Risk Analysis Financial Markets Main Techniques Risk Analysis
Risk analysis in the financial markets
This essay mainly intends to outline and explain the objective of risk analysis in the financial market and the main techniques used in risk analysis. In a bid to answer this question the study will first of all include a summation of the types of risks that are found in the financial markets. The financial market here has been classified into three groups that are; the stock market where company stock and shares are traded, the bond market where the Australian government usually sell its' treasury bills and bonds and lastly the international financial market.
Different risk analysis technique will spelt out in the two markets and then the objectives of risk analysis will then be mentioned before the essay concludes.
Types of risk in the financial markets
In his studies Jensen (2009) noted that there are three major risks that investors in the financial markets are exposed to and this include; operational risk, credit risk and market risk. Financial advisors have been quoted describing market risk as the possibility of an investor incurring loss in his or her trading operations at the financial market due to moves in market factors. There are four main market risk factors that are namely; currency risk i.e. risk that foreign exchanges rates will fall, equity risk that is risk in the fall of stock prices, commodity risk that is the risk in fall of prices of commodities such as gold or oil and lastly interest rate risk which is the risk that interest rates will change and erode returns.
Credit risk also known as risk of default on the repayment of debt, is in the financial markets described as risk that affects trading operations when an investor fails to take up securities he or she had initially bought or takes up the delivery and fails to pay at settlement of derivative contract.
Operational risks in the financial market are described by Scholes (1972) as the risks that originates from players in the market and the entire process at the financial market. Mistakes by brokers and even fraudulent activities by them amount to operational risk, in addition factors such as technological failures, poor management, errors in financial reporting, rogue trading i.e. brokers making personal gains from funds of investors and lack of control and accountability all amount to operational risk in the financial market.
Lintner (2005) in his studies outlined some of the risks that stock investors are exposed to while trading in the financial market that include economic risks of which individual investors are at risk of the economy turning sour anytime like in the recent global economic recession experienced between 2007 and 2010 and the great depression of 1930's, these two scenarios of economic crisis resulted into stock investors incurring huge losses from the market. Inflation is also another risk that stock investors are faced with as it erodes value of most of their fixed incomes and when the market doesn't respond to anticipation of investors even in good stock they are said to be faced with market value risk.
Financial analyst and business advisors have also documented some risk in investing in bonds that involves the risk of reinvesting bonds at a lower rates than what the bond initially provided, interest rate risk that reduces the value of fixed rate of returns, the risk that bonds will be called back by its issuer and also the risk that issuer will fail to pay investors their duly earned interest and even the principal amount.
Investors in the international financial market are faced with other unique risks like the exchange and transfer risk deriving from the foreign exchange risk, the sovereign risk as well as the political risk.
Techniques used for risk analysis in the financial markets
Stock market risk analysis techniques
There are two generally applied and comprehensive techniques for measuring risks at the stock market that can also be applied at the general business field and they include; the standard deviation method and the co-efficient variation method. The standard deviation is the measure of disport ion from the mean or expected cash flow; it is always prudent to incorporate the risk premium rate to arrive at the rate that it is to be used i.e. risk premium rate will be added to the risk free rate to arrive at a composite rate to discount future cash flows, important to note is that the higher the standard deviation the more risky the stock is assumed to be. The co-efficient of variation is a relative measure of risk because it considers the risk against the expected cash flow it is used to compare stocks of unequal values, the higher the co-efficient of variation the higher the risk of the project.
Stock investors can use the historical volatility of interest rates to measure its risk and there is also other comprehensive ways of which this can be measured and it involves using mathematical models to forecast interest rates scenarios. Credit risk is easily measured from the credit rating agencies who give credit rates to companies and their stocks. Liquidity risk can be assessed using the bid-offer spread, the less the spread is the less risky the stock is and when the spread is long the more risky the stock is.
Operational risk can be calculated using three different approaches that include; standardized approach, basic indicator approach and the advanced measurement approach. Both the standardized and basic approach assesses capital requirements based on revenues while the advanced measurement technique uses risk measurement techniques which have been established by the industry.
Bond market risk analysis techniques
Jensen (2009) in his studies applied the capital asset pricing model to measure the risk of bond investments. He goes on to say that to use the CAPM one must first of all calculate the bond's beta, the expected return on the market and the nominal risk free rate. Bonds with betas that are greater than one are viewed to be more risky and bonds with betas of less than one are considered to be less risky.
The other way of measuring risk in bond investments is by looking at the yield for example what the Australian government bonds are offering in respect to individual investor horizon i.e. For a 5-year investments consider the yield of a 5-year bond. Add the yield together with the premium and the result will be the risk figure (Bollerslev, Engle and Wooldbridge, 2008).
Its is rather difficult to assess risks such as geopolitical risk or economic risk as these risks are out of control of the financial market and hence neither can they be controlled or measured. Political and economic risks happen at unexpected times, which could be due to various reasons that include natural calamity like the floods in Australia, terrorism scare or attacks and even economic meltdown or recessions. Consequently such risks are hard to measure but necessary steps have been adopted to mitigate their effects.
For foreign exchange risk in the international market, the only technique that are available, is like the forward contracts that only help in predict the foreign exchange rate in the future and such techniques can be used to mitigate the risk arising out of foreign currency exchange in the international market.
Objectives of risk analysis
Risk analysis is conducted primarily to ascertain whether a particular investment in the financial market is viable or not, for example a more risk investment is not advisable for a risk avers investor however it is important to note that the more risky an investment is the more returns it is likely to make in the financial markets, this according to Friedman and Hahn (2007).