Stock Exchange and Fair Market Place - Essay Example

Finance and Accounting AC2650 cw2 Contents Contents 2 Introduction 3 The issues in trading shares where unreasonable investor inequalities could potentially exist 4 Market Risk 4 Default risk 4 Risk of Inflation 5 Risk to capital 5 The ways in which stock markets are structured and regulated in order to maintain a fair market place 6 Systematic Risk 7 Legal Risk 7 Credit Risk 8 Now we will discuss about some regulations of London Stock Exchange 8 There are several regulatory requirements to be fulfilled in the LSE by a company to get listed over there- 8 The ways in which exchanges might handle the inclusion of equities which do not meet the normal minimum requirements 9 The problems with the inclusion of new and smaller companies within stock exchanges 10 Default Risk 10 Liquidity risk 10 Risk of illegal activities 10 The ways in which stock exchanges might handle these types of problems 11 Conclusion 12 References 13 Introduction Stock Exchange can be defined as an exchange which offers services for traders and stock brokers to trade on bonds, shares and other financial securities. It also gives various facilities to issue and redemption of shares and other financial securities. Companies issues IPO or FPO to pool additional finance by issuing new shares. Stock exchanges act as “continuous auction” in the market with sellers and buyers doing transaction at the same level which is known as the floor of the stock exchange. Investing in stock exchanges gives better return but it also includes various risks. Every investment comes with different types of risk associated with it. Investors may think that making investments according to the advice of the financial experts are free of risk. But this is not true, as it also comes with various risks. Investors need to understand that to generate wealth over a period of time it needs to accept a high amount of risks. Stock market always fluctuates and it depends on several factors like profitability and performance of the company, political and social factors, and govt. decisions. Share prices of a company always fluctuate due two types of risks – systematic and unsystematic risk. Systematic risks are the market risks and can be measured by beta. On the other side unsystematic risks are those risks which arise from the internal problem of the company like labor problem, problem in managerial decisions and problems in other code of conduct of the company. Unsystematic risks can be measured by alpha. Now we need to consider the various types of risks that are associated with investing in the stock market. The issues in trading shares where unreasonable investor inequalities could potentially exist There are several types of unreasonable risks that are faced by the investors in the stock market. Evaluating and analyzing the risk that are involved in any investment is very complex. According to the risk taking ability the investors can be differentiated into different category. Risk taking ability of an investor is known as risk portfolio of the investor. There are several types of investors like high risk potential investor, medium risk potential investor and low risk potential investor. Risk tolerance level of an investor depends upon several factors like the age of the investor, objectives of investment, aim of the investment and future goals in life. Thus to discuss about the unreasonable risks we need to consider the several types of risks that can affect the performance of the investors in the stock market. Market Risk Market risk includes a wider picture which means if an investor wants to invest in to a less costly stocks and not safe stock then he/she needs to consider various factor before investing like the economic condition of the nation, or even the condition of the world if he/she is investing into the international stock, political stability as these can be the reason of the fluctuation in the return from the financial instruments. It is also relevant for investing in bonds and other financial securities (Forbes, 2012). Default risk Default risk is depends on the quality of the underlying assets on which the investment is done and it is very much important in case of investing in a single company’s bonds and shares. When an investor invests into shares of a company then he/she expects a guaranteed return from the securities, the return will always be higher than the return in a savings account but here comes the risk of default. What will be happened if the company will declare bankruptcy due to some reasons then the investor will not get back his/her money (Forbes, 2012). Risk of Inflation Inflation risk can be defined as increasing in the price levels which reduces the purchasing power of a return from investment or bond’s interest payments. Inflation reduces the purchasing power of the return from any investment. It specially affects those investments which pay a fixed rate of interest for a long period of time like certificates of deposits or interest rate on bonds (Investment company institute, 2014). Financial advisers expect that the rate of inflation runs around 3-4% in a year. But we need to consider that inflation can increase in particular year. Then it will affect on the return from the financial securities in the market. Thus when an investor assumes that the rate of inflation is 3% and the return from investments earns 1% APY, then the real return may be a loss of 2% in the year. It is because the real return is calculated by considering the rate of inflation (Forbes, 2012). Risk to capital Apart from the above mentioned risks, permanent risk to capital can be considered as a serious risk in the stock market faced by the investor. Investing in shares of a company which is in serious position of liquidity crisis or decline of profitability can lead to permanent lose of the investment capital. This may not happen with the large companies which have established business for several years but it can happen with companies which are dealing with riskier products. Thus when an investor invests in a company’s shares or bonds then he/she needs to have some knowledge about the company’s risk taking ability and its profitability. There can be several types of issues that may lead to loss of capital like- the company can face tremendous competition from other companies, advancement in technologies may reduce the demand for the product, the company may face difficulty in continue its operations or in getting loans for operations, changes in govt. policies which may affect the product or the service of the company, there might be sudden increase in the cost of materials and labor in the market, company may be indulges itself in illegal business or it may not di8sclose some important information’s and last but not the least, changes in economic condition of the nation may affect the value of the company and its products. Thus in these ways, if the company files for a bankruptcy then the equity shareholders of that company generally lose all of their investments. If the company can arrange some money by selling its assets then it needs to first pay off the bonds holders and the preference shareholders and if anything remains after paying off these liabilities then that can be distributed among the common stockholders. It can be seen that risk of equity shareholders are higher than the risk of bond holders. Thus investors need to be very careful while investing in the securities of a company (MassResouces.ORG, No Date). The ways in which stock markets are structured and regulated in order to maintain a fair market place The regulatory functions of various stock exchanges were limited to deciding rules and declaring various aspects of existing frameworks. In the present time exchanges play an important role in maintaining the corporate governance and enforce elated regulation necessary for this. Stock exchanges have offered various rules and regulations for establishing itself as a useful source to maintain proper corporate governance in the economy. It has increased transparency and reduced irregular or illegal practices by companies and traders in the capital market. Thus stock exchanges in today’s date have earned a reputational goodwill where investors can trust before investing their money. Stock exchanges allow traders and investors to manage the risks more efficiently and effectively and also helps to reduce certain risks. There are several types of risks that are minimized by the stock exchanges and the degree of risk also depends on the structure of the stock exchange. Systematic Risk Effective stock exchanges try to reduce the systematic risk. They may also face systematic risk because of the inability of some participants to perform better can act on the performance of other participants and they may also face obligations to meet their goals. Apart from this, inefficiency of a stock exchange to complete the open settlement can act on the market it serves and the economy of the nation. These adverse situations may arise from reversing or unwinding deliveries and payments, sudden close of guaranteed transactions, liquidity crisis, problems in margin for settlement, delay in settlement. If a stock exchange takes these types of steps then the investors will face sudden unreasonable liquidity and credit crisis. Thus stock exchanges should ensure safety of the investors and reduce interdependences among other stock exchanges to mitigate the disruptions in the transactions (BIS.ORG, 2012,pp. 18-19). Legal Risk Legal risk is another unexpected risk which arises from change in law and regulations by the govt. It can also arise from uncertain application of related rules and regulations. It also includes the risk of monetary losses which can be happened due to a delay in return from financial assets for legal processes. Thus a stock exchange and its participants may face losses due to legal formalities and to reduce these losses stock exchanges should be structured as per the regulation of the nation (BIS.ORG, 2012,pp. 18-19). Credit Risk Stock exchanges and their participants may face several types of credit risk or counterparty risk due to failure to meet the expectation from an individual or an entity. Apart from this, they may also face the replacement cost risk which loss from unrealized gains or incomplete transactions with counterparty. Thus stock exchanges should allow those companies to trade which are having enough potential and profitability in the market (BIS.ORG, 2012,pp. 18-19). Now we will discuss about some regulations of London Stock Exchange London Stock Exchange is one of the largest stock exchanges in the world. Large companies prefer to be listed on LSE to demonstrate their quality of business to the investors. It helps to encourage the confidence of the investors and attract a large pool of capital in Europe. There are several regulatory requirements to be fulfilled in the LSE by a company to get listed over there- Premium- the companies needs to follow the rules of London Stock Exchange and standard of disclosure to get premium listings. Standard- the companies needs to follow the rules of London Stock Exchange and standard of disclosure to get standard listings. High Growth Segment- to get a high growth segment an institution needs to follow the high growth segment rules of LSE and necessary standards of disclosure. But to get listed in the LSE, companies must show their full prospectus and need to get approved it from the UK Listing Authority (UKLA) for listing in any of the segments mentioned above. It is the responsibility of the UKLA to look after the admission procedure into a regulated financial market to judge the potentiality of the company to mitigate the uncertain risks. It includes revising and approving the prospectus of the listing participants. The prospectus needs to be submitted to Authority by the key financial advisor of the company and it should contain data about the business process of the company and should meet the other rules and regulations of prospectus. The UKLA communicates with the key financial advisor of the company to discuss about the company and the main business of the organization. The company needs to meet the rules and requirements of the admission procedure and standard of disclosure of the exchange. On the other side, the exchange will help the company to earn maximum return from the market. These rules and regulations ensure that there is very low risk of capital loss and other uncertain risks. Listing becomes effective when all the documents of the company get approved by the UKLA and UKLA permits them to trade on the exchange. After listing the company is subjected to maintain rules lay down by the LSE and UKLA jointly. It includes that company will disclose necessary information regarding its financial statement in the annual report of the company and disclosure of information to all investors that may affect the share price in the market (London Stock Exchange, No Date). The ways in which exchanges might handle the inclusion of equities which do not meet the normal minimum requirements The stock exchanges need to handle the problems that are associated with the inclusion of new small and medium companies within the exchange. The new small and medium companies which get listed themselves in the stock exchange might be the cause of some serious issues in the market- The problems with the inclusion of new and smaller companies within stock exchanges There are several types of problems comes with the inclusion of new small and medium companies in the stock exchange and these are as follows- Default Risk The new small and medium companies always try to create a large pool of money for their further expansion of business. Sometimes they offer lucrative shares and bonds to attract the public towards the company. As because their share prices are low and medium as compared to the large companies thus small investors get attracted to them in a hope of high return. But as the operations of those companies are limited thus many times the companies are unable to give the promised return back to their investors and declare as bankrupt. Liquidity risk If the stock of the small and medium companies is overvalued then they face liquidity crunches which affect on their business activities and as a result, profitability gets hampered. Thus overall the company becomes inefficient in managing its business and doesn’t provide expected return. Risk of illegal activities As the main aim of the small and medium companies is to create a large pool of money for expansion of their business activities thus they might get involved in some illegal activities prohibited by the govt. and the stock exchanges. They might create some rumor to hike the prices of their shares to make the investor think positive about the company. The ways in which stock exchanges might handle these types of problems The stock exchanges should establish strict rules and regulations which are needed to be fulfilled by the small and medium companies before listing them in the stock exchange. As discussed in question 2, it is the responsibility of the stock exchange to mitigate the unreasonable risk of the investors. The stock exchanges need to minimize the systematic risk, legal risk, credit risk and insolvency risk in the financial market. The stock exchanges needs to examine properly the new small and medium companies to ensure that they are submitting their necessary documents like prospectus and financial reports and need to ensure that they are publishing relevant disclosure of information which can affect the share price of the company. As discussed above, we can London Stock Exchange has several rules and regulations for enlisting any company in the stock exchange. The responsibility for approval of admission and prospectus of the companies in the official list depends on the UK Listing Authority (UKLA). The LSE is responsible for permitting the companies to trade in the main market. Thus joining the main market in UK includes two different applications- one to LSE and another to the UKLA (London Stock Exchange, 2010, pp. 7-8). The UK listing Authority (UKLA) acts as the competent authority for listing in UK. It has set up several rules for listing which are as follows- Listing Rule- it includes the requirements for fulfilling the eligibility criteria for admission in the official list of UKLA. There are also some rules from the European Consolidated Admissions and Reporting Directive which needs to maintain in order to get listed. The requirements include three year financial record, related party transactions record and need for a sponsor to get listed in premium. Prospectus Rules- it states that the companies should submit their prospectus to the European Prospectus Directive to state the detail information about the business. Disclosure and Transparency Rules- it states that companies need to be transparent in their transactions and they need to publish disclosure of information which related to the shares of the company or which can affect the share price of the company. It includes periodic balance sheet, income statement, cash flows and other necessary transaction information of the company. These rules are created by the Transparency Directive and it is also a part of the Market Abuse Directive and Company Law Directive (London Stock Exchange, 2010, p. 14). Apart from the LSE, the New York Stock Exchange also has similar criteria before listing a company in the stock Exchange. Conclusion From the above study we can see that stock exchange is a place where buying and selling of financial securities takes place. Investors and brokers trade on the companies that are listed in the stock exchanges for higher returns. However, it can be seen that sometimes investors face many unreasonable risks in the stock exchange while trading for securities. These can be market risk, default risk, risk of inflation and risk of losing capital. Thus it is the responsibility of the stock exchanges to build up proper structure and regulations to minimize these risks. Apart from these we have seen that stock exchanges itself sometimes suffer from inclusion of new small and medium companies and to avoid this they need to create strict regulatory bodies which will look after the potentiality and prospect of the companies before admitting them in the stock exchange. It will help to maintain a healthy environment where investors can easily perform trading and transactions. References London Stock Exchange., 2010. A guide to listing on the London Stock Exchange. [ Pdf]. Available at : http://www.londonstockexchange.com/home/guide-to-listing.pdf. [Accessed on 4/3/2014]. MassResouces.ORG., (No Date). Risks to Investing in Stocks. [ Online]. Available at : http://www.massresources.org/investing-stocks-risks.html. [Accessed on 4/3/2014]. Forbes., 2012. Four Risks of Investing. [ Online]. Available at : http://www.forbes.com/sites/moneybuilder/2012/06/15/four-risks-of-investing/. [Accessed on 4/3/2014]. Investment company institute., 2014. Understanding the Risks of Bond Mutual Funds: Are They Right for Me?. [ Online]. Available at : http://www.ici.org/faqs/faq/faqs_bond_funds. [Accessed on 4/3/2014]. London Stock Exchange., No Date. Rules and regulations. [ Online]. Available at : http://www.londonstockexchange.com/companies-and-advisors/main-market/rules/regulations.htm. [Accessed on 4/3/2014]. BIS.ORG., 2012. Committee on Payment and Settlement Systems. [Pdf]. Available at : http://www.bis.org/publ/cpss101a.pdf. [Accessed on 4/3/2014]. Read More