FINANCIAL RISK MANAGEMENT

NAME: MEHBOOB ALAM

REG NO 11570

TOPIC: what if a firm uses financial instruments to reduce systematic risk?

Every investment portfolio has a specific level of risk. This risk is made up of both
systematic and non-systematic or diversifiable risk. Many investors mistake these
two types of risk and believe that they are reducing their systematic risk when
diversifying their portfolio. This is not the case.

Non-systematic risk refers to that risk related to individual companies or industries.

This company/industry specific risk can be curtailed through diversification (1).
Diversification can be achieved by taking up comparatively smaller positions in a
number of fairly similar companies in a similar market in contrast to taking large
stakes in one or two businesses(2). One can adequately diversify their portfolio by
just investing in a relatively small number of different firms. For example, when
comparing portfolio A with one stock and portfolio B with 3 or 4 stocks we can see
that the non-systematic rick of portfolio A in contrast to portfolio be in usual
circumstances will be substantially higher. We can see in the graph below that as
number of holdings increases the amount that non-systematic rick decrease
diminishes rapidly.

(3)
            It is clear that once non-systematic risk is reduced to its optimal level
through diversification there still remains a somewhat significant level of portfolio
risk, systematic risk. The levels of this risk depends on the economic climate you
live in, the volatility of interest rates, the political and economic stability of the
country you live in, etc. How this risk can be minimized is what I will be
discussing in this post.

Systematic risk is the risk attributed the entire market or market segment (4)
Systematic risk can affect our portfolio through interest rate hikes, a subprime
crisis, a bubble popping or even a country defaulting (5) any one of these could
cause massive panic selling and potentially could have a massive effect on the
performance our portfolio. I am now going to outline two methods to reduce
systematic risk, Asset Allocation and Hedging.

Mitigating Systematic risk through asset allocation is achieved through distributing

ones investments across assets from dissimilar markets and segments. The lower
the correlation between each asset, the more unlike the various assets will be. This
is a very important factor in portfolio theory. (6)

(6)

                From the graph above, if one has invested solely in A this risk and return
is at point A. Intuitively if one invests 50% in A and 50% in B their risk/ return
ration would be somewhere around point C. Modern portfolio theory states
otherwise. In fact if an individual decides to invest partly in both A and B, they’re
risk/return levels will be somewhere along the blue line (the efficiency frontier).
Note that investing heavily in A (less risky) and a smaller amount (10%-20%) in B
(more risky) lead to a risk/return at E.  At E we have a substantially higher return
with only a small amount of added risk (illustrated by the dotted lines above). As
more of the risky asset is consumed the Level at which return with respect to risk
increases diminishes. The Convexity of the efficiency frontier is also known as the
‘free lunch’ of investing. Using asset allocation potentially increases returns and
reduces volatility in a portfolio. The degree at which you benefit from asset
allocation is dependent on the number if holdings, risk/return levels in each asset,
the level of correlation between the assets (6). This is illustrated in the shape of the
efficiency frontier. Asset allocations can be indispensible method of reducing
Systematic risk.

When investing in futures, equities, bonds etc., investors always carry the risk of a
change in interest rates or exchange rates which could in turn reduce the value of
their portfolio. Mitigating the risk of this happening can be attained through
hedging. When investing in the US Market one must always to alert to changes in
the USD. The USD does not only represent the currency of the United States but it
is also an indication of the performance of the US economy as a whole. Removing
your risk of variations in the value of the USD also reduces your risk to sudden
declines in the US economy, therefore reducing your systematic risk (7). Let’s say
that you wanted to buy wheat futures. This means that you are bullish on wheat.
You expect the value/price of wheat to increase in future. If you are long wheat
then you are also indirectly short USD. If there is a crisis in Europe and the euro
becomes undervalued when compared to USD, you will be in a less favourable
position despite nothing fundamentally changing in the wheat market. The only
thing that has changed is the value of the USD. The risk associated with something
like this happening is included in the systematic risk of your portfolio. To combat
this we must also take up a bearish position in some other asset. Let’s choose Corn
as an example. You’re speculation that corn will decrease in value so you short
corn and as I’ve explained above you are long USD. No you’re in a position where
you are long wheat (and short USD) and short corn (and long USD). If we invest
equal amounts in each commodity we will essentially be long wheat / short corn
and the USD risk will be hedged out (7). A loss in one investment due to variations
in the currency will be offset by the other investment.
This Method of Hedging out risk can be particularly useful if firstly you are fearful
in the volatility of the currency you wish to invest in. This makes it desirable to
hedge out the currency’s influence one the return of the portfolio. Secondly, if you
happen to already want to buy one asset and short another for a particular reason.
For example if you know one asset performs particularly well in a certain period
while at the same time a different asset performs particularly bad (Cotton vs Sugar)

Com
bining the methods discussed above an investor can minimize both systematic and
non-systematic risk in their investment portfolios while keeping return as close to
the desired level as possible.
Beta:
The value of any stock index, such as the Standard & Poor's 500 Index, moves up
and down constantly. At the end of the trading day, we conclude that "the markets"
were up or down. An investor considering buying a particular stock may want to
know whether that stock moves up and down just as sharply as stocks in general. It
may be inclined to hold its value on a bad day or get stuck in a rut when most
stocks are rising.

The beta is the number that tells the investor how that stock acts compared to all
other stocks, or at least in comparison to the stocks that comprise a relevant index.

Beta measures a stock's volatility, the degree to which its price fluctuates in
relation to the overall stock market. In other words, it gives a sense of the stock's
risk compared to that of the greater market's. Beta is used also to compare a stock's
market risk to that of other stocks. Analysts use the Greek letter 'ß' to represent
beta.
Analyzing Beta
Beta is calculated using regression analysis. A beta of 1 indicates that the security's
price tends to move with the market. A beta greater than 1 indicates that the
security's price tends to be more volatile than the market. A beta of less than 1
means it tends to be less volatile than the market.

Many young technology companies that trade on the Nasdaq stocks have a beta

greater than 1. Many utility sector stocks have a beta of less than 1.

Essentially, beta expresses the trade-off between minimizing risk and

maximizing return. Say a company has a beta of 2. This means it is two times as
volatile as the overall market. We expect the market overall to go up by 10%. That
means this stock could rise by 20%. On the other hand, if the market declines 6%,
investors in that company can expect a loss of 12%.

If a stock had a beta of 0.5, we would expect it to be half as volatile as the market:
A market return of 10% would mean a 5% gain for the company.

Here is a basic guide to beta levels:

 Negative beta: A beta less than 0, which would indicate an inverse

relation to the market, is possible but highly unlikely. Some investors argue
that gold and gold stocks should have negative betas because they tend to do
better when the stock market declines.
 Beta of 0: Basically, cash has a beta of 0. In other words, regardless of
which way the market moves, the value of cash remains unchanged (given
no inflation).
 Beta between 0 and 1: Companies that are less volatile than the market have
a beta of less than 1 but more than 0. Many utility companies fall in this
range.
 Beta of 1: A beta of 1 means a stock mirrors the volatility of whatever index
is used to represent the overall market. If a stock has a beta of 1, it will move
in the same direction as the index, by about the same amount. An index
fund that mirrors the S&P 500 will have a beta close to 1.
 Beta greater than 1: This denotes a volatility that is greater than the broad-
based index. Many new technology companies have a beta higher than 1.
 Beta greater than 100: This is impossible, as it indicates volatility that is 100
times greater than the market. If a stock had a beta of 100, it would go to 0
on any decline in the stock market. If you see a beta of over 100 on a
research site it is usually a statistical error or the stock has experienced a
 wild and probably fatal price swing. For the most part, stocks of established
companies rarely have a beta higher than 4.

Why Beta Is Important

Are you prepared to take a loss on your investments? Many people are not and they
opt for investments with low volatility. Others are willing to take on additional risk
for the chance of increased rewards. Every investor needs to have a good
understanding of their own risk tolerance, and a knowledge of which investments
match their risk preferences.

Investors who are very risk-averse should put their money into assets with low
betas, such as utility stocks and Treasury bills. Investors who are willing to take on
more risk may want to invest in stocks with higher betas.

Would that be good for shareholders to reduce systematic risk?

Financial distress, potential insolvency and reduced shareholder wealth are the
ultimate results of mismanaged risk, and studies have identified factors that may
help managers and investors predict a company’s financial troubles, leading to a
better understanding of the company’s risk. Weston and Brigham (1990) proposed
that both asset structure (operating leverage) and financial structure (financial
leverage) are factors that affect a firm's systematic risk (beta). Generally hospitality
firms are fixed-asset intensive and highly-leveraged .

Operating leverage is the percentage of fixed costs in a company’s cost structure.

Generally, the higher the operating leverage (higher fixed costs than variable
costs), the more a company's income is affected by fluctuation in sales volume .
For example, a restaurant company with higher operating leverage will generate
greater operating income in times of sharply increasing sales than will a company
with a lower operating leverage (higher variable costs). Conversely, a restaurant
company with lower operating leverage will perform better when sales revenue
decreases. The more significant the volume of sales, the more beneficial the
investment in fixed costs becomes, which means the company does not have to pay
as much additional money for each unit produced or sold. However, the down side
to this high operating leverage is if a high percentage of a firm’s costs are fixed,
they do not decline as demand decreases, this can increase the company’s business
risk .

Financial leverage is the additional variability in earnings due to the use of debt.
The greater the degree of financial leverage, the greater the fluctuations (positive
or negative) in earnings per share. The common stockholder therefore, is required
to endure greater variations in returns when the firm's management chooses to use
more financial leverage rather then less .

In identifying the determinants of systematic risk or beta, previous studies have

examined the relationship between beta and liquidity, debt leverage, operating
efficiency, profitability dividend payout, firm size, sector analysis and growth
using multiple regressions with beta as the dependant variable.

• In the hotel industry, seven variables were examined as important factors of

systematic risk: leverage, growth, firm size, liquidity, efficiency, profitability, and
dividend payout ratio. Leverage ratio and growth were positively related to
systematic risk, while firm size had a negative relationship with systematic risk.
Correlations between the other variables and systematic risk were not found .

• Current ratio, leverage ratio, assets turnover ratio, and profit margin ratio were
investigated as potential determinants of systematic risk in 35 U.S casinos. Only
asset turnover was negatively related to a firms’ systematic risk; no relationship
was found with any of the other variables (Gu & Kim, 1998).

• Systemic risk (beta) was compared with liquidity, dividend payout ratio,
leverage, return on assets, and growth opportunities for 55 companies in the
restaurant industry (Borde, 1998). The levels of liquidity and growth opportunity
were found to be positively related to systematic risk while dividend payout ratio
and return on assets were negatively related. Leverage ratio was almost irrelevant
with risk, which was not expected as leverage is generally believed to be related
positively with risk .

• A study of 72 restaurant firms using liquidity, dividend payout ratio, leverage,

return on assets, and growth opportunities found systematic risk had a negative
relationship with assets turnover but had a positive relationship with liquidity.
• Shin and Kim (2007) investigated systemic risk (beta) with liquidity, dividend
payout ratio, leverage, return on assets (profitability), and growth opportunities in
the restaurant industry. They concluded liquidity, return on assets, and growth
opportunities were related to a firm’s systematic risk (beta). Dividend payout and
leverage were not statistically significant and therefore unsuitable factors in
explaining beta. Although their research did not relate to systematic risk, Barber,
Ghiselli, Deale and Whitham (2007) studied the relationship between company
financial performances on CEO turnover in the restaurant industry. They
concluded that negative stock and accounting returns can be a good predictor of
turnover. The assumption was that a board of directors would act (relatively)
quickly to avoid the risk of further financial or market deterioration due to poor
executive and company performance.