Analysis and Management of Risks in the Share Market - Coursework Example

Analysis and Management of Risks in the Share Market Introduction Risk simply refers to a situation where the possible consequences of a decision taken or to be taken are unknown. It implies the extent to which the results of a decision made may lead to loss or unfavourable outcome. As Strong (2008) points out, risk is an integral part of any investment decision taken and therefore, investing in a share market comes with various unavoidable risks. On any given trading day in a share market, the potential for losses exists, which impacts on either individual stocks or the whole stock market. The risks that have an impact on individual stocks emanate from internal conditions and events to a firm or an industry and are known as unsystematic risks (Tang & Shum, 2003). On the other hand, those risks that affect the whole stock market emanate from conditions and occurrences outside individual firms or industries and are known as systematic risks. When events that lead to these risks occur, they affect share prices in stocks either favourably or unfavourably. Investors, nevertheless, have devised mechanisms to analyse and get rid of the risks that can be eliminated and to manage or mitigate those that cannot be easily eliminated (Tang & Shum, 2003). This paper describes the mechanisms adopted by investors in the share market to analyse and manage the aforementioned two types of risks. In addition, the paper examines how these risks affect share prices. Systematic risk As noted, a systematic risk refers to the risk associated with external factors that affect performance of the share market. It is usually determined by macroeconomic factors such as inflation cycle, interest cycle, currency fluctuations, business cycle and exchange cycle, affecting the whole economy (Choi, 2003). This type of risk may also be associated with sociological factors such as a change in preferences of habits of people that eventually affects the demand of a given product. Political issues may also lead to systematic risks especially in situations where a government implements new policies. For instance, a government may consider nationalising certain industries, thereby affecting the prices of all securities in a given economy (Byrne & Lee, 2000). Usually, all these factors tend to put pressure on the prices of all stocks in such a way that they move in the same direction. During a boom, for instance, prices of all securities in an economy usually rise. These external or systematic risks are uncontrollable and non-diversifiable and hence, they highly affect investments in the share market (Hawawini & Viallet, 2010). Unsystematic risk This type of risk is associated with factors related to an individual investment or an industry. Unlike a systematic risk, an unsystematic risk is uncorrelated with the returns in the whole share market. One of the common types of unsystematic risks is liquidity risk (Jones, 2009). This kind of risk results when a firm or an issuer of security faces shortage in availability of funds, hence exposing investors to liquidity risks. Another type of unsystematic risk is default risk. This risk occurs as a result of failure, winding up or closure of a firm or an issuer of securities, hence failing to pay back investors the entire of their investments. Operational risk is also a common type of unsystematic risk which arises as a result of failure in the operations of an issuer of securities for a given period of time (Howard, 2006). A good example is the closure of operations of a firm for some time, causing a reduction in production, turnover and profitability, hence leading the firm to fall short of its guidelines. A strike by employees in a firm or an industry may also lead to an operational risk. Mechanisms used to analyse the risks There are various models used by investors to account for risk in a share market. The most common of these models is the Capital Asset Pricing Model (CAPM) (Pratt & Grabowski, 2010). This model is used to predict or explain the returns to an asset as depending on how risky the asset is compared with the average in the market. The model assumes that investors have the ability to eliminate unsystematic risks by holding common stocks in well diversified portfolios and thus, this type of risk is not included in the study (Davidson, 2002). The model makes use of the concept of beta () to link risk with return. Investors use this model to access trade-off between risk involved in any investment decision and return. The following equation expresses the relationship between systematic risk and the required rate of return on a single asset. E(R) = RFR + (R-RFR)  Represents the measure of systematic risk of the asset and it is standardized. It is derived by dividing assets covariance Cov (i,M) “with market portfolio by the variance of market returns (). E(R) represents cost of equity R-RFR represents market risk premium. R is expected market return RFR represents a risk free return Therefore,  is the measure of systematic risk and helps investors to predict how the price of a stock will respond to changes in market prices. It measures the responsiveness of returns to a stock to a specific external risk factor (Pratt & Grabowski, 2010). Arbitrage Pricing Theory This is an alternative to CAPM and unlike the latter which considers a single factor (the market return) to explain the risk of an asset, it includes multiple factors. In addition, it requires fewer assumptions compared to CAPM (Hull, 2012). Arbitrage Pricing Theory (APT) assumes that there is perfect competition in capital markets. It also assumes that investors prefer more wealth to less and that a multiplicity of factors determine the returns to an asset portfolio. However, this theory fails to specify the factors that impact on returns and hence, it fails to explain the differences in returns for different assets. How the investors manage risks Diversification As mentioned earlier, investors employ the strategy of diversification to eliminate unsystematic risk. As Kevin (2006) points out, there is risk in choosing to invest money in one company. For instance, there is a high risk in choosing to use all of one’s savings to purchase bonds/debentures or shares of just one company or industry. Therefore, investors manage unsystematic risk by efficient diversification of investment portfolio. This helps to ensure that if investment in a given company or industry significantly loses value, the loss is offset by profits derived from investments in another company or industry. According to Maheshwari (2008), diversification extends to spreading investments into more than one type of asset rather than concentrating on one kind of asset. For instance, if a financial assets class is composed of bonds, cash, shares and mutual funds, investors reduce risk by diversifying into more than one of these constituents. Therefore, the basis of the concept of diversification is that it is not advisable to put all eggs in one basket. The important aspect of unsystematic risk is that it is uncorrelated with the risks affecting the whole economy or the whole share market and hence, investors are able to eliminate it easily by diversification. However, this strategy is not as effective as asset allocation in offsetting systematic risk (Mayo, 2007). Asset allocation Asset allocation is a strategy employed by investors to minimise risks and maximise returns in an investment portfolio (Mayo, 2007). This strategy involves distribution of investment capital among different broad categories of assets such as debentures, bonds, cash and shares, in specific percentages. The model adopted in this strategy has specified percentages of investment portfolio to be allocated to each category. Allocation in this case is determined by an investor’s risk-return profile. An investor’s risk-return profile is dependent on different factors such as market outlook, capacity to tolerate risks, time and period of investment and interest rates movements. Thus, according to Maheshwari (2008), asset allocation is a dynamic exercise and there is no specific allocation model that is valid for all times. Usually, investors adjust and balance investment portfolio after a certain period in order to bring it back in line with their preferred model or in line with their changed financial goals. One of the major advantages of the asset allocation model is that it is sensitive to changes in economic conditions that affect different categories of assets. Hence, effective asset allocation is likely to achieve greater benefits compared to simple diversification within an asset class. As a result, investors employ the asset allocation model to mitigate systematic risk. However, as Maheshwari (2008) notes, investors employ both strategies simultaneously to reduce both types of risks. Rupee Cost Averaging This is a process that involves the investment of a fixed amount of rupee at regular, systematic time intervals. According Maheshwari (2008), this process may be effective in smoothening out ups and downs in a share market in the long-run, when adhered to. However, the programme does not guarantee return in a declining market. Futures and options Investors use futures to manage investment risks associated with prices and changing interest rates. According to Subramani (2011), long future positions increase the exposure of a portfolio to risks while short futures decrease such exposure. Thus, investors mitigate systematic risk by selling short futures. On the other hand, options give investors the right (but not obligation) to sell or purchase an underlying asset. As Subramani (2011) explains, purchasing a call option limits exposure to risk while purchasing a put option when an investor owns the underlying security has an impact of controlling the risk downside. Therefore, options provide investors with a mechanism of hedging, which allows them to manage risk in accordance with their risk appetite. How the risks affect share prices The two types of risks affect share prices differently. According to Hawawini & Viallet (2010), unsystematic risk may have either favourable or unfavourable impact on share prices, depending on specific circumstances. For instance, an anticipated win of a lawsuit related to liability of a firm will have a favourable impact. Other events that may have positive effects are announcement of returns that are higher than expected and the discovery of a new product. Examples of events that may lead to unfavourable impacts are failure to win an anticipated liability lawsuit, an accident resulting into shutdown of production facilities and labour strike. However, if taken together, the above favourable and unfavourable effects are not likely to have a great impact on returns especially where an investor has a well diversified portfolio (Hawawini & Viallet, 2010). This is because the positive impact of favourable events is going to cancel out the negative effects of unfavourable events. In such a case, the unsystematic risk of investment portfolio will approach zero. As noted earlier, unsystematic risk results from events that affect the whole economy and not a single firm or industry. These market wide or external events affect share prices in the whole economy in the same fashion. A good example of such events is an announcement by the central bank to raise interest rates (Subramani, 2011). An anticipated rise in interest rates is an unfavourable event to the stock market as prices of most shares are likely to go down. Such an announcement is thus likely to affect the prices of most or all shares in a stock market. However, according to Subramani (2011), systematic risks may have less or more impacts on different stocks, depending on sensitivity to market wide events. Conclusion In conclusion, risk is an inescapable in investment decisions taken in the share market. As noted, systematic risk emanates from factors that are external to a firm or an industry and affects the whole economy. This risk is non-diversifiable and difficult to eliminate. However, investors mitigate this type of risk through effective asset allocation strategies. An unsystematic risk is determined by internal factors to a firm or an industry and hence, it is easily eliminated by investors through effective diversification of investment portfolio. The rupee cost averaging strategy and the use of future and options are also adopted by investors to manage risks in the share market. Investors adopt the CAPM as well as the principles of APT theory to analyse the two types of risks. Generally, the two types of risks may affect share prices either favourably or unfavourably but the impact is minimised by investors through effective management of the risks. References Byrne, P. & Lee, S. (2000). The impact of market risk on property portfolio risk reduction, Journal of Property Investment & Finance, 18(6): 613-626. Choi, F. D. S. (2003). International finance and accounting handbook. New York: John Wiley and Sons. Davidson, A. (2002). How to win in a volatile stock market: The definitive guide to investment bargain hunting. 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