Portfolio Theories and the minimization of Risk - Free Essay Example

Sample details Pages: 4 Words: 1313 Downloads: 5 Date added: 2017/06/26 Category Business Essay Type Narrative essay Did you like this example? The fundamental goal of Portfolio theory is to determine efficient way of portfolio selection in order to minimize risk of portfolio to specific extent as it possible and, thus, to maximize return of assets. To achieve this aim it is necessary to provide the diversification of portfolio (Crouhy,Galai, Mark, 2006:110). Diversification is able to find solution in order to reduce the possibility of specific risks existence (McClure, 2010). Don’t waste time! Our writers will create an original "Portfolio Theories and the minimization of Risk" essay for you Create order However, portfolio theory has limits: systematic risk cant be removed by diversification (McClure, 2010). Historical trends are helpful to foresee upcoming return and risk, but past analysis not always impacts on further data. Arnold (2008:273) highlight past trends lead to particular extent, but the possibility of making mistake is high. Huge amount of profit can influence on calculation, which is difficult to account (Arnold,2008:273). Capital Asset Pricing Model theory is beneficial to find solution to avoid specific risk by diversification, also allows avoiding systematic risk by calculation of beta. Beta is compensation for taking systematic risk, that allows understand why a portfolio has distinguish expected returns (Lim, 2009). Nevertheless CAPM has disadvantages: Roll (as sited by Fama and French, 2004:41) supposes that as the reason of measurement instruments use proxies, not adequate market portfolio, it doesnt give clear understanding of CAPM. Fama and French deb ate that beta is not useful in explanation of nature financial statements as returns, stated on current rates and other financial securities (Jonathan Berk, Peter DeMarzo, 2007:393). To predict future returns the CAPM theory use the past data, which could give error results (Jonathan Berk, Peter DeMarzo, 2007: 389). Black-Scholes Model The advantage of the Black-Scholes model is possibility to compute a huge number of option prices in a small period of time. In addition, Black-Scholes is the first congruent concept is recognised by traders, it is applicable almost in all business scopes of trade. Black-Scholes is very flexible in using, particularly, in calculations and mathematic approaches, and there are several versions of Black-Scholes In other hand, there are serious limitations as difficulties in dividends, the formula is suitable for only call options, and does not sufficient in early-exercise options or American style options. There are problems with modification of formulas versions, and the conditions are not always realistic (Ward, 2004:217). Modigliani and Millers theory argues the level of companys prosperity does not depend on assets diversification, and proves the benefits from financial debts. Gearing is efficient because it gives an essential opportunity to reduce governmental taxes, however, there is a threat of risk, restrictions in precision and a high level of systems complexity (Crouhy,Galai, Mark, 2006:433-437). TYPES OF FINANCIAL RISKS There are several types of financial risk factors impact current economy. All factors influence on the organizations is working with cash flows. Each factor could change range of risk in financial institutions, or even can lead to bankruptcy. In most situations this risk interrelated with each other. All of this risk played own role before and after financial crisis and bankruptcy of Lehman Brothers Holdings, Inc in USA which influenced negatively to current world economy. According to Jorian (2009:247) there are several key elements of financial risk: market risk, credit risk liquidity risk and operation risk. Market risk includes interest rate risk, equity price risk, commodity risk, foreign exchange risk (Crouhy, M., Galai, D., Mark, R., 2006:27). All these key risk elements causes to financial crisis which began in 2007. Interest rate risk is a product of process in changing of percentage rates that can negatively impact to financial institutions. It is not independent from economical, political factors and volatility of inflation (Homer, Sylla, 2005:10). The bright example is financial crisis and bankruptcy of Lehman Brothers Holding, Inc. One of the aspects that led to financial crisis and bankruptcy was fall of houses prices, however interest rate increased, and consequently there were difficulties in refinancing in many parts of USA in 2006-2007. And many construction companies suffered from increase of interest rates (Vine, Magaldi, 2009) . Foreign exchange risk is volatility of currency rate that can threat to financial institutions. The substantial reasons of fluctuation are volatility of currency rate and unpredictability of international interest rates (Crouhy, M., Galai, D., Mark, R., 2006:28). This type of risk could happen in Airbus Company. Decreasing dollars can lead company to bankruptcy. The significant problem that major part of company manufacturing in Europe and consumptions cost in euro, however it selling planes in a sector which currency is USA dollar. For instance, two years ago Airbus A380 was cost $ 300 million dollars which is 170 million pounds. Now currency is changed, and if Company exchanged dollars to pounds with today currency, they would lose approximately 15% or 25 million pounds (Lea, 2007). Credit risk could take place in financial institution when debtors couldnt pay back debt. There are a lot of factors that can lead to appearance this risk such as market risk and others. Also it integrates with all of other types of risk. For example, in USA when interest risk went up and prices for houses went down most of construction companies couldnt pay back money to banks and it led to financial crisis (Vine, Magaldi, 2009). One of the factors of Irish crisis was that people, who took loans, couldnt give back debts At the end of September, more than 40,000 mortgage loans had been in arrears for more than 90 days. Combined, the mortgage loans are worth ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¡Ãƒâ€šÃ‚ ¬7.8 billion ($10.6B) (Boulden, 2010). Liquidity risks components are funding liquidity and asset liquidity. This risk occurs when in conditions of supplys existence there is no consumption and when financial institution couldnt sell immediately production or their assets (Crouhy, M., Galai, D., Mark, R., 2006:30). As it was mentioned before, that most of Constructions Company suffered from liquidity risk, because there was no demand for houses, therefore there were no opportunities to sell real estate and if they couldnt sell properties and pay debt (Vine, Magaldi, 2009). RISK MANAGEMET AND TOOLS The risk management is essential part of financial institutions that helps to identify risk and to avoid or cut risk. It was important to identify risk in order avoid Lehman Brothers bankruptcy, however it had poor management and was one of the big mistakes of the company (WHEELHOUSE ADVISORS, 2010). And most of researches and risk managers consider Lehman Brothers observations with aim to avoid mistakes in the future. And there is a lot of information in books suggestions from observers to risk managers. The tools, which are helpful to avoid risk, have own pros and cons. One of them is diversification, which avoids risk through dividing assets and reducing risk of portfolios. Thus, decline of share value is compensated by growth another (Glantz, 2003:488). Diversification illustrates that there is a threat to put all money in one wallet, because if you lose the wallet, you can lose all your money. In other way, it suggests to split your money into different cells. H owever disadvantage of diversification does not solve a systematic risk. When financial crisis happened most of sectors suffered, and diversification did not help in that situation to stop looses in assets (Lepetit, 2010). Hedging is effective way of managing risk in unstable economic situation, and its purpose is to protect from negatively movements in prices and everything can affect your well-being such as rates of currencies, interest rates, loans rates, the prices of gold and oil and others factors (Berk, DeMarzo, 2007:946). In order to produce gasoline it is reasonable to buy oil, however in the conditions of instability of prices on oil there is threat of oil prices decrease when it is a time to sell petroleum to the consumer, moreover, nobody will not to buy it at that price in which you have put the expenses. Therefore, to be insured from this serious trouble, it is necessary to sign a contract or another way it calls put option with fix quantity and prices of product without any changes. Certainly, it is dangerous options of losing of potential profit as a consequence of oil prices growth (Berk, DeMarzo, 2007:937).