Risks and Share Prices - Report Example

Running Head: Risks and Share Prices Risks and Share Prices Name Course Lecturer Date Introduction Uncertainty and risks are an essential part of any investment decision. Technically, risk is defined as any situation where the outcome or consequences of a decision made is known. Risk also refers to the precise amount a given asset deviates from the expected value plus the probability of the deviation. The key focuses that are seen to contribute to risks are interest and price. In addition, internal and external considerations also influence risks. The external risks are referred to as systematic risks and are uncontrollable. They widely affect investments. Risks that are due to internal environment of an industry or those affecting a particular firm are known as unsystematic risk. The systematic risks are described as non-diversifiable and are essentially, associated with economic, political, sociological, legal considerations and securities markets. The main effect of the systematic factors is to create pressure on the securities in a way that the prices of the stocks move in the same direction. For instance, in a boom period, the prices of the securities raise indicating prosperity in the economy. It is also important to note that systematic risks contain interest rate and market risk. On the other hand, unsystematic risk is basically unique to an industry or a firm. Ideally, it does not affect an investor. This risk is affected by consumer preferences, labor strike and irregular and disorganized management policies. The factors are said to be independent of prize system that is mainly operating in securities market. In addition, unsystematic risk covers financial and business risks. Mechanism of analyzing and managing risks There are various mechanisms that the investors have used in analyzing these risks. Risk management refers to the procedure of measuring, evaluating risk and developing specific strategies that are directed in managing the risks and maximizing on the return. It involves the use of variety of models, financial analyses and trading techniques. Managing risks involves identifying various types of risks and putting in action to mitigate the impact of these risks on investment portfolio. One of the mechanisms that the investors are applying in analyzing and managing the risks in the share markets is the use derivatives. Derivatives do control the risk of interest change rates, currency movements, price fluctuations and various other factors that are likely to affect revenue and profits of investors like corporations, individual and governments. Financial derivative is a basic tool that derives its value from underlying assets. In such, an asset may be anything existing as a trade able entity. The value is essentially derived on a future anticipation of an asset price movement that will be experienced by investors in the transaction of a specific asset. Therefore, a risk associated with the movement of the asset price is introduced. The risk is calibrated in a form of price differentials and the main value observed of a derivative does derive itself from price of an asset expected in the future. Still, the uncertainty of future is then quantified as a specific value that does signifies a change in the price of a particular asset that an investor is expecting. This procedure applies derivatives to protect the expected profitability against the movement of prices. Of importance to note is that the uncertain future is transformed into values that may be traded on the markets with the interest directed on the expected value at a particular date. Therefore, the risks are transformed into opportunities that will generate gain through trading derivatives having future expectations. However, a risk still remains a risk and may not be reduced or transformed into other form (Bryan & Raffert, 2006). As a risk management, derivatives can only distribute or spread the price of the risk movement rather than decreasing risks that are related with the future change in the price of an asset. Essentially, derivatives may not actually control the risk but spread this risk so that the consumer or producer may have the opportunity to secure profits against any possible negative outcome in the price movements. Another way of analyzing and managing mechanism that has been applied by the investor is the investment according to the trend of the market. Indeed, by following the trend of the market, an investor is in a position to manage risk in the share market. However, it is not easy as it sound. In following this trend, investors try to identify and align the trend of the market share. This is done with the assumption that market will be in a trend that can be followed within a day, week or even a year. Investors align their stocks with the trend that they have identified. In following the trend, an investor is somehow assured that the likelihood that stock will fall as the market is arising is reduced (Toporowski, 2000). Still, the investors have resulted in adding diversity to their portfolio in several different asset classes, sectors and companies. By having different stocks, investors are able to reduce the impact of risks in the market share. Therefore, there is a reduction of impact created from a loss of stocks in one sector. Exchange Traded Funds do offer a significant way to add diversity in portfolio. This is because they do hold shares of different companies based on index. This index may be for a segment of a market or the whole market. In applying Exchange Traded Funds, investors ensure that liquidity is sufficient in order to avoid creating unwanted risk. Equity options are viewed by many as risky investments. This may be true depending on the increment of the leverage used. Nevertheless, some investors use some options in order to reduce the risks of the portfolios. This include the covered call options that are brilliant way to introduce side protection as one is increasing return of the portfolio. These options are appropriate for IRA accounts. The authorities view them as a less risk investment strategy. The use of protective put options also does lower the risk a portfolio may be facing. These options provide security in case there is a sudden fall in prices. Stock index futures have been applied by investors to manage market risks. Indeed, the stock index futures have been able to open new dimensions for managing the risks. This is done through hedging. Most investors have opted for this as it is inexpensive and is constant with majority of investment strategies. Investors that have stock portfolios hedge risk by selling their stock index futures. Investors in stock portfolio that have risks suffer loss when there is a fall in the market as the portfolio will also fall. When the market falls, the prices of the stock future also fall. In case of a fall in the market, investors need to make profit from a future fall in prices to offset a loss in the portfolio. As a future seller will make profit from when there is a fall in the future prices, investor would then hedge by selling the futures. Still, a rise in the market, the losses expected in the future contract may be partly be offset the gain obtained in the previous stock portfolio. Therefore, by selling the stock index futures, an investor reduces the price unpredictability of the portfolios that may be caused by any market wide events. In applying this mechanism, investors do not have to alter composition of the portfolio (Van Der Pijl, 2007). Effects of risks on share price Systematic risks are due to the external factors facing a firm or an organization. These factors are uncontrollable from a firms’ point of view. Systematic risk is described as a macro nature as it has an effect on large number of organization in the same domain or operating in the same stream. In addition, these risks cannot be planned by a firm or organization. Systematic risk includes market, inflationary and or purchasing power and interest rate risk. Interest rate risk is seen to rise as a result of variability that is observed in the interest rate periodically. The risk affects debt securities because they do carry the fixed rate of interests. In addition interest rate risk affect price and reinvestment rate of share markets. According to Houston & Brigham (2009) market risk is mainly associated with constant fluctuations observed in the trading price of any specific securities or shares. This affects the share price as they expose some assets to particular factors. The inflationary risk or purchasing power affect the share prices as they may cause increase in cost as a result of an increase in demand over supply. Creates a situation whereby the supply fails to catch up the demand, thus, cannot expand. It may also cause increase in goods and services as a result of high production. Unsystematic risk is as a result of influence from the internal factors that are prevailing in a firm or organization. These factors are controlled by a firm or an organization. This risk can be described as micro in nature as it only affects a particular firm. In such, measure may be taken to mitigate the risk. This risk include; operational, financial and business risk. Liquidity or business risk affect share price in that it originates from purchase and sale of securities. This may due to technological changes or business cycles. A change in the capital structure of a firm may be as a result of credit or financial risk. A negative in the structure may result to loss or fall in price shares. Operational are as a result of human errors. A breakdown in people, systems, policies and internal procedure may either result to a fall or rise in the organization affecting the share in the stock markets (Toporowski, 2000). In conclusion, there are risks that observed in the stock markets. Every investor is aware of this and therefore, they have employed different mechanism to cope with the risks. This includes diversification and derivatives. However, these mechanisms do not always create an assurance that the risks would be felt in the share prices. Essentially, they are seen to decrease great effect on investors. These risks may either cause a fall or raise the market share. However, in most cases, they cause a fall in the share price. References Bryan, D. & Rafferty, M. (2006). Capitalism with derivatives: A political economy of financial derivatives, capital and class. New York: Palgrave Macmillan Houston, J & Brigham, E. (2009). Fundamentals of financial management. New York: Wiley & Sons, Inc Toporowski, J. (2000). The end of Finance: The theory of capital market inflation financial derivatives, and pension fund capitalism. London: Routledge Van Der Pijl, K. (2007). A survey of global political economy, Pragmatism and Intuitionalism, University Of Sussex, pp. 92-144 Read More