High risk investments
Risk is absolutely essential to investing; no discussion of performance is meaningful without some mention of the involved risk. High risk investment is one in which there is a relatively high chance of capital loss or underperformance.
Reasons why investors may be attracted to high risk investments
In economics, it is an axiom of standard economics that in order to get above average or good returns one has to involve above average risks. They believe that no reward is earned without risks; you don’t become successful without taking risks (Elton, 2009). The Capital Asset Pricing Model (CAPM), an economic model used to evaluate stock, derivatives, securities and assets by equating risk and the expected return, predicted that excess returns comes after taking excess risks. This model is based on the idea that investors who demand additional expected returns are advised to accept additional risks.
Following the relationship between risks and returns, most investors tend to be obsessed with looking for high risk investments in anticipation that the rewards will consequently be high. However, the level of risk that one is able to tolerate depends on a number of factors. Not all people would be more comfortable with taking high risks.
High risk tolerance implies that an investor is more aggressive and often gets more satisfied in taking higher risk levels in exchange for higher rewards. Despite that, it is also important to remember that high risks also implies that the investor is ready and willing to bear with larger losses, having in mind that there might be larger gains later (Damodaran, 2016).
Other factors that can determine the amount of risk an investor can take are; investment preferences, time and also an investor’s personal situation. Time horizon measures the likelihood that an investor will have to recover from a decline in value before one need to sell a portion of the investment to meet a need. Longer time usage allow investors to be more aggressive. Preferences of investment relate to any personal preferences, hang-ups or biases that will make an investor to avoid or take an investment type (Grinblatt, 2000). A person’s personal situation is also significant in the sense that it determines how one perceives risk and how one invests to reach the desired goal.
Risk associated with exchange traded derivatives
A derivative is contract between two or more parties whose value is based on an underlying asset that is agreed upon like security. Businesses and investors face risks in form of changes in prices to the inputs and outputs, changes in interest rates, and changes to interest rates. Derivatives are issued by a third party independent of the issuer of the underlying assets, usually an investment bank.
The range of assets in which derivatives can be issued include stocks, stock indices, commodities, currencies or a basket of securities. Derivatives have risks associated with them including volatility and time decay. These risks are inherent in any business and therefore, they should be carefully and effectively managed (Elton, 2009).
One of the tools used in mitigating risks is hedging. Hedging is a process by which one tries to fix a price for a future sale or purchase of a given asset. Investors with a core exposure to business can effectively reduce their net exposure by buying or selling derivatives. The risks involved in these securities are quite high due to high return (Grinblatt, 2000). These securities are less liquid and cannot easily be marketed. Other types of risks involved are issuer default risk, gearing risk, uncollateralized risk of product, extraordinary price movements, expiry considerations, foreign exchange risk, market risk and liquidity risk.
The derivative products are exposed to political, economic, currency and other risks of a specific sector or market related to single stock, basket of stock, currency, index, commodity, future contract etc. Current theory suggests that the incentives to hedge stem from progressive taxes, underinvestment problems or contracting costs. These issues are internal and cannot be solved by external investors (Damodaran, 2016).
Challenges related to regulating a complex global financial firm and suggestions for regulatory improvements
In 2004, the SEC made changes on leverage rules for five Wall Street Banks which replaced the 1977 capitalization rule. However, by 2008, out of the five banks only two survived with the assistance of the bailout provided by the government Grinblatt, 2000). A breakdown in underwriting standards in which forced problematic mortgages, greed and advanced technology have played important roles in the impacts and changes in the market.
The internet plays a significant role as it provides all time access to information. Apart from accessing the information it also tells whether the information is accurate or not. Inaccurate information can mislead investors and consequently can cause potential losses. A regulatory improvement I would suggest is employing a third party vendor to perform auditing procedures of the company. This will ensure that the organization has a neutral company in charge of their financial data and statements (Elton, 2009). Audits should also be done on a regular basis to ensure all policies, procedures and regulations are well taken care of.
Also, trading I securities markets in the United States is regulated by a myriad of laws. The major governing legislation includes the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1933 Act needs full disclosure of relevant information relating to the issue of new securities. This is the Act that requires registration of new securities and issuance of a prospectus that contains details of the financial prospects of the firm (Grinblatt, 2000).
Ethical violations of the company
In 2003, Hollinger Inc. was created by Conrad Black and was one of the largest outlets of media. It was created after parent company Hollinger based out of Chicago, IL. The Chicago Sun-Times was its top paper amongst other newspapers that made up the business (Elton, 2009). Conrad Black, the CEO, controlled a majority of the organizations finances and was later confronted by stockholders regarding the overpayments made to him and other transactions that he was a part of.
This resulted in arrest of the CEO in 2007 being convicted on four charges and sentenced to 78 months in prison. Due to that, the Hollinger Inc. filed bankruptcy in 2007. Conrad Black was released in 2012 after serving only 42 months. This affected his position of authority and also impacted his position of power and the ability to control finances going forward. His decisions also affected those around him as his decision alone resulted in the forfeiture of a company as a whole (Damodaran, 2016).
Consequences appropriate for the senior management of the firm and implications for brokers trading in high risk investments
Generally, all investments carry some degree of risk. Stocks, bonds, exchange traded funds and mutual funds can lose value if market conditions become unfavorable. Even conservative, insured investments such as certificate of deposits (CDs) issued by a credit union or a bank come with inflation risk. They may not earn enough over time to keep pace with the increasing cost of living (Grinblatt, 2000).
The majority of the empirical evidence indicate that individual investors, earn poor long-run returns and would be better off had they invested in a low cost index fund. This evidence of poor performance is particularly compelling when we include transaction costs such as bid-ask spreads, commissions, market impacts and transaction taxes (Elton, 2009).
Individual investors realize that they are at an informational disadvantage when trading and only do so for non-speculative reasons including taxes, rebalancing and liquidity needs. Investors may need to purchase stocks to save or sell stocks to consume (Damodaran, 2016). Investors need to rebalance their portfolios to manage risk-returns tradeoffs. Also investors will want to harvest tax losses to minimize their tax bill.
Scenario where high risk investment would be beneficial
Initial public offerings (IPOs) like the Snapchat attracts a lot of attention that can skew valuations and the judgments professionals offer on short-term returns (Damodaran, 2016). Other IPOs are less high-profile and can offer investors a chance to do shares purchases while a company is severely undervalued leading to high short and long term returns once a correction in the valuation of the company occurs.
Despite the efforts made by the company to disclose information to the public to get the green light on the IPO by SEC, there is still a high degree of uncertainty as to whether a company’s management will perform the necessary duties to promote the company. This is the main reason why IPOs are risky (Elton, 2009).
Damodaran, A. (2016). Damodaran on valuation: security analysis for investment and corporate finance (Vol. 324). John Wiley & Sons.
Elton, E. J., Gruber, M. J., Brown, S. J., & Goetzmann, W. N. (2009). Modern portfolio theory and investment analysis. John Wiley & Sons.
Grinblatt, M., & Keloharju, M. (2000). The investment behavior and performance of various investor types: a study of Finland’s unique data set. Journal of financial economics, 55(1), 43-67.