The Strategies for Minimizing the Effects of the Crisis on the Investment Portfolio - Assignment Example

Risk Management The importance of investment risk management is highlighted by the current global crisis. As a fund manager with “VICKY INVESTMENTBANK”. Discuss the strategies you should have used to minimize the effects of the crisis on your investment portfolio. Risk management is defined as employing substantial means in safeguarding your money from any probability of making wrong investment choices. As such, risk management should include methods that (Knapp, 2006): 1. Minimizes risk in stock investment and fully knowing that any transactions done within the stock market involves a certain amount of risk. 2. Increases the opportunity of having or earning profits from any stock venture. 3. Get investor/s out of sticky situations when a particular stock falls or when the market changes entirely. Risk management is in no way a forecast when situations will change or things may go wrong. It is in all actuality a defense against any chance that the good things that are currently happening may somehow become bad. Thus, in portfolio management, the first rule is not to lose and the second rule is not to forget the first one (Knapp, 2006). Every investment that is made bears a certain amount of risk. The threat in risk management is that it makes the investor sufficiently careful in not making the much wanted money if he accepts more risk. Take the following circumstances: 1. A common risk management that makes losses is a situation that propels an investor to buy multiple types of stocks that will earn money after the preliminary purchase has been made. The money that was lost is not accounted for the stocks that were bought but in not purchasing all the stocks in a single acquisition at one time, which in the event that the stock price has increased could have earned a considerable larger sum of money. 2. Trading stocks due to a short-term drop in prices could momentarily halt your losses for the mean time. However, if the stocks should turn around and the prices go back up beyond the price at which it was recently sold for will cost an immense lost in profit if the investor have just hanged on to the stock in the first place. 3. The diversification process of buying stocks in order to limit losses in general is costly and will present more losses than profit in the long run if it is only known what particular stock is the most excellent to be purchased to maximize profit. Practicing risk management done to safeguard one’s money or investment from great or devastating losses. Avoiding big losses by balancing risk against reward opportunities in the long term will make your investment returns fare better and bigger than expected. It is important that losses are controlled because the opportunities to make up for such losses are quite difficult. Losing five-percent (5%) in a stock investment would require gaining five-percent (5%) to offset the loss. But as the percentage of loss increases it usually needs a double amount of gain to compensate for it, which could triple or quadruple in a given period. And making up or making a break-even for such high losses are improbable (Knapp, 2006). Various investment strategies require the ability to understand how public security markets really operate from a risk and return perception. The movement of market securities is a continuous adjustment of supply demand, which involves price changes that occur when the stock market opens and closes. The following are significant observations regarding the stock market exchange (Russell, n.d.): 1. The cumulative market return comprises of payouts that includes gains on capital and loses that involves all investors. The aggregate market return is the overall probable return for publicly traded stocks/securities. 2. The stock markets generally try to fathom possible future events that are currently unknowns, and this is usually based on how major playing stocks perform within the stock market for a number of succeeding days. 3. Most marketable securities are markdown against their expected or projected future values to recompense the risk taken by the investor. Stock prices normally differ from one security to another since the anticipated monetary returns differ; and because investors distinguish greater or lesser certainty in making such expected returns a reality. 4. The present prices of all marketable stocks or securities shows the equilibrium of “expected risk and expected return.” Such valuation is an agreement that reflects the balance which includes all actively playing participants that consists of those who are merely observing and does not choose to act on any available movements happening within the market. 5. Current market prices likewise mirror all known information connected with a certain security. And market values show the general agreement among all the investors. 6. New information is circulated extensively and swiftly. Investors in general hastily deduce such new information for potential effects on stock value and risk. The prices quickly the new information that was recently given out because supply and demand like wise changes promptly and the prices of stocks/securities alter for that reason. 7. In connection to the collective or aggregate market return, some investors “win” and others “lose”. Skill or luck in winning and losing in any form of investment are all factors that determine whether a potential loss could actually be regained through a breakeven or turn around profit. The acquisition and implementation of preferred strategies must involve scientific evidence to reduce uncertainty and strengthen the confidence to be able to beat the unpredictable factors of the stock market. It is quite significant that an investor is made aware of the basic movements of the market and how and when to implement the correct strategies needed to maximize returns and lessen big losses (Russell, n.d.). After considerably knowing the issues concerning actual market movements and the factors involve in securities investment, some important terms in relation to investment come in the form of “asset allocation” and “hedging”. Asset allocation is a form of investment diversification that divides the total investment portfolio into various forms of investments that involves ventures on bonds, stocks and money market securities (Carther, 2007). To aid in determining the appropriate investment for a financial portfolio, it is essential to know the following related terminologies (Carther, ): Large-cap stock – these are shares which are given out by big companies that usually require a capitalization which is greater than ten-billion dollars ($10B). Mid-cap stock – are shares issued by medium sized companies that have a market capitalization from two-billion dollars ($2B) to ten-billion dollars ($10B). Small-cap stocks – are stocks which represents small sized companies who have market values of less than two-billion dollars ($2B). These assets are more prone to high risk which is attributed to lower liquidity. International securities – such assets are issued by foreign companies that are listed within the foreign exchange. While International Securities permit investors to have some investment diversification outside of their own countries, the risk involved here is primarily known as country risk, which is defined as another country not being able to honor its financial commitments once a crisis occurs. Emerging markets – these are securities from developing countries, that may offer a higher rate of return it also possess a higher risk due to political instability, country risk and low liquidity. Fixed-income securities – this form of securities pay investors a regular amount of set-interest that is given from time to time or when the security matures. Such securities have less volatility and less risk because of the fixed income which is provided. While a steady stream of income could be gained from fixed-income securities the issuer is could default and so a risk in the form of default could be expected. Corporate and government bonds are included in fixed income securities. Money market – are debt securities that are very liquid and which normally mature in less than a year. Treasury bills or T-bills comprised the majority of money market securities. The main objective for asset allocation is to minimize the risk of losing a great deal of investment in a single form of asset. However, an investor must be aware that all forms of investment include a certain degree of risk. Low profile assets give out low returns and low risks, while high earning assets may give high returns butt also involves a high risk. To illustrate the aforementioned statements, below is a figure that depicts returns on investments. The figure above clearly shows that the lower the investment, the lower the risk and the return. Hence if a particular individual or investor wants a high yield to his or her profits then he or she must be ready to face losses too in case the investment made did not flourish as expected. There are plenty of ways on how to tackle risk management. It entails using simple methods or techniques where a potential investor eases his or her way gradually into the market until being able to learn and apply more sophisticated techniques that are further than the know-how of any typical investor. It likewise pays to know the various types of risk and the role they play in the market. Risk comes in two basic types as follows (Investopedia, n.d.): 1. Systematic Risk – is a risk that affects majority of the assets within a portfolio. Protecting one’s investments against this type of risk is not possible since all forms of investment are accompanied by some sort of risk and losses. 2. Unsystematic Risk/Specific Risk – is a basic kind of risk that touches a few number of assets. A related example would be an unprecedented strike of employees which affects how a particular stock will fare in the market. Asset diversification is the best protection against unsystematic risk. There are more specific types of risks that are often associated with stocks and bonds, which are described below (Investopedia, n.d.): 1. Credit Risk or Default Risk – is a risk wherein a company or individual is unable to pay its obligation on the principal and interest of a debt. Government bonds and corporate bonds are often the ones which are exposed to this type of risk. 2. Country Risk – is a risk wherein a country cannot meet or honor its financial obligations. Should a country default on its obligations it has a negative impact on the other financial instruments within its territory, and it adversely affects its relation with other countries. This type of risk are often manifested in emerging markets or developing countries. 3. Foreign Exchange Risk – investing in a foreign country requires appropriate consideration that the value of an investor’s currency versus the currency of that country could either appreciate or depreciate. If the monetary value or exchange on the country where the investment was made devalued against the investor’s own currency then losses are inevitable. 4. Interest Rate Risk – is a risk wherein the investment value reverses as a consequence of a change in interest rates. This type of risk mostly affects bond values than stocks. 5. Political Risk – is a form of financial risk that a certain government will suddenly change its policies. This is the rationale why emerging markets or developing countries are deficient in foreign investments. 6. Market Risk – this form of risk is also termed as “volatility”. Market risk represents the daily fluctuations of stock prices and it particularly affects stocks and options. Along these lines comes the word “hedging” which is a division of risk management. Hedging is a word that stands for the buying and or selling of a security, which in general is an alternative to offset any potential risk that is within one’s own investment or financial portfolio (Knapp, 2006). Hedging is a means of minimizing risks that accompanies an investment. There are many kinds of risks that could be hedge and there are various types of hedging that could be employed. ‘To hedge is a way of insuring an investment against risk (Schlenker, 1996).” The most common risk in the holding of any particular stock is market risk. Example: if the market falls sharply, the possibility of any stock listed in the stock exchange will likewise fall. Hence, even if a stock is currently considered by an investor to be good or faring well but the market is considered to be overpriced, it is advised that the investor hedges his or her position. There are plenty of ways to hedge against risk and the simplest form is to purchase a particular stock that you already have or own (Schlenker, 1996). It is the most expensive form of hedging, since purchasing the said stock is not only insuring one’s portfolio against any potential risk but also “against the risk of the specific security (Schlenker, 1996). An example for this scheme is to purchase an option on the market that will “cover general market declines.” Hedging could likewise be done by “selling financial future shares.” The best and probably cheapest type of hedge formula is to ”sell the stock of a competitor to the company whose stock you hold.” Example: if you prefer DHL over UPS and have a premonition that DHL will eventually buy-out UPS; then buy DHL shares and sell UPS shares which are currently in your possession. This type of hedging normally keeps the market risks at bay. An investor who makes such decision could make a good sum of money as long as the information about the two companies are correct. Consequently, it makes little or no difference at all if the stock market booms or crash after you went through such a transaction. In trying to hedge an entire portfolio against any market or security risk that could occur would probably require “selling future shares” that is comprised of fortune 500 company stocks. Major drops in the market could be hedged by “selling covered calls on stocks” (that is if they have options for such calls). While this may not be able to entirely protect against major market drops, it provides some protection and the probability of having a “roll up” for credit (Schlenker, 1996). The different types of hedging are described as follows (Abdullah, 2004): 1. Forward Market Hedges – use of forward contacts to effect exchange rate exposure. For expected inflow of foreign currency a t a specified rate to stabilize against the depreciation of value of that particular currency. This also goes true for the expected outflow of foreign currency where the foreign currency is bought/purchased at a specified rate to protect against the appreciation of the foreign currency value against the home currency. 2. Money Market Hedges – makes use of borrowing and lending in the money market, where in the expected inflow of foreign currency, the investor could borrow at a fixed rate and convert it into the home currency, then deposit the borrowing (home currency) at a fixed interest rate. Upon receiving a foreign currency use said foreign currency to pay off foreign currency borrowings. As for the expected outflow of foreign currency – use the foreign currency interest rate as the discounted rate and borrow an equivalent amount of home currency. Identify the present value of the foreign currency and open a foreign currency deposit. When paying time comes, withdraw the foreign currency deposit which may now be more or less equal to the payable amount and issue the payment. 3. Hedge Using Swaps – swap is defined as the exchange of an agreed amount of currency for another type of currency at a specified future time. This is a complex type of a currency forward contract. Example: A UK firm has a receivable in Canadian dollars from a Canadian buyer. Hence, it is seeking Canadian dollar denominated liability to hedge its receivable. On the other hand, a Canadian firm exports to the UK and has Euro denominated receivables. It would need a UK liability to hedge its receivables in Euro. An agreement could be reached by: 1. The UK firm receives the Canadian dollar and gives it to the Canadian firm so it could repay the Canadian dollar denominated loan. 2. The Canadian firm receives Euros and gives it to the UK firm so it could repay the Euro denominated loan. Consequently, both firms must transact at a current spot rate for future payments by swapping their own particular receivables. As a fund manager, it is common knowledge that the root cause of risk generally originates from assets that are not liquid and from the mismanagement of finances. Being honest is also a trait that a fund manager should possess, because investors totally rely on the advises made by their financial portfolio managers. Therefore, once the client has selected a particular portfolio approach, it is essential to perform regular portfolio assessment to evaluate needed changes that would affect the differing values of every asset class. So, when an investor who may have started out with a conservative type of portfolio could presently have an increase in assets within the year that would affect strategies for balancing a current portfolio that is accompanied by a higher form of risk. A recommendation to reset the portfolio to its original condition needs rebalancing, where assets that have accrued a significant gains are sold and the money gained from the sales are used to purchase additional securities or assets that have recently had a decline or less value. Investors or clients with financial portfolios must be informed of the essence in selecting the suitable asset allocation plan and performing periodic reviews that will ensure the correct maintenance of long term investment and achieve desired profits at the least amount or possibility of risk. The following figure shows the trend types of investors and the risk that they are willing to take: The following illustrations would define what each type of portfolio should contain in relation to the trend type and risk as shown above: 2. Capital markets must be efficient. Discuss. The bulk of businesses take place among groups of institutions and individuals who are interconnected by telephones, computers or electronic links, and mail, carrying on the business of buying and selling money and credit (Robinson, 1992). The financial market or capital market is a vast and complex mechanism because the financial needs of business and government are vast and complex. Billions of dollars’ worth of goods moves everyday from manufacturer to wholesaler to retailer to consumer. Literally, billions of dollars must change hands each day in this process. All this could perhaps be done without the need for financial markets except for one important point: Generally, the retailers, wholesalers, brokers and dealers who buy and sell goods do not have the billions of dollars necessary to pay for the purchases they make (Horvitz, 1983). Since the financial market, covers such a diversity of transactions, it is helpful to divide it into several sectors for the purpose of analysis, keeping in mind the fact that in the real world, the various sectors blend into and overlap with one another. The principal distinction usually made is between short-term and long-term financing, or between the “money market” and the “capital market.” Obviously, the dividing line between short term and long term is an arbitrary one, but we will adhere to the usual custom of considering money markets as those that deal in financial instruments with a maturity of under one year and the capital market as dealing in longer term debt obligations and equities. For various purposes, it is useful to make other distinctions among financial markets. An important distinction, for example, is between the market for newly issued securities or primary market and the trading of securities that are already outstanding in the secondary market. Active secondary markets are necessary if financial assets are to have liquidity. This liquidity provides an important link between the primary and secondary markets. That is, an investor is more willing to buy primary security if there is an active secondary so that he can resell the security if he should need cash (Horvitz, 1983). A distinction between the market for debt instruments, such as bonds or loans, and equity instruments involving ownership of a business corporation or financial institution, such as common or preferred stock. Other classification schemes, based on whether the issuer is a business firm or a government unit, or whether the issuer is business firm or a government unit, of whether the interest received on the financial asset is subject to normal taxes or is tax exempt (Van Horne, 1998). These classification systems are useful to potential purchasers of financial instruments because they enable them to analyze those attributes of the asset in question that are of most direct concern to them. The return they expect to derive from purchasing the security or making the loan and the risk they are taking that they will not receive what they expect. The return is simply the interest paid on the instrument plus any increase in the market price of the asset while it is held. The risk in financial assets comes from several different sources. First of all, the borrower or issuer of the security may not meet its obligations with respect to interest or repayment of principal. This is called credit risk or default risk. If the security is sold before maturity, the price received may be different from the cost. This is normally termed as market risk. An important factor making for the changes in market price is a change in interest rates that may likewise result to interest rate risk (Homer, 1997). Even if a repayment was made exactly as anticipated, the change in the price level may make the return more or less than what is expected in real terms. This is called an inflation or price level risk. Hence, an investor who is contemplating the riskiness of alternative investment decisions is primarily concerned with the risk of an adverse result – ending up with less than what he or she actually anticipated. It is useful sink some analyses of investment decisions to consider the risk in terms of both favorable and unfavorable variability in returns. Much of the effort or portfolio analysis is an attempt to reduce this risk through diversification or through selection of combinations of assets that will result in less risk that that of any single asset (Ritter, 1988). References Abdullah, AKM. 2004. Hedging as Exchange Risk Offsetting Tool. [Online}. Available: www.willamette.edu/~fthompso/IFM/18.Hedging.ppt [26 October 2004] Carther, Shauna. 2007. Achieving Optimal Asset Allocation. [Online]. Available: http://www.investopedia.com/articles/bonds/08/bond-portfolio-strategies.asp Homer, Sidney. 1997. A History of Interest Rates, 2nd Edition. New Brunswick, N.J.: Rutgers University Press, 1997. Horvitz, Paul M. 1983. Monetary Policy and the Financial System, 5th Edition. Prentice-Hall, Inc. Englewood Cliffs, New Jersey, 1983. Investopedia. (n.d.). Risk and Diversification: Different Types of Risk [Online]. Available: http://www.investopedia.com/university/risk/risk2.asp Knapp, David Can. 2006. The Importance of Controlled Risk and Minimizing Loses in Stock Investing. [Online]. Available: http://www.sensiblestocks.com/article5risk.html Ritter, Lawrence S. 1988. The Flow of funds Accounts: A Framework for Financial Analysis,” The Bulletin, New York University Graduate School of Business Administration Institute of Finance, August 1998. Robinson, Roland I. 1992. The Management of Bank Funds, 2nd Edition. New York: Mc-Graw-Hill, 1962. Chapter 19, 1992. Russell, Lawrence. (n.d.) The Skilled Investor. [Online]. Available: http://www.theskilledinvestor.com/ss.item.24/introduction-to-investment-valuation-and-securities-risk.html Schlenker, Norbert. 1996. Subject: Strategy: Hedging. [Online]. Available: http://invest-faq.com/cbc/strat-hedging.html [12 December 1996] Van Horne, James C. 1998. Financial Market Rates and Flows. Englewood Cliffs, N.J.: Prentice Hall, 1998. Read More