Mechanisms Used by Investors in the Share Market - Example

Describe the mechanisms used by investors in the share market to analyze and manage systematic and unsystematic risks. How do these risks affect share prices? Your name:   Course name:         Professors’ name: Date: Introduction Every investment comes with a certain degree of risk. A successful investor is the one who can successfully negotiate any risk. It is impossible for an investor to bring all the variables under his/her control as they are innumerable. If a person thinks on investing in stock or other securities investments, there are risks which he/she must thing about. Two prime types are systematic risk and unsystematic risk. Risks are usually created by the odds stacked against the performance of shares that an investor has invested in. Thus, risk management is the prime business of any investor. Investment in stock exchange can be compared to betting business. An investor will bet on the performance of a company by purchasing its stock (Grinold & Kahn, 2000). There are many ways in which business risks can be classified. One way is to distinguish between systematic risk and unsystematic risk. Systematic risk is associated with the overall economy or the market. In other words, this risk is usually associated with the market returns; this is the risk to the value of an investment portfolio that cannot be credited to the specific risk of individual investments (Grinold & Kahn, 2000). Systematic risk will include macroeconomic factors such as recessions, wars, changes in interest rates, inflation, fluctuations in currencies etc that affects the whole market environment. Unsystematic risk is associated with a specific firm or asset. In other words, these risks are usually associated with small group of investments or specific to the individual investment and are uncorrelated with stock market returns. Other names that can be used to describe unsystematic risk are diversifiable risk, specific risk, residual risk and idiosyncratic risk (Bansal and Yaron, 2004). In order to understand the principle of risk management, this paper will use Santomero and Oldfield (1997) categorization of risks. Accordingly, most businesses face three types of risks: risks that can be transferred to others; risks that can be eliminated; and risks that can be managed in the business. In most cases, many businesses have been found to avoid certain risks by simple business practices and will not involve themselves with activities or businesses that impose risks on their operations. Systematic risks Systematic risks can be managed through hedging. A hedge is an investment position that is used to offset potential losses that a company may incur as a result of its investment in foreign currency. In other words, hedge is used to reduce any losses suffered by that company (Munya, 2010). An organization is able to construct a hedge from many types of financial instruments, including insurance, stocks, exchange-traded funds, swaps, forward contracts, options, future contracts and money market (Guay, 2006). An effective hedging program will not eliminate the systematic risk but it will be able to transform the risk into an acceptable form. The most important thing for any company when it comes to managing systematic risk is to determine the risks the business is able to handle and the ones the business chooses to transform by hedging (Gulen & Mayhew, 2000). Systematic risk can be illustrated in the following manner, Imagine an investor who buys shares or stocks worth 10,000 dollars in 10 different biotechnology companies. If unexpected events happened leading to a setback in shares falling, one or more biotechnology company will face a drop in the share price, thus a share investor will experience a loss. On the contrary, if an investor buys shares worth 10,000 dollars in one biotechnology company. The investor would suffer 10 times the loss from such dealing (den Haan, 2010). Option derivative An option derivative is a contract that gives an investor in the share market the right to trade (buying or selling) shares of stock exchange at a strike price (particular price). But the contract in this case will not require the investor to make a sale (put option) or a purchase (call option). This kind of derivative can be used by investor in shares who have shares of stock, but can also be used by share investors who currently don’t have their own stocks (Gulen & Mayhew, 2000). During risk management, the option contract will specify whether it is a call or put, the strike price, the contract’s expiration date, the number of shares in question, and any terms that is related to settling a closed position (den Haan, 2010). Option derivative is have been found to be versatile security but can be used in different ways. Investors will use option derivative to speculate- which is a relatively risky practice, while other investors will use option derivative to reduce the risk of holding a share in a company. In speculating, option writers and buyers will have conflicting views with regard in the performance of the security (Maginn, Tuttle, McLeavey, and Pinto, 2007). For example, because the option writer will need to provide the underlying shares in the event that the share’s market price will exceed the strike, an option writer that sells a call option (a purchase) believes that the underlying share’s price will drop relative to the option's strike price during the life of the option, as that is how an investor is able to reap maximum profit from trading. For an option buyer, this will be exactly the opposite (Gulen & Mayhew, 2000). An investor will wait for the stock to rise, and if this happens, then the option buyer will able to buy shares at lower prices and then sell the same at a profit (Maginn, Tuttle, McLeavey, and Pinto, 2007). Options derivatives can be grouped into following types: over-the-counter options and exchange-traded options. Over-the-counter options (sometimes called “dealer options”) involve two private investors, and are not listed on a stock exchange (Maginn, Tuttle, McLeavey, and Pinto, 2007). Options types that are traded over-the-counter include: currency cross rate options, interest rate options, and options on swaptions or swaps. In exchange-traded options (sometimes called “listed options”) have standardized contracts, and can only be settled through clearing house. Since these contracts have been standardized, accurate pricing models can be found. Exchange-traded options include: bond options, stock options, options on futures contracts, bear contract and stock market index options (Maginn, Tuttle, McLeavey, and Pinto, 2007). Future derivative Future derivative is a contract between two investors in which one investor agrees to buy the stated shares at a future price and date. This is similar to an option contract, because when an investor purchases a future contract he/she creates an obligation instead of a right. In other words, the shares investor will purchase a future contract in the agreed upon date. The seller of share will sell his/her shares while the buyer will not have any option of letting the future contract expire without buying the shares (Grinold & Kahn, 2000). Future contract In future contract, a share investor will get the margin to buy the share, while in stock trading the share investor will be required to have the actual amount to buy the shares. For example, if a share investors plan to buy stock X at 100 dollars and quantity 200 shares the the share investor will be required to pay 20,000 dollar. But if the share investor plans to buy X future contract and that contract lot size has the same number of shares (200 shares) then instead of the share investor paying 20,000 dollar, the share investor will only pay 20 per cent to 30 per cent of the whole amount which comes to 2000 dollars to 2200 dollars. In other words, in the future trading, the share investor will be required to pay just 20 per cent to 30 per cent of the whole amount required to buy the share of that actual price. Warrant derivatives Warrant derivatives is similar to option derivative because it grant the share investor the right- but not the obligation- to purchase the underlying share (stock or asset) at a specific time or future date (Elosegui, 2003). Unlike option derivatives, the company is the one that will issue the shares warrant rather than the share investor, and are offered to holders of the organization bond and preferred shares or stock. Therefore, a company warrant will allow a share investor to call warrant (buy) or put warrant (sell) shares of the company’s shares at a certain price. A warrant will allow a share investor the option of buying or selling stock at later date and this will reduce the dividend or interest rate that the investor will receive (Maginn, Tuttle, McLeavey, and Pinto, 2007). Forward derivative Forward derivative can be compared to a future derivative but the only difference is that it creates an obligation between two share investors to exchange shares at a particular price and on a particular date. In forward derivative, money and shares will only be exchanged on the settlement date, and this will create one cash flow rather than a series of cash flows in the futures contract (Elosegui, 2003). Unsystematic risks Unsystematic risks or diversifiable risks are risks that are specific to a certain company. These risks will include dramatic occurrences or events such as natural disasters such as fire or floods, or strikes, or slumping in sales of a particular product. Two common sources of diversifiable risks are financial risk and business risk (Elosegui, 2003). Many share investors have been able to reduce unsystematic risk from their portfolio through diversification of shares or stocks. Therefore, by diversifying, and investor is able to reduce his/her risk. On the other hand, some unpredictable occurrences or events can affect all companies at the same time. Occurrences such as war, inflation, fluctuating interest rates will have an influence on the entire economy of a country, not just specific industry or company (Elosegui, 2003). In order to have higher returns, investors must are induced to take risks. However, not all risks will yield such potential rewards. Therefore, it is important for an investor to identify these risks and eliminate them from their portfolio through diversification of shares. Through diversification, positive performance of certain investments in the portfolio will neutralize the negative performance of other investments of the portfolio. Therefore, diversification will properly function if the shares or stocks in the portfolio are not perfectly correlated (Krusell and Smith, 1998). Mathematical models and studies have shown that when an investor has a well-diversified portfolio of 20 to 32 stocks will give the most cost-effective level of unsystematic risk reduction. Therefore, an investor who invests in more securities will yield more diversification benefits, albeit at a smaller rate (Gulen & Mayhew, 2000). Further, an investor can benefit from diversification if he/she invests in foreign securities because they are not correlated with domestic investments. For example, and economic downturn in the U.K. economy may not affect U.S. economy in a similar manner; therefore, having U.S. investments would help an investor cushion himself/herself against losses due to the British economy downturn. Most share investors have been noted to have limited investment fund, and may find it difficult to have proper diversified portfolio. Therefore, when such a situation arises investors should buy shares in a mutual fund because it is an inexpensive source of diversification portfolio. Risks factors that affects the share price Company’s performance When an investor purchase shares in a firm, that investor will be buying a part of that firm. The failure or success of that investment will depend on how well that firm is being operated, but also analysis of market factors and general market conditions (Krusell and Smith, 1998). Some of these factors include interest rate. Interest rate has a varied and wide impact on investment in shares. When interest rate is raised in a country, the effect of this is to reduce the amount of money that is in circulation in a particular country (Krusell and Smith, 1998). The effect of this will make inflation to be low, also makes borrowing money to be expensive. This in return affects how investors spend their money; this increases expenses for investments, lowering earnings on investments. Finally, it tends to make share market to be less attractive place to invest; thus reducing the prices of shares in the affected country (Krusell and Smith, 1998). Company’s earnings Another factor that can affect share price is the company’s earnings. Earnings is the revenue or profit the company realizes over a period of time, and in the long run no firm can be able to conduct its business. Public companies are required by the law to report their earnings four times per year. Newspaper watches with attention in these periods. The reason is that people will base their future value of their shares in a public company to project their earnings. If the firm posts good results, the share price will jump up. If a firm’s results are disappointing, then the share price will fall (Krusell and Smith, 1998). Economic downturn In the times of dot-com bubble, share investors predicted good fortunes for certain start-up firms such as Facebook, Amazon and AOL, and purchased their shares in anticipation of good returns in the future. The same speculation was experienced in biotech firms that created cure for a major disease (Cochrane, 2008). Shares price for firms that are new and promising industries have been found to trade at high prices as compares to companies that have been in the market for sometimes. Similarly, during economic downturn, investors were seen to purchase defensive stocks they predicted will perform well when the country’s economy was in bad shape. Defensive stocks include firms that manufactured basic necessities such as: liquor, tobacco, personal and food products (Cochrane, 2008). During boom time, electronics, auto, travel, hospitality, appliances and travel shares performed well because customers have enough money to use. Even though shares of these stocks don’t always perform as expected, share investors tend to adjust their portfolios to over-weight those shares and the share prices rise as a result (Cochrane, 2008). Conclusion Introduction of derivatives in risk management had beneficial effects on the risk of the stocks underlying the futures and options contracts traded. There are many choices which an investor can use when it comes to hedging risk. The investor can try to eliminate or reduce the systematic risk through financing and investment choices, by using derivatives or through insurance. Not all choices are economical or feasible with all systematic risks and it is important to make an inventory of the available choices and compare each one of them. The two common hedging derivatives that are widely used by investors are options, futures, warrants and forward. References Bansal, R., and A. Yaron. ( 2004). Risks for the long run: A potential resolution of asset pricing puzzles, Journal of Finance 59, 1481-1509. Cochrane, J.H. (2008). The dog that did not bark: A defense of return predictability, Review of Financial Studies, 21, 1533-1575. den Haan, W. (2010). Comparison of solutions to the incomplete markets model with aggregate uncertainty. Journal of Economics Dynamics and Control, 34: 4–27. Elosegui, P.L. (2003). Aggregate risk, credit rationing, and capital accumulation. Quarterly Journal of Economics and Finance, 43: 668–696. Grinold, R., & Kahn, R. (2000). Active portfolio management – A quantitative approach for producing superior returns and controlling risk – Irwin Library of Investment & Finance, McGraw-Hill. Gulen, H., & Mayhew, S. (2000). Stock index futures trading and volatility in international equity markets // Working paper, Purdue University, University of Georgia. Krusell, P. and Smith Jr., A. (1998). Income and wealth heterogeneity in the macroeconomy. Journal of Political Economy, 106: 867–896. Maginn, J., Tuttle, D., McLeavey, D., and Pinto, J. (2007). Managing Investment Portfolios: A Dynamic Process. Hoboken, New Jersey: John Wiley & Sons, Inc., p.231–245. Read More