International Financial Market - Systematic and Unsystematic Risks - Assignment Example

Finance and accounting Capital pricing model is one of the corporate finance models that are solely used to describe the rate ofreturn on a portfolio. Any addition to an already existing portfolio is guaranteed non-diversifiable risk. The portfolio sensitivity and non diversifiable risks are taken into consideration by the model. The risks involved are systematic and unsystematic risks. The systematic risks affect the entire portfolio and cannot be prevented while the unsystematic risks are reduced by diversification of the portfolio. They are often represented by beta b the expected return of portfolio and risk free expected return. The two vital characteristics in the model include book to price and earnings to price. The earning to price characteristic indicates the expected returns of an asset. It is valid as it has a positive correlation to the future risky growth earnings. 2. Efficient market hypothesis advocates that financial markets have sufficient information and there is no information asymmetry among the counterparties. One cannot time and again realize returns in surplus of the average market return on risk that is adjusted on a given investment. Market anomalies plays a role of giving misleading supernormal returns more than required since they base on financial reports. The anomalies are: earnings announcement puzzle. In this case, stocks with the best news of earnings outperformed the stocks with relatively low earnings by even four percent. Consequently the prices do not reflect all the available information as required by the efficient market hypothesis at the end of the earnings announcement days. This leads to under reaction of potential investors in the stock market to the announcements and hence can only be fully aware when further information is gathered. This invalidates the efficient market in total hence inconveniences. The new issue puzzle: this anomaly arises when firms issue stock to the public and investors rush to buy them and whoever is lucky gets rewarded and stock get immediate capital gain. The early gains consequently turn into losses at the end. This too inconveniences the weak, semi-strong and strong hypothesis where by all the past, public and other important information should be disclosed. 3. Financial market anomalies are situations where performance of stock in the market deviates from axioms of the weak, semi-strong and weak market hypothesis. Such events in the market cannot be clearly be elaborated using such efficient market hypothesis. They relate to factors such as lack of market transparency, unfair competition in the market and regulatory actions existing in the financial market. Additionally, behavioral biasness by the economic agents also plays part in the financial anomaly. The anomalies are categorically divided into four distinctive types. The first is calendar anomalies: these are anomalies that are associated with time period of in the market. They include weekend effect where prices fell most likely on Monday than closing Friday. The turn of the year effect described anomaly of increase in the prices of stock and other underlying assets in the very last. Following these anomalies, the investors are in a position to earn abnormal profits from their stocks in the market. The second type of anomalies is fundamental anomalies that include small cap effect, value anomalies, and high dividend yield, low price to book, low price to earnings and finally low price to sales. Value anomaly occurs because of false forecast that is made from investors. In some time, they overestimate the future value in earnings and returns of stable companies and underestimate the future earnings and of value companies. The value stock performs candidly with respect to growth stocks because the growth rate is lower than the value of stocks. Individual investors make an overestimation by making judgment errors and mainly focus on past performance. The beta and return volatility indicates that the value of the stock is less risky than the growth in the stock. High dividend yield: stocks with high dividend yield outperformed in the market. When the yield is high, the stock generates more returns. Low price to earnings ratio generated more returns while stocks with high price to earnings ratios outperformed than even the index. This due to underestimation of companies with low price to earnings as investors becomes pessimistic about the returns after bad news in the market. The outperformance of these fundamental anomalies contradicts the three efficient market hypotheses. The third anomaly is the technical anomalies. Momentum effect causes the investors to gain advantage by trading the auto correlated returns in a short span of time and buying past winners then sell losers to gain abnormal profits. Trading range break is a technical analysis based upon confrontation and bear level. Buy signal is created when prices reaches resistance level. When an investor advocates for selling at peak season, the resistance level break out than previously. This caused a buy signal. When selling, a selling signal is fashioned when the prices reaches the support level which is the bare minimum price level. Fourthly, the other anomaly is the behavioral anomalies that relates to attitudes and beliefs about the probabilities. Attitude towards risks: when investors make risky decisions, they consider whether the losses are material to the returns or not. This is because the investors are risk averse and do not like to be surprised with negative surprises. Beliefs about the probabilities: investors dealing with the investment of stocks are not certain about the future outcomes. The projection of the recent experience to future and to forget the lessons learned from the past analysis give them a challenge. The attitude toward risk and the attitude about the stocks inconvenience the efficiency in the market hypothesis. 4. Binomial option pricing is one of the powerful techniques that are used to solve complex option pricing problems. It is based on assumptions such as use of probabilities and no arbitrage. The assumptions used in the model are: constant rate of interest, market is frictionless, investors are neutral and possible prices are down price and up price. For example, let us consider a company whose value Vo. The next month, the price is going to increase by c% or drop by e%. no other outcome is expected. The probability for increase is p and that of decreasing is 1-p Vo(1+c) Vo p 1-p Vo(1-e) Assuming that a call option exists at the end of the month, strike of call option be X. when a holder decides exercise the call option the payoff will be as follows: Max (Vo (1+e) –x,0) Vo 1-p Max (VO (1-e)-x, 0) The expected value of pay off is p*max {Vo (1+c)-x, 0) + (1-p)*max {Vo (1-e)-x,0} Analyzing binomial probabilities using arbitrage Once the payoff is computed, expected value of the pay off will be discounted using risk free rate to get arbitrage free price of the call option. From the above example, the probability becomes P= Where p= probability of increase R = risk free e =decreased factor c = increased factor 5. The difference between speculation and hedging. Speculators are individuals that trade to make profits resulting from price changes in the shares that are traded in the market while hedgers on the other hand have the objective of protecting the price changes in the shares and other equity instruments in the stock market to prevent occurrence of losses in future. They make the buy and sell choices as their insurance to offset their exposure to unfavorable movements in the equity instruments. As an example on hedging, we consider coffee processing company and a farmer who grows the coffee berries for the company. The company looks forward to hedge the risk of price increases of coffee berries in future by purchasing future contracts on them. In such a case, when the prices hike in future, the company’s profits on the contract offset higher prices of the berries. On the hand the farmer can benefit by selling the futures on the berries so that when his future position on money goes down, offsets reduction in his products. Speculators watch out to make handsome amount as they observe the movement. Arbitrage involves a trader who simultaneously purchase hold and resell an asset such as shares with a hope that future price will rise and consequently make profits from difference in the prices. Traders achieve this by taking advantage of market inefficiencies in the market that results in the price differences. 6. Covered interest rate parity is one of the no arbitrage conditions in the foreign markets that depend on the availability of the forward market. It is rearranged to give the forward exchange rate a function of other kinds of variables. Forward is rate is a price of forward contract that derives its value from pricing spot contracts and additional information on interest rates. Investors eliminate the exposure to foreign exchange risk with the help of forward contract which covers the exchange rate risk. For instance, domestic investor would equally earn returns if he/she invested in domestic assets or in foreign currency in a country that experiences different rates of interests. In case of equilibrium, sheltered interest rate allows a no arbitrate on returns on deposits. 7. Intrinsic value in option contract is the difference in price of underlying asset and its strike price. The intrinsic value in call option is calculated by subtracting the strike price from the underlying price. For the put option, the intrinsic value is calculated by subtracting the underlying price from strike price. Time value refers to premium that is excess of the intrinsic value. Price determinants in option value include: The call option increases when the price of the stock increases and will drop as the price of the stock decreases. The call option increases as the volatility of the stock price. A high dividend payout policy drags rate of growth of stock price that accordingly decrease payoff from call option lower the call value. The longer the time to expiry, the increase in call option. This is because of the increase in unpredictable future movements in prices. As the length of the expiration increases, the present value falls and consequently increasing the option value. The call value increases as the interest rates increases and decrease in price as the interest rates decrease. 8. Forward contract is an agreement between two parties the buyer and the seller to buy or sell a product at a future price that is fixed today and delivery made in the future. The price of the contract is set so that future value of the forward contract is equal to the present value of the contract at the time when the investment is being entered. The principles of hedging in forward contract are: a long position in foreign currency can be hedged by selling currency and delivery made in future. Additionally, a short position is taken to hedge foreign currency by purchasing them for a delivery in future. 9. The proposition of the behavioral finance is that almost all the investors are rational and perfect arbitrage are tremendously contradicted by the institutional evidence and psychological constrains. The psychological concerns are attitudes towards the risk as they are uncertain about the future returns on the assets or portfolios. Institutional evidence includes the issue of gathering more financial information about the price movements in the stock exchange to make sound decisions. The model shades light to the available financial data in a more precise manner than efficient markets hypothesis and makes predictions over security prices in future. 10. The main features of foreign exchange market include: It is a sole market that operation is 24 hours except in weekends. There are voluminous transactions in the market due to numerous players in the market making it liquid. The foreign exchange presents all countries that are geographically dispersed making it unique. There exists geo political, liquidity, interest rates makes the foreign exchange more difficult to trade in. lastly, and the market has a feature of low transaction costs. The mechanisms of foreign exchange include: A take profit order that spell out price quote for which it would like the position to be closed. Stop loss order is a mechanism that puts ceiling over losses a misinform trade can cause. A market order instructs a broker to sell or buy currency at current market price. The trader and broker have no control over the execution of trade. 11. Relevance of arbitrage to: 12. The efficient markets hypothesis The principle does not allow risk free net profits. In understanding the role of prices movements in financial market, arbitrage do not require each individual to be fully rational and also do not ,motivate decision makers to access sufficiently to make notice on mispricing. The arbitrage therefore helps in the efficient and smooth understanding of the price movements in the stock markets. 13. Relevance of arbitrage in pricing currency forwards: Arbitrage enables investors to capitalize on interest rates between different rates using forward contract to cover the exchange rate risks. Arbitrage strategy of exchanging domestic currency with foreign one at the spot rate covers interest rates. This further enables negotiation under forward contract sell the derivative and delivery to be made in future. 14. Relevance of arbitrage to binomial option pricing model: The model uses alternative procedure in price option allowing specification of time and time period. The concept of arbitrage and assumption of efficient market engineers the model to lower the possibilities of price changes. 15. Payoff profiles for I. Buying calls: The profile for buyer of put call is positive when the underlying asset price becomes lower than strike price of the option. This is due to the right that the buyer has to sell the underlying asset at higher rate than prevailing market price. II. Writing calls: The call option gives the buyer a right and not an obligation to buy the fundamental asset at a strike price. As the spot price hikes, the writer makes losses. At expiration, when the value of underlying asset is lower than strike price, then the option expires unexercised and the writer keeps the premium. III. Buying puts: Payoff profile of the put option is positive as the underlying asset is higher than the strike price. When the strike price becomes higher than the asset price, seller in the put option would have an obligation to buy the asset at strike price. This happens only in adverse situations only. IV. Writing puts: In this scenario, a buyer has a right and no an obligation to buy an underlying asset at specified price. If the spot price becomes lower than the strike price then the buyer will exercise the option but when the price of underlying price is more than strike price, then the option will not be exercised and will consequently keep the premium. 16. a. in this case the relevant example is the shares which have non linear payoffs, uncertain timing and high volatility. The merits of using options in hedging than the forward contracts are: options are more liquid than forwards, can hedge non linear payoffs, can hedge cash flows with uncertain timing and are more suited to speculating on direction and volatility of exchange rates as compared to forward contracts. b. The key characteristics of trading in foreign exchange market includes: all countries that are geographically dispersed are represented in the market. The foreign market operates twenty four hours in a day except in weekends, large volumes representing huge asset class in the entire world and consequently increasing the liquidity. C. forwards are contracts: in forward contract, the parties enter into a contract to fix an exchange rate today for future transaction. This prevents a future loss on the underlying asset. For example Mr. John who owns an asset which he expects to exchange in one year later enters into forward contract with peter who is now the buyer. Peter agrees to buy the asset for $150000. As the buyer, peter has entered into a long hedge while the seller who is john has entered into a short hedge. At the expiry of the time, the market value of the asset was $170000. Though the price had risen, the seller had an obligation of selling at $150000. The buyer reduces the risk of increase in price of $20000. Futures contracts are used in international markets to protect the loss in value of the currency of either an exporter or an importer. For example an England exporter invoiced an USA customer $9000000 payable in three months time. The spot rate is 16 – 18$/£ and the three months forward is 16.5 – 18.8$/£. The receivables to be received in three months time is ($9000000/18.8) = £47900000. If the exchange rates in the three months time is 16.5 – 18.95$/£, then the risk reduction will be (9000000/18.95) – (9000000/18.95) = £400000. Options give the holder a right and not an obligation to either purchase or sell the underlying asset. Call option gives the holder the right to buy the asset at specified price within stipulated time. Consider a call option with the following characteristics: exercise price of $100, premium per call option is $10and the market price of underling asset are $60, $80, $90, $100, $110, $120 and $150. Market value Exercise price $100 Exercise? Value of the call Profit/ loss 60 NO 0 -10 80 NO 0 -10 90 NO 0 -10 100 NO/YES 0 -10 110 YES 10 0 120 YES 20 10 150 YES 50 40 The value of the call is (10+40)- (10+10+10+10) = $10 it shows that increase in the market price of an asset, increases the call value hence reducing the risk of risking more than what one can bear. d. option analysis using binomial probabilities The assumptions used in the model are: constant rate of interest, market is frictionless, investors are neutral and possible prices are down price and up price. For example, let us consider a company whose value Vo. The next month, the price is going to increase by c% or drop by e%. No other outcome is expected. The probability for increase is p and that of decreasing is 1-p VO (1+c) p VO 1-p VO (1-e) Assuming that a call option exists at the end of the month, strike of call option is X. when a holder decides exercise the call option the payoff will be as follows: p max (Vo (1+e) –x,0) Vo 1-p Max (VO (1-e)-x, 0) The expected value of pay off is p*max {Vo (1+c)-x, 0) + (1-p)*max {Vo (1-e)-x,0} Analyzing binomial probabilities using arbitrage Once the payoff is computed, expected value of the pay off will be discounted using risk free rate to get arbitrage free price of the call option. From the above example, the probability becomes P= Where p= probability of increase R = risk free e =decreased factor c = increased factor e. Covered interest rate parity is one of the no arbitrage conditions in the foreign markets that depend on the availability of the forward market. It is rearranged to give the forward exchange rate a function of other kinds of variables. Forward is rate is a price of forward contract that derives its value from pricing spot contracts and additional information on interest rates. Investors eliminate the exposure to foreign exchange risk with the help of forward contract which covers the exchange rate risk. For instance, domestic investor would equally earn returns if he/she invested in domestic assets or in foreign currency in a country that experiences different rates of interests. In case of equilibrium, sheltered interest rate allow a no arbitrate on returns on deposits. Read More