , 2013 (accessed 5 August 2013). Barclays. “Asset allocation at Barclays”, Wealth and Investment Management, , 2013 (accessed 5 August 2013). Barclays PLC. ‘Pillar 3 Report 2011’, Barclays approach to managing risks, , 2011 (accessed 5 August 2013). Barclays. ‘Operational risk management overview’, Risk Management Strategy, , 2013. (accessed 5 August 2013). 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