So, what is an example of a risky position? Take the case of an investment in a share that will give a return of 0% with 25% probability, –10% with 25% probability, and 10% with 50% probability. This is clearly risky, for the outcome can take one of three possible values, one of which would lead to a loss for the investor. Financial securities are exposed to multiple types of risks.
Credit Risk: This is the risk that the deficit budget unit, which raises funds, may not make payments as promised to the investor. For instance, a business may issue bonds to the public with a face value of $1,000, and an assured interest rate of 10% to be paid every year. At the end of a financial year, however, it may be unable to make the promised interest payment. Or else, at the time of maturity of the security, it may be unable to repay the principal in full. Similarly, a financial institution like a bank, which makes loans to borrowers, is also faced with the specter of nonpayment. Such risk is also termed as default risk.
Price Risk: Price risk or market risk is the risk that the price of the security at the time of purchase may be higher than its price at the point of a subsequent sale. In other words, it is the risk that there could be a capital loss for the investor. All marketable securities are subject to such risk.
Reinvestment Risk: Whenever investors receive a cash flow from a security, they should reinvest it in the market, in order to ensure that they get an anticipated compounded rate of return. There is always a risk, however, that the prevailing market interest rate may be lower than what was expected at the outset. If so, the investor will have to settle for a lower than anticipated compounded rate of return. Such risk is termed as reinvestment risk.
Inflation Risk: Inflation, or the erosion of purchasing power of money, is associated with every investment. Every investor will have a required rate of return that will include a premium for the anticipated rate of inflation; however, if the rate of inflation were to be higher than anticipated, the effective rate of return in terms of the ability to buy goods and services may be lower than expected. The return from a security in the absence of inflation is termed as the real rate. All investors will obviously demand a positive real rate of return. They will add a mark-up to this for the expected inflation, to arrive at what is called the nominal or money rate of interest. If inflation is higher than anticipated, however, the real rate received at maturity may be less than expected and can possibly be negative. The anticipated interest rate is referred to as the ex-ante rate. The interest rate that is eventually received is termed as the ex-post rate. In the absence of default, the ex-ante nominal rate will be equal to the ex-post nominal rate. However, because of inflation, the ex-post real rate may be lower or higher than anticipated and may possibly be negative.For instance, assume that the ex-ante real rate is 4% per annum and the expected inflation is 2.5% per annum. Thus, the nominal rate will be set at . However, if the actual rate of inflation is 4% per annum, the ex-post real rate will be only 2.5% per annum. If the actual rate of inflation were to be 8% per annum, the ex-post real rate will be a negative 1.30% per annum.
Liquidity Risk: We have already expounded on this issue. Whenever funds are blocked in an investment, there is always the risk that at the time of its subsequent sale, the market may not be as liquid as it was at the time the securities were acquired. If so, the seller may have to make a substantial concession by way of a reduction in price in order to complete the transaction. It must be remembered that if a transaction takes a considerable amount of time for execution, there is an associated cost, for time is money. Thus, the absence of an adequate number of buyers or sellers poses a risk for a party seeking to sell or to buy.
Foreign Exchange Risk: This is a risk that is associated with an investment in a foreign country. If the domestic currency were to appreciate with respect to the currency in which the assets are denominated, there could be a loss for the investor.Assume that a US investor makes an investment of $100 in an Indian security when the exchange rate is INR 75 per dollar. At the end of one year, the price of the asset has increased from INR 7,500 to INR 7,800. Thus, there is a 4% return in rupee terms. However, the exchange rate at the end of the year is INR 80 per dollar. That is, the rupee has depreciated or the dollar has appreciated. Now, if the funds are repatriated to the United States, the American investor will receive only $97.50. Thus, there is a loss of 2.50% for him in dollar terms.
Sovereign Risk: Such risk is associated with the structure of foreign economies and governments. Assume that a bank makes a loan to a party in Latin America, which subsequently defaults. In such cases, the lender may not have access to the same legal means of redressal that prevail in the United States. Besides, foreign governments may not be democratically elected or legally accountable. In certain countries, governments may suddenly impose exchange controls for instance, which could preclude a foreign company from repatriating the funds invested by it. It is not only foreign corporate securities that pose such risk; foreign government securities too are risky. There is always a likelihood that a Latin American government, for instance, which has issued bonds denominated in US dollars, may default. Such parties need not default on debt securities denominated in their own currencies, for they have the freedom to print money; however, such countries cannot print foreign currencies like the dollar or the euro.
AFTER THE TRADE – CLEARING AND SETTLEMENT
After a trade has been matched by a trading system, a post-trade process called clearing and settlement needs to commence in order to ensure that the seller receives the cash that is due to him, while the buyer receives the securities that he has acquired.
Clearing refers to all the post-trade processes other than final settlement, where the term settlement refers to the payment of cash to the seller and transfer of ownership of the securities from the seller to the buyer. Settlement is the last step in the post-trade process.
Different security types have different settlement cycles. Money market securities such as negotiable CDs and commercial paper settle for cash, that is on the same business day. Most US Treasury securities settle on the next business day. Most foreign exchange transactions settle for spot, that is two business days after the trade date (T+2 settlement). Equity and municipal bond transactions in the United States settle three business days after the trade date (T+3) settlement.
DEMATERIALIZATION AND THE ROLE OF A DEPOSITORY
A depository is a facility for holding securities in electronic form so that the purchase and sale of shares can take place via a process of book entry. The shares may be either dematerialized or immobilized. The term dematerialization refers to the replacement of physical share certificates by electronic records. On the other hand, if the securities were to be immobilized, an electronic record would be created without destroying the original physical certificates, which would continue to be held in secure storage.
The function of a depository is akin to that of a commercial bank. We will illustrate the similarities with the help of a simple tabular format as shown in Table 1.1.
The benefits of holding securities with a depository in dematerialized form are as follows.
1 It offers a safe and convenient way to hold securities.
2 It facilitates immediate transfers of securities.
3 No stamp duty is payable in most cases when securities are transferred in dematerialized form.
4 Transfer of shares in physical form has certain attendant risks such asBad deliveryFake certificatesDelaysTheftsThese can be eliminated by holding securities in dematerialized form.
5 There is considerable reduction of paperwork involved in the transfer of securities.
6 There is a reduction in the transactions costs involved in securities trading.
7 The concept of lot size has no meaning. Even one share can be bought or sold.
8 Nomination facility is available.
9 A change of address of holders gets registered with all the companies in which they hold securities. This eliminates the need for them to correspond