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 unfavorable outcome. As Strong (2008) points out, the 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 favorably or unfavorably. Investors, nevertheless, have devised mechanisms to analyze 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 analyze and manage the aforementioned two types of risks. In addition, the paper examines how these risks affect share prices.
The systematic risk or Market Risk.
As noted, a systematic risk refers to the risk associated with external factors that affect the 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 nationalizing 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, 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 a 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 a 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 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 (b) 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 + b(R-RFR)
b 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, b 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 the 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 the 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 to 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 program 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 favorable or unfavorable impact on share prices, depending on specific circumstances. For instance, an anticipated win of a lawsuit related to the liability of a firm will have a favourable impact. Other events that may have positive effects are the announcement of returns that are higher than expected and the discovery of a new product. Examples of events that may lead to unfavorable 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 unfavorable 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 unfavorable 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 analyze 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. London: Kogan Page Publishers.
Hawawini, G. & Viallet, C. (2010). Finance for executives: Managing for value creation. New York: Cengage Learning.
Howard. M (2006). Accounting for unsystematic risk. Financial Management, pp. 29-31.
Hull, J. (2012). Risk Management and Financial Institutions. New York: John Wiley & Sons.
Jones, C. P. (2009). Investments: Analysis and Management, New York: John Wiley and Sons.
Kevin, S. (2006). Security analysis and portfolio management, Delhi: PHI Learning Pvt. Ltd.
Lumby, S. & Jones, C. (2003). Corporate finance: Theory & practice. London: Cengage Learning EMEA.
Maheshwari, Y. (2008). Investment management. New Delhi: PHI Learning Pvt. Ltd.
Mayo, H. B. (2007). Investments: An introduction. Mason: Cengage Learning.
Pratt, S. P. & Grabowski, R. J. (2010). Cost of Capital: Applications and examples, London: John Wiley & Sons.
Strong R. A. (2008). Portfolio construction, management, and protection: With stock trak coupon, New York: Cengage Learning.
Subramani, R. V. (2011). Accounting for investments, equities, futures, and options. London: John Wiley & Sons.
Tang, G. Y. N & Shum, W. C. (2003). The relationships between unsystematic risk, skewness and stock returns during up and down markets. International Business Review, 12(5): 523-541.
Get Professional Assignment Help Cheaply
Are you busy and do not have time to handle your assignment? Are you scared that your paper will not make the grade? Do you have responsibilities that may hinder you from turning in your assignment on time? Are you tired and can barely handle your assignment? Are your grades inconsistent?
Whichever your reason is, it is valid! You can get professional academic help from our service at affordable rates. We have a team of professional academic writers who can handle all your assignments.
Why Choose Our Academic Writing Service?
- Plagiarism free papers
- Timely delivery
- Any deadline
- Skilled, Experienced Native English Writers
- Subject-relevant academic writer
- Adherence to paper instructions
- Ability to tackle bulk assignments
- Reasonable prices
- 24/7 Customer Support
- Get superb grades consistently
Online Academic Help With Different Subjects
Literature
Students barely have time to read. We got you! Have your literature essay or book review written without having the hassle of reading the book. You can get your literature paper custom-written for you by our literature specialists.
Finance
Do you struggle with finance? No need to torture yourself if finance is not your cup of tea. You can order your finance paper from our academic writing service and get 100% original work from competent finance experts.
Computer science
Computer science is a tough subject. Fortunately, our computer science experts are up to the match. No need to stress and have sleepless nights. Our academic writers will tackle all your computer science assignments and deliver them on time. Let us handle all your python, java, ruby, JavaScript, php , C+ assignments!
Psychology
While psychology may be an interesting subject, you may lack sufficient time to handle your assignments. Don’t despair; by using our academic writing service, you can be assured of perfect grades. Moreover, your grades will be consistent.
Engineering
Engineering is quite a demanding subject. Students face a lot of pressure and barely have enough time to do what they love to do. Our academic writing service got you covered! Our engineering specialists follow the paper instructions and ensure timely delivery of the paper.
Nursing
In the nursing course, you may have difficulties with literature reviews, annotated bibliographies, critical essays, and other assignments. Our nursing assignment writers will offer you professional nursing paper help at low prices.
Sociology
Truth be told, sociology papers can be quite exhausting. Our academic writing service relieves you of fatigue, pressure, and stress. You can relax and have peace of mind as our academic writers handle your sociology assignment.
Business
We take pride in having some of the best business writers in the industry. Our business writers have a lot of experience in the field. They are reliable, and you can be assured of a high-grade paper. They are able to handle business papers of any subject, length, deadline, and difficulty!
Statistics
We boast of having some of the most experienced statistics experts in the industry. Our statistics experts have diverse skills, expertise, and knowledge to handle any kind of assignment. They have access to all kinds of software to get your assignment done.
Law
Writing a law essay may prove to be an insurmountable obstacle, especially when you need to know the peculiarities of the legislative framework. Take advantage of our top-notch law specialists and get superb grades and 100% satisfaction.
What discipline/subjects do you deal in?
We have highlighted some of the most popular subjects we handle above. Those are just a tip of the iceberg. We deal in all academic disciplines since our writers are as diverse. They have been drawn from across all disciplines, and orders are assigned to those writers believed to be the best in the field. In a nutshell, there is no task we cannot handle; all you need to do is place your order with us. As long as your instructions are clear, just trust we shall deliver irrespective of the discipline.
Are your writers competent enough to handle my paper?
Our essay writers are graduates with bachelor's, masters, Ph.D., and doctorate degrees in various subjects. The minimum requirement to be an essay writer with our essay writing service is to have a college degree. All our academic writers have a minimum of two years of academic writing. We have a stringent recruitment process to ensure that we get only the most competent essay writers in the industry. We also ensure that the writers are handsomely compensated for their value. The majority of our writers are native English speakers. As such, the fluency of language and grammar is impeccable.
What if I don’t like the paper?
There is a very low likelihood that you won’t like the paper.
Reasons being:
- When assigning your order, we match the paper’s discipline with the writer’s field/specialization. Since all our writers are graduates, we match the paper’s subject with the field the writer studied. For instance, if it’s a nursing paper, only a nursing graduate and writer will handle it. Furthermore, all our writers have academic writing experience and top-notch research skills.
- We have a quality assurance that reviews the paper before it gets to you. As such, we ensure that you get a paper that meets the required standard and will most definitely make the grade.
In the event that you don’t like your paper:
- The writer will revise the paper up to your pleasing. You have unlimited revisions. You simply need to highlight what specifically you don’t like about the paper, and the writer will make the amendments. The paper will be revised until you are satisfied. Revisions are free of charge
- We will have a different writer write the paper from scratch.
- Last resort, if the above does not work, we will refund your money.
Will the professor find out I didn’t write the paper myself?
Not at all. All papers are written from scratch. There is no way your tutor or instructor will realize that you did not write the paper yourself. In fact, we recommend using our assignment help services for consistent results.
What if the paper is plagiarized?
We check all papers for plagiarism before we submit them. We use powerful plagiarism checking software such as SafeAssign, LopesWrite, and Turnitin. We also upload the plagiarism report so that you can review it. We understand that plagiarism is academic suicide. We would not take the risk of submitting plagiarized work and jeopardize your academic journey. Furthermore, we do not sell or use prewritten papers, and each paper is written from scratch.
When will I get my paper?
You determine when you get the paper by setting the deadline when placing the order. All papers are delivered within the deadline. We are well aware that we operate in a time-sensitive industry. As such, we have laid out strategies to ensure that the client receives the paper on time and they never miss the deadline. We understand that papers that are submitted late have some points deducted. We do not want you to miss any points due to late submission. We work on beating deadlines by huge margins in order to ensure that you have ample time to review the paper before you submit it.
Will anyone find out that I used your services?
We have a privacy and confidentiality policy that guides our work. We NEVER share any customer information with third parties. Noone will ever know that you used our assignment help services. It’s only between you and us. We are bound by our policies to protect the customer’s identity and information. All your information, such as your names, phone number, email, order information, and so on, are protected. We have robust security systems that ensure that your data is protected. Hacking our systems is close to impossible, and it has never happened.
How our Assignment Help Service Works
1. Place an order
You fill all the paper instructions in the order form. Make sure you include all the helpful materials so that our academic writers can deliver the perfect paper. It will also help to eliminate unnecessary revisions.
2. Pay for the order
Proceed to pay for the paper so that it can be assigned to one of our expert academic writers. The paper subject is matched with the writer’s area of specialization.
3. Track the progress
You communicate with the writer and know about the progress of the paper. The client can ask the writer for drafts of the paper. The client can upload extra material and include additional instructions from the lecturer. Receive a paper.
4. Download the paper
The paper is sent to your email and uploaded to your personal account. You also get a plagiarism report attached to your paper.
PLACE THIS ORDER OR A SIMILAR ORDER WITH US TODAY AND GET A PERFECT SCORE!!!
