Equity Risk

Equity capital

Historically, financial markets originated as a means of providing businesses with the

investment capital they needed to grow and prosper; and despite the growth of these
markets as an arena for pure speculation, businesses' need for investment capital is still
the driving force behind the world's markets.

There are two ways for companies to raise money for long-term business investment –
they can borrow it and/or they can issue shares - otherwise known as stocks. In the
world of corporate finance, stocks are called equity capital and borrowed money is debt
capital.

Equity (stocks/shares) differs fundamentally from debt in that it represents an ownership

interest in a company – if you buy a stock you are buying a share of the company not
lending the company money. And for investors this fundamental distinction has two
important implications.

Capital appreciation:

A proportion of net profits are always going to be retained by the board of directors to
reinvest in the business. Smaller, growing companies usually need to reinvest all of any
net profit. Nowadays, many large companies don’t pay dividends either – particularly
those which have become dominant in the newer industry sectors.

So where is the benefit to a shareholder if profits are reinvested rather than distributed?
Answer – by using profits to grow the company, this should increase the value of the
company’s shares. Here is the plan.

In this scenario the shareholder sees increasing investment returns through an increase
in share price. What is a share price?
Shares, like other securities, are issued in a primary market and traded in a secondary
market. Three types of price are involved in this process:

1. Nominal price - all shares have what is called a nominal price, or face value. As
the name suggests, this is usually represented by a small nominal amount such
as 10p or 10 cents.
2. Issue price - this is the price a share is first sold at; the price it is issued at.
3. Market price - this is the price a share trades at in the marketplace after it is
issued. In other words, the price another investor will pay to buy your share.

Nominal price and issue price are determined by the issuer - the company whose
shares are being issued. Market price is determined by the market; and a rising share
price - capital appreciation - has, in recent years, become the main ingredient of
shareholder returns.

But this can be a pretty elusive type of return.

Investment return as capital appreciation is uncertain because it relies on the market to

start valuing your investment more highly than it did when you bought it. And it must
keep on valuing it more highly, because, crucially, capital appreciation only turns into a
capital gain (an investment return) when you realize it - when you sell the shares.

So the market is pretty important. But what is a stock market?

Equity / Stock market:

When we think about stocks and shares one of the first things that come to mind is the
stock market. But not all companies’ shares are traded in a stock market.

Think of a small private company which simply raises equity capital among a group of
private investors. The company will issue shares and the shares can be bought and
sold; but if you wanted to buy some, how would you even find out about them?

This gets to the nub of what a stock market is for; it is a public arena in which equity
capital is raised (the primary market) and stocks are then traded (the secondary
market); and when you enter that arena, either as an issuer or an investor, you have to
play by the rules of the market, which are usually enforced by a self-regulating body
within the context of wider statutory regulation.
For issuers – the companies themselves – stock markets give them the opportunity to
reach a far wider pool of buyers for their primary market issues, and so, of course, raise
a lot more capital. For investors, a stock market provides established mechanisms and
practices by which stocks can be bought and sold (the secondary market).

Traditionally stock markets were physical locations – with trading floors full of various
kinds of market player. But a stock market (and indeed, any capital market) does not
require a physical location. It is only necessary that the buyers and sellers can
communicate efficiently within an agreed framework of regulation and practice.

The trend (increasingly the norm) - across all capital market products - is away from
trading floors and to electronic markets.

Now at this point, a question may have crossed your mind; what is the difference
between a stock market and a stock exchange?

Well, somewhat tautologically, if the market is made under the regulation of something
called 'an exchange' it’s an exchange-traded market. If it isn’t though, it is still a market.

Stocks are traded off-exchange all over the world in what is called the OTC (or over-the-
counter market) by telephone and computer. And to compete with the speed and
efficiency of these markets, stock exchanges have had to become a lot more like OTC
markets.

What makes for an efficient stock market?

Efficient stock markets – whether they are called an exchange or not - have the
following characteristics:

o Transparency: timely and accurate information on the price and volume of

past transactions and on prevailing supply and demand.
o Liquidity: the time involved to complete a transaction (the ease of finding a
buyer or seller) and the certainty of the price.
 o Low transaction cost (internal efficiency): the lower the cost of the
transaction the more efficient the market.
o Rapid adjustment of prices to new information (external efficiency): If
supply and demand conditions change as a result of new information,
participants want this information reflected in the price of the stock.

Risk in Equity:

Risk management can make the difference between your survival or sudden death with
forex trading. You can have the best trading system in the world and still fail without
proper risk management. Risk management is a combination of multiple ideas to control
your trading risk. It can be limiting your trade lot size, hedging, trading only during
certain hours or days, or knowing when to take losses.

Equity risk is the risk that one's investments will depreciate because of stock market
dynamics causing one to lose money.

The measure of risk used in the equity markets is typically the standard deviation of a
security's price over a number of periods. The standard deviation will delineate the
normal fluctuations one can expect in that particular security above and below the
mean, or average. However, since most investors would not consider fluctuations above
the average return as "risk", some economists prefer other means of measuring it.

What is equity risk? Well in one sense it is quite straightforward. Which of these two
shares is the riskier?

Well, pretty obviously from above chart, it is B. Its price is more volatile. Where does
this kind of volatility come from?
In other words, the value of your investment rides on the company’s ability to be
successful and profitable at whatever it is it does and the market’s ability to recognize
that success. It sounds risky already doesn’t it?

The market perception part of this riskiness is a more tricky issue than the hard facts of
whether a company is actually likely to be successful and profitable. Believe it or not,
there are companies with a strong track record which the market consistently fails to
value as such; and, even more unbelievably, companies with no track record at all,
which the market places a very high value on.

The risk on equity arises at many levels and situations:

o Risk on their own stock for corporations. Corporations may not have chosen the
appropriate capital design, weighting debt versus equity too much or too little.
Corporate may be exposed to equity risk, in the case of mergers or acquisitions.
Private equity and venture capital groups bear also an important equity risk, but
with very freshly or even not yet issued equity stocks.

o Risk on equity for equity stock or index position holders like funds (mutual and
hedge funds), equity trading desk of banks. Also relative value trading desk also
referred to as risk arbitrage desks may have important equity exposure.

o Risk on specific stocks and indexes for equity derivatives holders, like trading
institution but also corporations using derivatives for various purposes like return
enhancement or hedging.

Traditionally, one split the risk between

A. Financial Risk
o Market risk: any type of risk due to the market conditions and
evolution. As such, equity risk, interest rates risk, and any other
product risk belongs to this category as well as liquidity risk.

o Model risk: this refers to the inaccurate modeling of derivatives due to

modeling errors. For any non-liquid derivatives, one is doomed to have
a residual model risk. The goal of financial engineers is precisely to
minimize it.

o Credit risk: this relates to risk of counterparty’s default, change of

credit environment and so on.
 B. Non-Financial Risk:
o Operational risk: risk of running a business, risk in execution of deals
and other risky business.

o Other non-operational business risk like reputation risk, impact of a

brand, depreciation risk of non-financial assets, risk on human capital.

o Other non-directly business and financial oriented risk like political risk,
economic exposure and so on.

Sector/market risk relationship:

Different types of business are sometimes put into categories to help you understand
how they might react to longer-term market risk factors – how the shares should
respond to economic cycles of general economic growth and recession. There are three
main categories.

Defensive stocks: These are stocks which tend to be resilient to economic downturns.
They are ‘safe’ shares - which won’t go down as much as the market average in bad
times, but won’t gain as much as the market average in good times; food companies for
example, or utilities providing essential services like electricity suppliers or water
companies.

Cyclical stocks: These are stocks whose profitability – and so share price – tends to
track the growth of the wider economy; the classic example being building companies.
In boom times they (and their shares) do really well, but in recession they drop more
sharply than the market average…and stay there until the next boom. So they will only
be an uncertain investment across business cycles – not during a strong up or
downturn.
Counter-cyclical stocks: These are stocks that do well during bad times and not so
well during good times. Fantastic for a diversified portfolio – but it is difficult to find an
entire sector which can be called counter-cyclical. An example here may be
an accountancy firm with a large insolvency or receivership practice.

These categories are useful when it comes to understanding how a company may
perform in different stages of the economic cycle. Share prices are based on
expectations of company earnings and the state of the wider economy is a key factor in
giving any one company the background potential to make profits. But you must be
careful as there really is no such thing as a single, broad economy which all companies
operate in.

Economic activity varies between geographic regions and industry-sectors. A single,

unitary, national economic environment can be a bit of a misleading idea. Some
companies are closely tied to a region and/or niche market; others are global and/or
highly diversified. Factor company-specific risks into this and you can see that these
categories are probably most useful for taking a sector rather than stock-specific view to
your portfolio risk exposures.

Another problem with these frequently-used categories is that there is no clear-cut

relationship between the current level of the stock market price and the level of broader
economic activity. Mild economic growth can spur massive stock market growth and
vice versa. As the American economist Paul Samuelson famously observed, " The stock
market has predicted nine of the last five recessions”.

The market will always be more volatile than any general measure of economic activity
warrants, except in the midst of a full-blown recession where all share-trading volumes
will drop dramatically. So the categories are really only helpful when taking a long-term
view of portfolio risk exposure.

So to cut it short, equity risk is in most cases one component of market risk. Optimal
Portfolio theory aims at reducing the systemic risk in a large portfolio. Using
optimization-computing techniques, it looks for the less risky portfolio (in a sense of a
risk measure to be defined, often the variance) for a given return.

Risk in Equity Markets

Equity markets like any other financial markets always bear an important risk in terms of
market correction. Highly publicized because of financial impact, the various equity
crashes (1929, 1973, 1987) have had important macroeconomic consequences,
general recessions and rising unemployment. For equity derivatives traders, market
correction can end in big losses because of unhedgeable skew and correlation positions
as well as important barrier risks, triggered by the market change.

Productivity, general outlook and general business and growth conditions are the most
important factors for the overall level of the equity markets. Specific industries are also
sensitive to their particular sector’s competitive environment. In addition, equity markets
are widely influenced by general macroeconomics factors like monetary policy of central
banks and the impact of interest rate and inflation levels on business cycles.

Risk in Equity Derivatives Markets

When holding equity derivatives, the trader, investor, speculator bear an equity risk that
can be quantified by risk ratio like the Greeks. The most common way of determining
how many equity she is long or short is to look at the delta of the portfolio, which is the
price change with respect to the equity underlyings. The delta provides a good estimate
of the number of forward or futures contract to buy or sell in order to have a portfolio
neutral at first order with respect to small move of the equity underlyings. However, for
very convex portfolio, it is also interesting to quantify the second order risk by looking at
the gamma of the portfolio. This can provide a good understanding of the evolution of
the delta as well as the break-even strategy. To gain a detailed understanding of the
delta and gamma, it helps to split the risk arising from simple equity spot risk, the one
from the joint move of equity spot and volatility1, and the various cross gamma effect
such as quanto and convexity correction. One may also assess the equity risk by
various value-at-risk analyses. These risk scenarios are very appropriate for portfolio
presenting large gap risk, as for instance capital guaranteed structure on illiquid asset
and various crash puts.

Reducing Risk
Equity is inherently riskier compared to many other assets. However, several tools helps
mitigate the risk of investing in stocks.

Along with the growth of the stock markets in various countries, the global financial
services industry has also grown rapidly. As more and more countries liberalize their
financial markets, thousands of new employees are being hired by growing financial
services firms such as brokers, investment banks, financial news services, and equity
research companies. They hire some of the world’s smartest and well-trained people,
compensating them well, both through high salaries and generous bonus schemes.
Their knowledge and skills are now available to investors.

Diversification
Investors have a number of strategies available to them to reduce the risks of
investment, and chief among them is diversification. The world of share investing today
is very large, with many markets and companies available to invetors. Therefore, the
opportunity to diversify is greater today than ever before.
Diversification is the process of spreading the total investment money available across
different assets classes, counties, industries and individual companies. Diversification
also entails choosing investments that are, as far as possible, negatively correlated,
which means that when investment A is performing poorly, investment B is likely to be
performing well.

Corporate Governance
Probably the most effective but least used tools to reduce risk when investing in publicly
listed companies is corporate governance. For any investor, one of the most obvious
risks that present itself when making an investment decision is whether the company
will be honestly managed and, more importantly, managed in the interests of all the
shareholders, particularly the minority shareholders. Senior managers of nay firm, but in
particular of large, publicly listed companies, are often in powerful positions-which
enable them to act in their own interests rather than in those of their company’s
shareholders. More recently, corporate scandal in the Satyam demonstrated that even
the most financially company have problems with corporate governance. The main
elements of these principles are as follows:

Fairness: Shareholders should be treated fairly, especially foreign and retail

shareholders.

Transparency: Sufficient company information should be disclosed for investors to

make informed decisions.

Accountability: The responsibility for governance should be clear, and efforts should
be made to align the interests of company mangers and their shareholders.

Responsibility: Companies should comply with the other laws and regulations in the
countries within which they operate.

The Risk-Reward Ratio

Risk is a part of trading. Every trade carries a certain level of risk. A Risk-Reward Ratio
is a calculation that shows the maximum amount of risk and maximum reward on a
particular trade. It is one of the best factors in deciding whether to enter a particular
trade. Every trader must know the amount of risk that is being assumed on each trade.
Knowing the amount of risk on each trade is one way to limit it and to protect your
trading account. The risk-reward ratio should be at least 1:2. A higher ratio (1:4 or 1:6)
is even better. If the Risk-Reward Ratio does not meet the minimum requirement, the
trader should not enter this trade. The Risk-Reward Ratio is an excellent risk
management tool and should be used by every trader on every trade.

The risk-reward ratio is a parameter that helps a trader to determine the level of risk in a
trade. It shows how much a trader is risking versus the potential reward (or profit) on a
trade. While this may seem simplistic, many traders neglect taking this step and often
find that their losses are very large.

How to Determine the Risk-Reward Ratio?

The first step is to determine the amount of risk. This can be determined by the amount
of money needed to enter the trade. The cost of the currency multiplied times the
number of lots will help the trader to know how much money is actually at risk in the
trade. The first number in the ratio is the amount of risk in the trade.

The reward is the gain in the currency price that the trader is hoping to earn from the
currency price movement. This gain multiplied times the number of lots traded is the
potential reward. The second number in the ratio is the potential reward (or profit) of the
trade.

Examples: Here are a few examples of the risk-reward ratio:

o If the risk is Rs.200 and the reward is Rs. 400, then the risk-reward ratio is
200:400 or 1:2.
o If the risk is Rs. 500 and the reward it Rs. 1,500, then the risk-reward ratio is
500:1500 or 1:3.

Active Equity portfolio management

Equities, by definition, carry risk. For an investor in equities, risk cannot be eliminated
altogether. However, to hedge equity risk in large portfolio, one can use various tools
more or less sophisticated such as research, professional advice, diversification,
financial planning etc. First, advanced versions of the capital asset pricing models
based on a portfolio optimization under constraints can help to decide the appropriate
asset allocation. Like for any investment strategy, there is a tradeoff between risk and
return. When doing historical backtesting, it is important to use a risk adjusted
performance measurement.

Last but not least, over the last few years, portfolio managers have shown growing
interest toward two alternatives investment decision methods: behavioral finance,
emphasizing the individuality of traders and investors, and artificial intelligence expert
systems analyzing millions of rules, often inspired from technical analysis to provide the
best performing ones.