Download PML_Paper3_Financial Risk

Paul Mihai Lazureanu
Paper 3 – version 1
December 6, 2012
Math 89S – Game Theory and Democracy
What are financial markets?
A financial market is a system that facilitates the trading (buying and selling) of financial
securities (such as stocks), commodities (oil or agricultural products) and any other fungible
items of value at low transaction costs and at a fair price, which is set through the free market
mechanism of interaction between supply and demand. In economic theory, financial markets
are deemed to be the real markets that best emulate the concept of perfect competition, and
as such are the most efficient markets in existence, offering consumers the best possible prices
while also fulfilling the needs of the producers who supply the market with the products that
are traded.
There are significant differences between the world’s numerous financial markets, but in the
end they all serve the same basic functions. Arguably the most important role of financial
markets is to set the prices of goods and assets. The latter can be either financial, such as stocks
and bonds, or non-financial, such as real estate or industrial equipment. Furthermore, financial
markets facilitate the raising of capital by firms that need money to make investments and
expand their business, but they also offer a platform for commercial transactions between
different companies or people. Additionally, financial markets provide firms and people with an
opportunity to invest funds that are not needed immediately and hopefully earn a return on
these investments in the future. Last but not least, they probably constitute the most powerful
risk management tool that is available to businesses. Financial instruments such as futures,
options and other derivatives were specifically designed to offer protection against various
types of risk, say for example, the risk that a foreign currency will depreciate against the
domestic currency of a company that is supposed to receive payment in that foreign currency
for exported goods. [1]
Risk in financial markets
It is obvious that any financial transaction involves a certain amount of risk for the parties that
are engaged in that transaction, and this varies based on the nature of the transaction, as well
as its size. Although the financial markets offer instruments that can protect against these risks,
they will only do this if used properly. Misuse of derivative instruments can significantly
increase financial risks instead of allaying them, which in extreme situations can lead
companies, or even people who are involved in trading, into bankruptcy. If financial risk would
only affect the entities that are directly involved in risky financial transactions it would not be a
significant problem, because those entities implicitly accept the risks that are intrinsic to their
financial instrument of choice. However, the defining characteristic of modern financial markets
is that they are almost completely interlinked. We can imagine all investors and traders
operating on the hundreds of different financial markets as forming one single complex system.
The high speed at which information travels in the modern world, in addition to globalization
and increasingly free trade between different countries have resulted in almost immediate
interaction between the various global financial markets. The bankruptcy of some major bank
in France a hundred years ago would have definitely lead to a crash of the Paris stock exchange,
but its effects would have been limited to France and, possibly, its neighboring countries.
However, if BNP Paribas, France’s largest bank, were to declare insolvency tomorrow, this
would probably lead to a global panic in financial markets, similar to the one caused by the
failure of Lehman Brothers in 2008. This close interconnection of modern financial markets has
the effect of compounding the risks that are taken by various investors in various markets.
Thus, it is conceivable today that a relatively small number of reckless investors who take on a
large amount of risk and lose money as a consequence of this could cause a global financial
crash. [2] It seems like modern financial markets would be very similar to a ticking time bomb if
investors would be allowed to operate freely and take on as much risk as they desire. This is
however not the case, as governments all over the world are constantly working on regulating
financial markets, so that reckless speculators cannot cause losses to anyone but themselves. [3]
As described above, different financial instruments involve very different amounts of risk that
are usually, but not always, in direct correlation to the complexity of the specific instrument. In
the following paragraphs I will attempt to describe how risks affect some of the most widely
used financial instruments, while also analyzing the implications of these risks for the market,
and even the economy, as a whole. While uncertainty is essentially the cause of any kind of
financial or economic risk, different financial markets compound the effects of unexpected
events at very different magnitudes.
The bond market is generally considered to be the least risky financial market; this does
however by no means mean that the bond market is even close to being risk free. A bond is a
debt security, because it represents a debt that the issuer of the bond must repay to its buyer
with a previously specified interest in a certain time period. Thus, if an investor buys a 10 year
US government bond, he or she effectively lends money to the government over a 10 year
period. By selling the bond, the government obliges itself to repay the loan when the bond
matures, in this case after 10 years, but also to pay interest on the loan at a previously specified
rate. Bonds can be sold not just by national government, but also by any private company or
government institution that cannot or does not want to borrow money from banks. They can
also be traded freely on the bond market by their owners at any time between their dates of
issue and maturity. The best way to quantify the risk that bondholders are taking is to measure
the ability of the issuer to repay its bonds, more specifically the probability that the bond issuer
will not be able to fulfill its payment obligation when the bonds mature. Fortunately, investors
don’t have to spend countless hours analyzing the financial information of companies or the
state of public finances of a certain country in order to make sure that their bond investments
are secure, as this is exactly what credit-rating agencies do. These institutions examine the
financials of virtually all bond issuers, as well as any other information related to the markets or
national economies that are of relevance to these bond issuers, and assign a credit rating to
every single issuer. This credit rating is supposed to be the best possible approximation of the
probability that a bond issuer will default on, or not repay, its debt. The higher the credit rating,
less likely it becomes that a government or corporation will default on its current bonds.
Historically, governments with the highest credit rating (usually called AAA) have never
defaulted on their debt, and investments in bonds with high rankings, also labeled investment
grade, have been very safe. Most bond investors prefer to buy highly rated bonds, in order to
make sure that their money is safe. However, as riskier bonds tend to pay higher interest, some
investors choose to buy low-rated debt in order to achieve higher returns. These riskier bonds,
also called subprime bonds, have caused investors to incur significant losses during economic
downturns, such as in the years 2000 and 2001. Nevertheless, investors are usually very well
aware of the risks they are taking in order to receive higher interest payments due to the low
debt ratings of high-yielding bonds. The ratings issued by the largest credit- rating agencies
have historically been very accurate, with the notable exception of major systemic crises. Such
events, most notably the financial crisis of 2008, usually affect all global financial markets as
well as the global economy, and thus might even make top-rated bonds seem risky. However,
as such rare events lead to depreciation in the price of all assets, whether financial or nonfinancial, a safer alternative to bonds will probably by very hard to find. [4]
The following is a comparison of the credit-rating scales of the three major agencies:
[5]
Another class of financial instruments that is generally considered to involve low risks contains
equity securities, more commonly called shares or stocks. The stock market is very similar to
the bond market, in that its main function is to supply capital, albeit in this case only to
corporations and not to national governments. By buying a newly created share of a company,
either in an initial public offering (IPO) or after the company has already become public, an
investor offers the company funds that it can invest into expanding its business or financing any
other sort of financial needs. In return for these funds, the investor gets part ownership of the
company in direct proportion to the amount he has invested, as well as the right to vote on
major company decisions and to receive part of the company’s profits through dividend
payments. However, unlike bonds, shares do not oblige firms to make any sort of monetary
payments to their shareholders; the latter will only be able to profit from their investments if
the company is successful. For this reason, stocks are generally perceived to involve higher
risks, as well as higher potential returns, than bonds. As bond contracts compel companies and
other institutions to repay their bonds no matter what, it is highly unlikely that bondholders’
investments will suffer losses. This being said, bond investors also have no way to profit from
the success of a company, as the interest payments they are entitled to are fixed. Stockholders
on the other hand can demand that a successful corporation share a part of its earnings with
them, which makes the return on their stock investments directly reliant on the stock issuer’s
economic success. However, just as investing in a company that turns out to be highly
successful can be very lucrative, a bad investment choice can potentially cause huge losses.
Fortunately, there is a simple way in which novice stock investors, or any investors that don’t
want to take on too many risks, can protect their assets. Instead of investing in only one or a
couple of stocks, an investor can choose to add much greater diversity to his or her holdings.
The easiest way to do this would probably be to equally divide your shares between the largest
500 American companies (contained in the Fortune 500 list), or even the largest 500 global
companies. Nowadays, investors don’t even have to possess the actual shares of so many
companies in order to own a diversified portfolio; one can simply buy shares of an exchangetraded fund, or ETF, an investment fund that owns the shares of a variety of companies and
sometimes even tracks a specific stock index. Thus, by owning stock in the SPDR S&P 500 ETF
(SPY), an investor would indirectly own shares in all companies that are part of the S&P 500
stock index, that is the 500 companies that are deemed to be the most representative of the
performance of the US economy. As the following logarithmic graph of the value of the S&P 500
from 1950 to 2008 shows, the previously described investment strategy would probably have a
very good chance of delivering a good return, especially in the long run.
[7]
Although such highly diversified stock investment strategies turn out to be almost risk-free in
the long run, most proficient investors avoid them because the returns that they generate are
far inferior to more targeted investment strategies. Some investors do therefore take on a
significant amount of risk in the stock-market in the hope of gaining considerable profits. Even
so, this does not pose any kind of risk to other stocks, financial markets or the economy as a
whole. If speculators mistakenly drive the value of a specific stock up, and it later collapses, by
as much a 90% in some cases, this shouldn’t normally hurt other companies or investors. This
relative independence of stock prices relative to each other, coupled with the existence of
various options to diversify one’s stock portfolio, makes the stock market less prone to both
systemic and individual risks than almost any other financial market. Nevertheless, as is always
the case in financial markets, it is possible for an investor to lose money even if his assets are
considered almost risk free. [6]
One of the basic functions of financial markets is to price risk. A consequence of this is the fact
that markets tend to also reward investors who take on the most risk, thereby creating a
general rule of trading, which states that the assets that contain the most risk also offer the
possibility to earn the most substantial profits, as well as the highest losses. Naturally, there is a
category of usually very sophisticated investors who are willing to accept taking big risks with
the goal of earning huge profits. In order to satisfy the needs of this group of investors,
brokerage firms and investment banks have come up with a type of financial instruments that
does exactly what these traders desire, maximize both risk and potential profits or losses. The
members of this relatively new family of instruments are called financial derivatives, because
they derive their value from an underlying asset, without implying the actual possession of that
asset. Thus, derivatives are simply contracts between two entities, which specify under what
conditions that are related to the underlying asset a payment is to be made between the
contracting parties. Possession of a derivative contract does in no way involve the ownership of
the underlying financial or non-financial item of value, as derivatives are simply a way to earn
money by accurately forecasting evolutions in financial markets. The purpose of financial
derivatives being large profits, they naturally create significantly higher amounts of risk than
traditional instruments (like stocks and bonds) for individual investors and financial systems as
a whole. In the next paragraphs I will try to discuss the risks involved in trading two of the most
popular types of derivative instruments, equity derivatives and credit derivatives. [8]
One of the most common equity derivatives is the contract for difference, or CFD. CFD’s involve
margin trading, because they allow investors to buy or sell shares using money that is borrowed
from the stockbroker. The investor who is involved in margin trading is required by his broker
to deposit a margin, or collateral, with the stockbroker in order to cover his credit risk. As the
margin requirement is usually less than 1% percent of the total value of trading positions that
can be opened, margin trading through CFD’s allows investors to perform trades that are worth
more than 100 times the amount of money they have deposited in their accounts as collateral.
This allows margin traders to reap huge profits if their predictions are proven accurate, profits
that can range to as much as 500 times the amount they would have earned by only using their
own money to invest in stocks. However, the magnitude of the losses that can accrue as a result
of margin trading is just as large. Thus, an investor can literally lose all the money that he
deposited in his stockbrokerage account in a matter of minutes due to sudden changes in stock
prices. In this case, the stockbroker will issue a margin call, informing investors that they have
to increase their margin (money deposited as collateral) in order to protect their open trading
positions. If the investor cannot provide the required amount of money immediately, the stock
broker will close all positions automatically to avoid having to cover the client’s losses. Such
situations, which are not at all unusual in CFD trading, will almost always result in total losses
for unfortunate investors. Besides the huge amounts of risk involved, margin trading also
implies higher costs for traders, as the money used to acquire stocks is usually loaned by
stockbrokers and banks at considerable interest rates that can go as high as 15%. Equity
derivatives are undoubtedly enticing financial products, as they enable traders to obtain
enormous profits. However, I think it is very important to understand that CFD trading is, unlike
stock trading, a zero-sum game. A CFD is a contract between two parts, involving opposite bets
on the evolution of the price of a certain security. Inevitably, one part will win the bet and the
other will lose the bet. CFD’s don’t provide any other earnings, such as dividends, that might
offset a decline in share price, so the earnings of one investor are at the same time the loss of
another investor who has opened an opposite trading position (buy or sell a.k.a. long or short).
Risk –reducing strategies found in the equities market, such as long-term diversified investment
are also not available in margin trading, as the high interest rates charged on invested funds
make holding a position open for a very long time cost-prohibitive. Margin trading in the equity
derivatives market is thus one of the riskiest forms of trading for the investors that are involved
in it, but it does not pose any sort of risk for the financial system. As stockbrokers can always
cover the losses of their clients from the provided margin, their solvency (the ability to fulfill
payment obligations) and consequently, the solvency of any other financial institutions that are
not directly involved in margin trading, will not be threatened. Nonetheless, the U.S. Securities
and Exchange Commission, or SEC, has imposed significant limitations on CFD trading in the US
in order to protect unwary investors. [9]
Credit default swaps, or CDS’s, constitute another type of financial derivative that is considered
to be a significant source of risk for the financial system. Interestingly, the initial purpose of the
CDS was to protect banks and bondholders from credit risk. Bearing a lot of similarity with
common insurance policies, a CDS is a financial agreement which stipulates that the seller of
the CDS will compensate its buyer in the event of a loan default. In order to receive the right to
such compensation, the buyer must pay a regular fee to the seller of the CDS, as is the case with
almost any other insurance policy. The only reason why a CDS is deemed a financial derivative,
instead of a loan-insurance policy, is the fact that anyone, and not just the actual lender, can
buy CDS’s for any loan or bond. Thus, the CDS is a derivative product, which is usually but not
always sold by insurance companies, that allows speculators to profit from the inability of any
country, corporation or even person to repay a loan or a bond, but it also serves to protect
banks and other financial institutions that own debt assets. The ability to ensure financial and
non-financial assets is already built into the financial system as one of its main functions and is
provided by insurance companies. As is the case with any type of insurance, the price of credit
insurance is directly proportional with the risk of the insured loan not being repaid. Insurance
companies generally keep a substantial part of the credit-insurance fees they receive in a
special fund, which is used to repay lenders in case of a credit event that involves a default.
Insurers generally calculate the size of their reserve funds based on approximations of the
probability that various types of credit events will happen. This is generally done by using a
normal distribution model, also known as a Gaussian function (pictured above). Under this
model, minor credit events are placed closer to the mean of the distribution function’s domain,
as they are the most likely to happen. The probability of a default happening is in opposite, but
non-linear, relation to its size. The normal distribution function thus predicts a very low
probability for large scale defaults, such as the bankruptcy of a major bank or national
government. While it is relatively easy to use statistics to estimate how many mortgage
defaults one insurance company will have to cover in one year and how much they will cost the
company, it all but impossible to predict when a large scale credit default will hit. Credit
defaults of such size only happen once every few decades on average, which is why statistics
cannot be used to predict when they will take place. Insurance companies generally have
enough reserves to cover all but the most unpredictable credit events, also called “black swan
events” due to their high profile and unpredictability. The introduction of the CDS has had the
effect of amplifying the size of most credit defaults, as insurance companies now have to pay
both the owners of the actual debt and any holders of CDS’s for that debt. As insurers collect a
fee for any CDS they sell this should not be a problem. However, CDS’s tend to be cheaper to
buy than traditional insurance, as speculators don’t have the same need to insure their assets
as actual lenders. Therefore, insurance companies had to reduce the fees associated with credit
swaps in order to make them attractive to investors, which translated directly into lower cash
reserves as a proportion of the value of insured assets. Under normal circumstance this is by no
means a problem, as insurance companies still possess sufficient funds to cover the average
number of credit defaults. However, an unexpected black swan event will prove disastrous for
an insurance company that will have to repay CDS’s worth many times the value of real loans.
Such a situation is exemplified very well by the 2008 insolvency of American International
Group Inc.(AIG), whose financial woes were exacerbated by the numerous CDS’s on mortgage
loans that it had sold to speculators who were betting against the subprime mortgage market.
Although under normal conditions it would have been a profitable company, the number of
credit defaults that AIG had to cover during the 2008 financial crisis was so great that the
company eventually required 182.5 billion dollars in government assistance to be able to meet
all its payment obligations. [10], [11]
Credit swaps, like many other innovative financial instruments, were initially invented in order
to fulfill legitimate economic needs of the financial system, and in successfully doing so they
have had a highly beneficial impact on the economy. The problem lies, in my opinion, with
financial products whose sole purpose seems to be providing speculators with yet another tool
to reap profits. Reckless speculation based on CDS’s by traders who were able to predict an
oncoming financial crisis has probably amplified its severity, costing taxpayers hundreds of
billions of dollars to save the financial system and the economy. Similarly, margin trading can
be used by some to make enormous amounts of money overnight, while it probably renders
many others bankrupt. Bond and equity markets on the other hand serve a very important
economic function, providing governments and corporations with relatively cheap capital while
also providing investors with numerous good alternatives to the banking system. Derivatives do
not always serve economic interests, but they do always serve speculators who want to earn
money by correctly predicting the behavior of markets. For this reason, derivative markets
sometimes resemble a casino better than the traditional financial markets on which they are
based, and while I do not believe there is anything inherently wrong with gambling, I think that
financial gambling has to be very strictly regulated, as the potentially disastrous consequences
of this not happening have been very well highlighted over the past few years.
Sources
1. Marc Levinson, “The Economist Guide to Financial Markets”, 2010, pp. 1-3
2. Andrew Leonard, “Bear Stearns: Too interlinked to fail”, 2008
web <http://www.salon.com/2008/04/04/too_interlinked_to_fail/>
3. Randall Dodd, “Should the government do more to regulate financial markets?”, 2003,
web http://www.financialpolicy.org/FPFwsjclassroom.htm
4. Marc Levinson, “The Economist Guide to Financial Markets”, 2010, pp. 58-76
5. http://www.municipalbond.org/wp-content/uploads/2009/02/bond-table1857x1024.jpg
6. Marc Levinson, “The Economist Guide to Financial Markets”, 2010, pp. 132-168
7. Yahoo Finance, web
< http://finance.yahoo.com/q/bc?s=%5EGSPC&t=my&l=on&z=l&q=l&c=>
8. Rene M. Stulz, “Demystifying Financial Derivative”, 2005, web < http://www.cob.ohiostate.edu/fin/faculty/stulz/publishedpapers/milkeninstitute_pubpaper.pdf>
9. Bullbearing Ltd., “CFD trading guide”, web
< http://www.bullbearings.co.uk/cfd.trading.guide.php>
10. Marc Levinson, “The Economist Guide to Financial Markets”, 2010, pp. 226-229
11. Hugh Son (Bloomberg L.P.), “AIG’s Trustees Shun ‘Shadow Board,’ Seek Directors”, 2008
Web
< http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aaog3i4yUopo&refer=us>