Analyzing and Managing Risk, Capital Assets Pricing Technique - Essay Example

Analyzing and Managing Risk Insert Name Course, Class, Semester Institution Instructor Date Systematic risk and Diversifiable risks Commonly known as non-diversifiable negative possibilities, market risk also called systemic risk, systematic risk is risk which applies all securities in the market and cannot be eliminated through diversification of a company’s portfolio. Regularly market risk is associated with depreciation of overall set investment worth in other words nearly all investments in a company’s portfolio fall in value. Systematic risks are typically associated with politico-legal or socio-economic factors, civil unrest, dynamics affecting interest rates, and disasters. More often than not they are difficult to keep away from. Decisions that can bring about avoidance come from greater authorities such as the government in power (Kevin, 2006). Generally it is impossible to minimize systematic risk through diversification of securities in a particular section of the market. It may however be minimized by investing in various heterogeneous sections of the market since the factors associated with a particular risk can not affect the various market segments the same way. The key methods used to trim down these risks are: avoiding some investments, decrease the number of investments and practicing hedging. Systematic risks regularly prompt series responses in a financial system. They bring about modifications of strategies and policies by public administrations, organizations, financial institutions, money markets and private portfolios. Systematic risks are among the chief reasons for financial collapsing of financial institutions (An, 2007). The beta assessment of a security tells more about the market risk it faces. Also referred to as diversifiable risk, unsystematic risks are those risks that affect particular securities in the market and can be eradicated through diversifying a company’s portfolio. It’s dependent on company-specific experiences such as go-slows, court cases, legal restrictions, and failure in a key function such as strategic planning (Brentani, 2004). Non-diversifiable risk is can be linked to certain specific dynamics that affect a particular line of business or a company such as industrial relations, product class, expansion and improvement, costing, promotional policy and so on. The most prominent way of mitigating the effects of the unsystematic risks is through diversification of its portfolio. Investors’ Risk attitudes Before committing their funds to any market securities, investors seek information on the various risk profiles of the available options. Investors and shareholders have different risk attitudes. Decision makers are classified into three categories according to their attitudes with regard to risk. In this regard a decision maker can be said to be either: risk averse, risk taker or neutral to risk. Risk adverse decision makers are those that tend to avoid risky projects at all costs. Such decision makers go for those projects that have a low risk profile and a low return. Typically, projects with low risk are associated with low return. On the other hand, high risk projects are associated with high return (Damodaran, 2006). This is where the investors’ dilemma starts since all investors want high return and at the same time, most of them are risk averse. A risk taker is that decision maker who prefers high risk projects. Such decision makers are referred to as optimists. Unlike the pessimist who fears losses, the risk taker is always ready to take the risk so as to gain high returns. Usually high risk projects are associated with high returns within a short time. To the risk taker, utility and risk are directly proportional. To the risk averse decision maker, utility and risk are inversely related. The risk neutral decision maker, he is unconcerned about the risk profile of a security (Darrel, 2001)). As such, he chooses to invest in a security without taking into consideration the riskiness of the same. From the foregoing, it is essential that investors measure the risks associated with the available securities. There are various methods of assessing, measuring and managing both systematic and non-systematic risks. Such mechanisms are discussed below. Mechanisms used by investors to measure and manage risk Capital Assets Pricing Technique The Capital Asset Pricing method is an algebraic mechanism applied in giving information on how investments are valued by the stock exchange.  The fundamental postulations the valuation technique explain how it operates.  Investors’ major plan is to gain a return on their capital by selecting projects with a projected rate of return (Swensen, 2009).  It is assumed that, all factors held constant, when selecting the type of project to commit funds to, investors will go for that security that yields the highest return and puts them in a position to expect minimal chances of negative outcome. The return is an aggregate of the returns of the securities in the market. The market risks therefore a sum of all the risks of the constituent securities (Smithson, 2003).  When studying risk the major focus is on the volatility of the risks. This is the variation in price of the asset. A high level of unpredictability implies that a particular stock will rise and fall in value to a greater extent than a different asset with less unpredictability.  The Capital Asset Pricing technique presumes that the unpredictability of a security can be linked to the risk of the industry.  A link between the value of any security or share and the worth of the industry is called Beta.  A security having greater Beta value increases with regard to value more than the market, during the times during which the industry is on the rise. Similarly, such a security decrease to a greater extent than the market when there is an increase in the market.  A Beta whose value is 1 should shift to a similar extent as its industry. Beta whose assessment is less compared to 1 will shift to a lesser extent than the market. When the value of Beta is more than 1, it should shift to a greater extent compared to industry when there is a shift in the market. A negative value of Beta implies that the value of the security is likely to fall when the worth of the market rises.  Just like the Beta with a positive value, the bigger the value of the negative Beta the greater the degree to which the security changes inversely to the industry (Rejegopal, et al, 2007). The Capital Asset Pricing technique holds the assumption that shareholders will not agree to greater chances of unpredictability except if they are assured of desirable predictable profitability. Therefore, from the fundamental presumption, follows that market price ultimately will increase.  A security whose Beta value bigger than 1, is likely to leave the investors vulnerable the effects of higher levels of unpredictability. At the same time, it may as well compensate investors given that the price of this security is likely to rise at a greater rate than the market. The Capital Asset Pricing technique has a presumption assuming potential shareholders are willing to commit their funds to an asset that faces no risk and will give the least probable amount for all ventures. Since the potential investor is ready to commit their funds to the least intensity of uncertainty, they should get return rate proportionate to the degree of uncertainty they are open to in any of the securities (Puxty et al, 1988).  The Riskless Return Rate The riskless return rate CAPM is rate of profitability a shareholder should expect there being no subjecting resources to dangers.  Usually from the amount paid on temporary treasury bonds, this is the foundation for calculating the minimum profitability.  Irrespective of the security, riskless return rate must be incorporated expected rate of profitability (Kidwell et al, 2010).  This implies that all profits above the riskless rate will be due to the uncertainty level expected by shareholders to agree to the greater intensity of uncertainty assets.   The uncertainty Premium The uncertainty measure is a significant element of CAPM. The risk premium is a principal determinant in required rate of return.  Investors have a great assortment of securities to commit their funds to.  If an investor decides to invest their resources in the whole industry, then their expected level of profitability is that of the industry (Jones, 2008).  The expected rate of profitability Expected rate of profitability is basically a total of the certainty premium.  Every security has an expected rate of profitability, which is applied in determining the value of the security.  Beta value This is a straight measure of unpredictability comparing the market as a system and one security.  If a security appreciates at 300% of the market appreciation, the asset’s value should be 3. The concept is vital to CAPM, as it indicates the uncertainty in an asset in relation to the entire market.   The CAPM Formula Rq = RF + Bq (Rm - RF) Evaluated as: Rq = expected rate of return on security ‘q’ RF = riskless rate Bq = Beta coefficient for Stock ‘q’ Rm = profitability on the market set Arbitrage pricing theory/Model (APT/APM) Fundamentally a valuation model based on arbitrage that explains the connection between profits from a security and the proceeds of an assortment of multiple indefinite financial features.APM betas deal with uncertain financial dynamics influencing security profits and mean covariance among the independent asset proceeds and indefinite amounts. APT beta estimates the sensitiveness an adjustment in the profit on one asset to alterations in the dynamics incorporated in this concept (Jaeger, 2005). APT addresses the expected profit on a security to an indefinite set of indefinite financial dynamics. The APT mechanism adopts the following formula: n E(Rq) = α0 + Σ ( Bjq x Fj ) q=1 Where: E (Rq) = anticipated rate of security ‘q’ α0 = an invariable intercept term that is indeterminate Bjq = APM sensitivity of asset ‘q’ to factor ‘j’ Fj = Unknown Factor ‘j’ of multiple (n) unknown factors Arbitrage theory works on the assumptions that; Arbitrage activities compel pricing relationship, there is a linear connection between stock return factors and that multiple indefinite factors determine returns. The model has such advantages as: it is more wide-ranging valuation model, it covers the sensitivity analyses connecting an individual security return to compound economic factors and that it covers multiple economic factors other than just market risk premium (Grobys, 2009). The Security Market Line This is a technique that reveals the relationship between the profitability of a given asset in relation to uncertainty. The measure of uncertainty in this mechanism is beta. The origin of the line is at the riskless rate, and rises as it tends away from the zero origin. As level of uncertainty of a security rises, it’s projected that profit on the security will rise. The relationship between the risk and the return is directly proportional. An investor who is risk averse would select to invest at the origin of the line, that is, where the risk is lowest (Kevin, 2006). An investor who is a risk taker would select a project near the highest levels of the security market line. The effects of these mechanisms on the price of a share These mechanisms affect the share price variously. The capital markets pricing model, influences the share of prices by provoking speculation among potential investors. Such speculation is based on the riskless rate, anticipated market profitability and inherent uncertainty. Speculations among the investors affect the demand for shares and as such affects the prices of shares. The security market line is one of the factors directors consider when pricing a company’s shares(Kevin, 2006). The risk free rate and other changes in the interest rates are considered in pricing all securities. All these mechanisms are quite important in the measuring, assessing and managing risks. These mechanisms give a company’s directors the idea of mitigating risks. After a detailed analysis of the market dynamics through the above mechanisms, the company acquires the ability and knowledge of diversification in its portfolio. Diversification entails investing in various segments of the market and in a wide array of securities. Investing in different market sections helps accommodate the effects of systematic risks (Darrel, 2001). Non-systematic risks can be eliminated through careful and detailed analysis of the above discussed mechanisms. References An, X. (2007) Macroeconomics Conditions, Systematic Risk Factors, and the Time Dynamics of Commercial Mortgage Credit Risk. Ann Arbor. Proquest Information and Learning Company Brentani, C. (2004) Portfolio Management in Practice. Burlington. Elsevier Ltd. Damodaran, A. (2006). Analysis for Investement and Corporate Finance. New Jersy. John Wiley &Sons Inc Darrel, D. (2001). Dynamic Asset: Pricing Theory. New Jersey. Princeton University Press Grobys, K. (2009). Portfolio Management: Index Tracking Strategies. New York. Books on Demand Jaeger, L. (2005). The New Generation of Risk Management for Hedge Funds and Private Equity Investments. New York. Institutional Investor Books Jones. C. (2008). Financial Economics. New York. Routledge Kevin, S. (2006) Portfolio Management (2nd Edition). New Delhi. Prentice-Hall of India Kidwell, et al (2010). Financial markets, Institutions and money (2nd ed.). Milton, Qld: John Wiley & Sons Australia Puxty, et al (1988) Financial Management: Method and Meaning. London. Van Nostrand Reinhold Co.Ltd Rejegopal, et al. (2007). Project Portfolio Management; Leading the Corporate Vision. New York. Wiley and Sons Inc Smithson, C. (2003) Credit Portfolio Management. New Jersey. John Wiley, Inc Swensen, F.D. (2009). Pioneering Portfolio Management. New York. Simion & Schuster, Inc Read More