Finance 550 Assignment 2: Risk is Chiefly Fundamental to Investing (Research Paper Sample)

Finance 550 Assignment 2
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Finance 550 Assignment 2
Introduction
In their research study, Souder & Myles (2010) identify that risk is chiefly fundamental to investing. Böhringer & Löschel (2008) further add that there is no discussion of returns or performance that is deemed meaningful in the absence of at least some mention of the involved risk. However, the trouble for investors, who have just entered into the marketplace, involves the process of figuring where risk really lies, as well as what the difference between the various levels of risks. Relating to the manner, in which risk is fundamental to investments, a significant number of new investors tend to assume that risk is a well-defined and quantifiable idea. However, it is not the case. As such, a universally agreed definition of the term, and how it should be measured, has not been attained. Central to this paper are high-risk investments. It is a form of an investment where there is a larger percentage chance of capital loss or a high likelihood of underperformance. The purpose of this paper is to research high-risk investment brokerage firms that have been indicted or convicted of ethical violations to provide insight and understanding of this market segment. To realize this objective, the Internet will be used as the chief research method. The information sources will be derived from academic databases, such as Wiley Online Library and ProQuest.
The given paper is divided into six sections. The first section will attempt to explain why investors may be attracted to high-risk investments, such as exchange-traded derivatives, global funds, and other complex investment vehicles. The second section will concern the analysis of the risk associated with exchange-traded derivatives, such as futures and options, and what brokers might do to minimize the risk to investors. The third section will involve a discussion of the challenges related to regulating a complex global financial firm, and make suggestions for regulatory improvements. The next section will seek to analyze the ethical violations of the company researched. The following section will attempt to discuss the consequences that one believes to be appropriate for the senior management of the researched firm, and the implications for brokers, trading in high-risk investments. The end of the assignment will be marked by creating a scenario, where it is described how the use of high-risk investments would be beneficial for the investor, and a support for the rationale derived.
Why Investors May Be Attracted to High-Risk Investments
According to Ghosh, Moon, & Tandon (2007), exchange-traded derivatives, global funds, and other complex investment vehicles have one thing in common; they are all high-risk investments. It is not to say that investors are usually inclined towards avoiding these forms of investments. Instead, it has been identified that a majority of investors have a motivation to invest in them. The investors, who usually invest in these forms of ventures, usually do so in a quest to attain the high returns that they offer. However, high returns singly depend on the company establishing success, as well as increasing in value. Where investors perceive the investments as a good deal going into the future that is, the investor feels that the investments will skyrocket in terms of their prices, and he or she will become motivated to put their money in these investments. As such, when these investments rise in value, it implies that the investor will benefit ideally within a short timeframe.
Determining Whether an Investment is a High or a Low Risk
ExampleIf a stock and investor bought a share for $125, which dropped $105 in price in the following week due to some disappointing news regarding a new product, the investor would suffer a 20% loss. If the investor had purchased 200 shares at a cost of $25, 000, his investment would now be worth $21,000. If he sold at that point, and there might have been good reason to do so, the investor would have lost $4,000, plus - whatever transaction fees you paid. If on the next exchange day the prices went up significantly in a way that the investor gained immensely, the investment would be regarded as a high-risk investment.
High-risk investment
Cost of the stock
200 * 125 = $25, 000
Value of stock after the first week
200 * 120 = $21, 000
Gain/loss
$25, 000 - $21, 000 = $4, 000
Value of stock after the share prices rise (at $200)
$200 * 200 = $40,000
Total gain
High Risk Investment Low Risk investment$40,000 - $25, 000 = $15,000
High risk investment
Low risk investment
The above graph is used to represent a high and a low risk investment. As it describes, a high-risk investment may at first seem to be a very bad investment, but will become a high return investment after a short time. However, for a low risk investment, there will also be positive returns, but not so significant, as those of a high-risk investment.
Risk Associated With Exchange-Traded Derivatives
Among the most fundamental risks, associated with exchange-traded derivatives, is variable degree of risk. According to Ernst, Koziol, & Schweizer (2011), the transactions in exchange-traded derivatives usually carry a significantly high degree of risk. The person purchasing the exchange-traded derivatives may seek to offset or even exercise the exchange-traded derivatives, or allow the derivative to reach its maturity. Exercising an exchange-traded derivative will result into a cash settlement, with the purchaser acquiring or delivering the underlying interest. On the other hand, if it the stock is allowed to expire, it means that it becomes worthless, and the purchaser suffers the total loss of their investment, and this loss will entail the transaction costs, as well as the exchange-traded derivative premium.
Selling an exchange-traded derivative has also its fair deal of risks. While the premium is fixed, there is a potential of the seller sustaining a loss in excess of the amount. In this case, Ernst, Koziol, & Schweizer (2011) detailed that the seller would be liable for additional margin in order to maintain the position if there was an unfavorable market shift. Additionally, the seller will be exposed to the threat of purchaser of the exchange-traded derivative exercising it. The seller will be placed with the obligation to settle the exchange-traded derivative in cash, or to deliver or acquire the underlying interest. In the event that the seller is holding a position that corresponds in the underlying interest covering the exchange-traded derivative, it follows that the risk might be reduced. On the other hand, where the derivative is not covered, the possible effect is the risk of loss being unlimited.
While these risks are prevalent, brokers might take initiatives to minimize them to investors. One way a broker may conduct this, is through future exchanges. However, it requires the broker to put in a great deal of efforts. As such, the broker is required to keep and maintain track of every adjustment in the market worth of the asset in question (Böhringer & Löschel, 2008).
Another way that they can assist is through asset and liability-driven transactions. In this regard, the transactions ought to be driven by asset and liability management. It requires the broker not to speculate on the basis of future forecasts. In this way, the brokers will be able to sell investors risk free derivatives.
A further way of reducing these risks is through adopting and following the derivative policy. It requires the establishment of a derivative policy, which focus is on cost management, and maintaining a very minimal focus on forecasting. Additionally, the broker ought to cut down on expenses and costs.
Challenges Related to Regulating a Complex Global Financial Firm
According to Ernst, Koziol, & Schweizer (2011), the global financial crisis, which began in 2007, has emerged significant failings in the international regulatory policy. It has been assumed that the international regulators did not have the understanding regarding the manner, in which firms in different countries operated, as well as the practicalities of what these companies did. In this regard, it implies that the regulations made are particularly not helpful in resolving issues facing a company, such as problems pertaining to governance.
Another challenge that characterizes the global regulation of the financial market is in attempts to eliminate all the risks. According to Ghosh, Moon, & Tandon (2007), different from the urge on the part of the global regulators, it is usually that there have to be risks in all the underlying assets. Attempting to remove all these risks is critical, as it usually leads to a situation where there is prevalence of what Souder & Myles (2010) acknowledge as "vanilla" products. According to the researchers, these forms of assets are never viable investment benefits, as they do not deliver a thing that is particularly against the desires of an investor. There is a need for the regulators to entail an understanding that each country carries different levels of risks related to these products. Additionally, they must understand the risks that they are attempting to eliminate, and this should be achieved by initiating the stakeholders in the industry, participants, user-groups, and trade-bodies among others. While this is the case, due to the complexity of the global scene, it is a very challenging one, since what the participants in one country see as the most worthwhile, might not be the same understanding on that of participants in another country. As a result, there is no way that an effective and a sensible regulatory framework can be set in place.
The prevalence of these challenges does n...