Here is an essay on ‘Risk Management in Investment Banking’ for class 11 and 12. Find paragraphs, long and short essays on ‘Risk Management in Investment Banking’ especially written for school and college students.
Introduction to Investment Banking:
Investment banker functions consist of investment in securities such as equities, debentures, bonds, and government securities. It involves trading i.e. buying and selling of securities, commodities and derivatives. Derivatives trade may be for hedging or for profit. In order to understand essentials of risk management in investment banking and derivatives trade, the following information will be useful.
Bombay stock exchange and National Stock Exchange are two important institutions for securities trade. Likewise commodities exchange or commodities and derivatives exchange are important institutions for commodities trade. Trade always takes place through brokers. Buying and selling can be done from any place as the trade is online. While equities and bonds are familiar financial instruments, derivatives and commodities are of recent origin and somewhat unfamiliar to many investors.
Most importantly the difference between securities trade and derivatives is that in case of securities trade while buying or selling one has to pay and take delivery of the scrip or deliver scrip before taking payment as the case may be, but in derivative trade there is no need of giving delivery or taking delivery of an asset but only the difference in contracted price and spot price (market rate) is settled. Rules and procedures are similar for commodities trade and also stock and securities trade.
Risk in trading of financial instruments is managed with appropriate derivative instruments such as forward, future, option and swap. In other words, a derivative is a contract whose value is derived from the value of equities bonds, currencies, stock index etc. which are called underlying asset. Most common derivative instrument is are forwards, futures, options and swaps.
Market Risk of Investment Banking:
Risk involved in stock and securities and commodities trade is price volatility. Stock price is not stable but changes with high frequency. The risk may be systemic or unsystemic. Unsystemic risk means a particular company’s share price change due to company specific reasons. Systemic risk means the change in price will be due to reasons affecting the entire market.
Liquidity risk arises on account of inability to sell the securities at the market due to lack of buyers. Counterparty risk arise out of brokers failure to deliver the security or cash on due date. Cash flow risk arise on account of nonpayment of cash at the time of delivery. Operation risk arises out of procedural errors, omissions, fraud, forgery, delay etc.
Most of these risks to a large extent may be contained through derivatives. It is a contract for mitigation of risk in the original contract. Derivatives are used only to protect against risk. It is not the original transaction. But only a supportive trade for the main contract.
Forward and Futures:
Forward contracts are agreements between two parties to buy or sell an asset at a predetermined price on a future date. Futures contract is similar to forward contract on the basics. But differs on certain important aspects. Futures are a standardized contract traded in a recognized stock exchange. The trade will be for a standard quantity as specified by the exchange.
In forward contract it is left to the parties involved to fix the quantity they want to trade. Another important difference is that in case of futures contract the stock exchange plays the role of counterparty in case failure of the buyer or seller. But in forward contract there is no such possibility and hence it is prone to counter-party risk. The terms that are standardized in futures are Quantity, Quality, Delivery date, Unit price and location of settlement.
In option contract buyer of option has right but not obligation to sell or buy. In option contract the buyer can get out of the contract, but has to forgo the option premium paid in advance. However, the writer of option has no such privilege and has to fulfill his part on demand. On the other hand a forward or future contract is one where both parties are bound by the contract and bound to honour the terms. Option can be call or put option.
Call option means right to buy but not on obligation to buy a specified asset at a specified price. Put option means, right to sell a particular asset at a particular price. But there is no obligation.
There are two types of options viz.,
i. American and
ii. European type options.
American type option can be exercised at any time during the period specified in the contract. In European option it can be exercised only on the due date.
Basis Risk in Investment Banking:
The risk that the investments in a hedging strategy may not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position. In other words an imperfect hedging strategy would lead to basis risk.
The basis risk is the difference between future price and spot price. The situation can arise when the spot price on the due date of future contract may be more favourable than future price. That means one would have been better off without a future contract but the party cannot get out of future contract. But the important point is without future contract in place the person will face the risk of uncertainty of price.
Swap Contract in Investment Banking:
Swap deal is exchange of one for the other. More well-known swaps among the banks are interest rate swap and currency swap. In these contracts while the risk of loss is protected but there is no possibility of profit. Some are comfortable with fixed rate of interest and some others may prefer floating rate.
Here lies the scope for swap and thus cash flow on fixed rate loan can be swapped for variable rate. So also instead of buying or selling a specific currency there can be exchange of one for the other, say euro for U.S. Dollar. In other words a person can swap his receipt in U.S. Dollar for his payment liability in Euro.
Derivatives trade has an element of risk more than simple buying and selling of equities and bonds. It is not advisable for; someone with limited resources and limited knowledge in investment and trading with low risk tolerance to use derivatives.
An investor should therefore consider whether the use of derivative is in conformity with his investment objective, resources, knowledge and skill. While the brokers or others may argue that there is high profit in it with low investment, one cannot forget the fact that high profit always carry high risk.
Aspects of Investment Banking:
The purpose of investment in stock market is to make profit. Therefore the basic tenet is “Buy low and sell high” subject to safety, income and growth potentials. The decision to buy, hold or sell has to be taken with due care and judgment. Timing is very critical to decide on investment. Investor should be clear about the purpose or goal of investment.
It can be for periodical income to supplement existing income or it may be for accumulating the gain to a reasonable size for post-retirement need or to acquire a high value asset. The time frame should be decided, as to whether investment is for short period, medium term or long term.
In view of electronic trading one can buy or sell and reverse the transaction on the same day to make profit on price movement within a day. This is called intra-day trading and speculative in nature. Small investor should avoid such trade.
Bonds are known as fixed income securities, they are of different types. Zero coupon bond is issued at a discount and redeemed at face value on the due date. Regular bonds are issued with a face value and promised interest payment at a particular rate periodically. Convertible bonds are hybrid instrument.
After a particular time period, part value or full value will be converted into equities and if it is partly convertible, the unconverted portion will continue as bond and redeemed on due date. Here the term bond includes, debentures and other fixed income securities.
The bonds may be issued by private corporates, public sector undertaking or the Government. The value of the bonds will be redeemed after a specified period. But market value of the bond will vary from face value based on credit rating and remaining period (duration) for repayment.
As said elsewhere the market price of fixed income securities is inversely related to market rate of interest i.e. when market rate of interest goes up bond value in the market goes down and vice versa. Hence bond valuation is little complex.
The equities otherwise known as shares can be ordinary shares or preference shares. Shares are eligible for periodical dividend. Some good companies from out of the accumulated and undistributed profit, issue additional shares known as bonus shares free of cost.
Some shares are classified as blue-chip (highly rated good company shares). They are also classified as large cap, mid cap and small cap shares based on market value i.e. high, medium and small. Financial data on individual scrip’s and the market price will be available from financial dailies and Magazines. The company’s balance sheet and profit and loss account is yet another source of information on the company performance. These documents will be distributed to every share holder annually.
The market for securities is known as bond or debt market, stock (equity) market and money market. Money market is an exclusive club of commercial banks. They deal in short term loans, commercial papers and certificate of deposits. Money market is the avenue to the corporates to raise short term funds or invest short term surplus cash (less than a year). But they have to deal through a bank. Major operations consist of interbank lending and borrowing.
Mutual Fund and Hedge Fund:
The names sound similar but they are two different types of funds whose objectives and investment process are totally different. Mutual fund is meant for long term investment with a diversified portfolio. It is more safe than direct investment in stock market. Although mutual funds may not assure safety of capital and dividend or payout, but, it is generally conservative and therefore safe from the investor’s angle.
On the other hand hedge funds do many things other than long term investment. It engages in short sale, arbitrage, complex derivatives, Leveraging or large borrowings, fancy investments etc. Hedge fund does not hedge the risk but rather go for high risk and return. There may be possibility of huge return but there is every possibility of disaster also.
Even if one steer clear of derivatives and hedge funds and engage only in conventional buying and selling of stocks, there are several risks the investor has to manage, viz. concentration risk, systemic risk, un-systemic risk, price risk, interest risk, liquidity risk, counterparty risk, cash-flow risk and operation risk. There are several theories on management of the risks and more importantly volatility in price and how to mitigate it.
Two important strategies to identify and analyse the risk are:
(i) Fundamental analysis and
(ii) Technical analysis.
Both are not alternatives, but complementary. Fundamental analysis is somewhat similar to that of the bankers analysis of credit worthiness of the borrower before lending. It includes the study of company background, product, image, management, state of industry, competition, balance sheet and profit and loss account, future plan etc.
The technical analysis study the movement in market price over a period of time to guess the future price. The first one reveals the strength of the company. Second one, the market perception.
The other risk is interest rate changes which affect securities trade more specifically fixed income securities. Increase in the rate affect the profit of the company and also trigger fall in the value of the bonds and debentures, issued by the company. There will be contrary effect if the rate falls. These are the factors to be considered and consequences analysed by an investor/investment banker in an ongoing basis, to avoid market risk.
Oscar wilde said that people know the price of everything and the value of nothing. It is true in stock market. The price of stocks is easily available in the stock market quotations. But the value of the company and its share is difficult to judge or know.
There is also a humorous comment on investment. If there are fools to buy or sell shares on the hope of increase or decrease in price, there are always bigger fools to sell or buy the same for a contrary reason. May be there is some truth in it.
Risk faced by Investors:
The common risk in investment activities are:
(1) Losing the principal amount.
(2) Volatility of stock prices. Coupled with huge fluctuations in price.
(3) Unpredictable market movements.
(4) Difficulties in marketability of stocks quickly at reasonable price.
(5) Liquidity risk i.e. convertibility of stocks and bonds into cash.
(6) Unfavourable change in tax laws and policies.
(7) Inflation risk and consequent loss in a value of investments
(8) Problems involved in follow-up of corporate actions i.e., payment of interest on bonds and dividends on stocks. Declaration of bonus etc.
(9) Change in interest rate and the consequent adverse impact.
(10) Financial risk i.e., Default in repayment of principal and payment of interest.
(11) Psychological impact besides financial loss on account of market crash due to political or economical crisis, natural calamities, etc.
(12) Poor understanding and appreciation of risk reward mechanism.
(13) Over confidence on certain corporates on account of their size, age etc.
(14) Blindly following the crowd particularly in a booming market.
(15) Mourning over the loss instead of learning from loss.
(16) Depending too much on the so called market reports. When in reality there is no one, who can on most occasions if not always predict the market correctly.
An ordinary investor’s investment by itself may not be a significant amount but all such investors collectively account for a substantial portion of the market. But the drawbacks of the small investors are that they are not well informed. Rather many of them are not familiar with investment strategies and market activities.
Most of them are poorly informed on those matters and their ignorance may be taken advantage of by the share broker, investment advisor and others. The investor should know certain basic things about investment and the risk associated with investments. For a small investor investment in shares and bonds is a complex work.
First of all the investor should be clear about the purpose of investment, viz., whether it is for regular periodical income or long term capital gain and accordingly investment plan will differ. Although everyone is clear that the purpose of investment is to generate income/profit, investors generally do not know the ways and means.
The sources of gain/profit may be periodical dividend on shares and interest on bonds or increase in share price or issue of bonus share. In case of bonds if the market rate of interest goes down, market price of bonds will go up but there will be no change in the periodical interest payment. Likewise there will be a decrease in respect market value of bonds, if the interest rate goes up.
But the periodical interest payment will not change. The effect of stock split or merger is little complex. The investor has to necessarily understand the implications or seek information from the investment banker. It is generally very difficult to guess the changes in market. Trading requires choosing the right time to sell or buy to reap better benefits. Good or bad thing affecting the share price may be company specific or market related.
They have to be viewed and judged appropriately. Finally investor should know how much gain justifies taking risk in market operations. The bench mark is return on zero risk investment (say Government securities or Bank Deposits) and then one should decide how much more to expect to justify the risk in investment.
The judgment on the extra is not easy to make. The risk is that an investment banker may fail to inform the investor in time and appropriately. The failure to do right things either due to ignorance or carelessness of the investment banker will place investors in Jeoparoy.
The investment bankers and so also an individual investors face risk and uncertainty in stocks (shares) and bonds trade. The investment bankers are in a better position with their access to information and research capabilities. But small investors are worse off to a great extent due to lack of access to information and lack of knowledge to analyse and judge market trend.
Both of them should bear in mind the following truths:
(1) There are times not to break the time tested rules and precedents. But there may be situations in which they cannot implicitly follow them with safety. It is difficult to distinguish the two situations.
(2) Stock market operation risk is difficult to recognise and act. It is like the difficulty in correctly describing a tree. Although it can easily be recognized when one see a tree. Likewise stock market risk is not easy to anticipate or recognise, but easy to understand when it strikes.
(3) Market is by and large efficient but at times it is overwhelmed and becomes erratic. The actual cause may be weighty or silly.
(4) There is no mathematical or computer generated model to correctly predict market failure or crash.
In the circumstances any investor big or small should have plan and have clear idea on the following, as otherwise risk will be inevitable:
(1) Purpose or objective of investment
(2) Time horizon i.e., whether investment is for short term or medium term or long term gain.
(3) Style of operations (aggressive, moderate or conservative).
(4) Constant market watch on price movements and also disturbing or facilitating financial and other news.
(5) Periodical calculation and review of expected return and actual return and accordingly change the mix of investments. A good investor should not be contended with gain alone but should compare the actual gain with expected gain.
(6) Dividend amount, stock repurchase, stock split, bonus, merger or acquisition are matters to be analysed to judge the worth of the investments. Industry specific or company specific good news and bad news are very important to anticipate and measure gain or loss and also to decide whether to sell or hold or buy.
(7) It is always better to adopt an approach of safety, income and growth together and accordingly decide to buy, or hold.
(Forward, Future, Option and Swap Contracts):
Extensive use of derivatives to enhance revenue/profit is a recent phenomenon. Derivative as a financial instrument has only a brief history. In the beginning many thought of it as a mystery. But little later it was considered complex which only experts can handle and much later everyone, tried their hands and found exciting.
Slowly it became a matter of prestige and those who cannot handle were not considered as financial experts. Now fortunately or unfortunately many consider derivative as highly risky and even dangerous by some.
Volatility in stock price, currency rates and interest rates was there always which has now become intense. Good old days simple hedging was thought as appropriate measure to manage price risk. In due course complex derivatives as hedging instruments were designed enlarging their scope from protection to profit, culminating into super profit.
Although derivatives have become more and more complex, sense of complacency over shadowed the fear of risk. System generated mathematical model replaced time tested hard calculations based on experience and common sense. Down fall of financial giants of the west in the recent past shocked and surprised the lesser mortals all over the world.
Derivatives for hedging and derivatives for earning super profit are two different ball game. If one is conscious of the purpose and use derivatives appropriately the risk element although, may not decrease or disappear, the outcome will not shock or surprise the players. High risk means high profit or huge loss.
Wisdom lies in the saying “There is enough for every one’s need and not greed”. It is also good to remember the word of caution in the Murphy’s law “if anything can go wrong it will go wrong”.