Question

• What makes different financial assets risky and and what is affecting their risk?
• Which has greater interest rate risk, a 30-year Treasury bond or a 30-year BB corporate bond?
• What do you think are the most important criteria that rating firms use to rate different financial assets?
• Why does the value of a share of stock depend on dividends? Many actively traded public companies don't pay dividends, but investors are nonetheless willing to buy shares in them. Given your answer to the first part of this question, how is this possible?  

Answer 1

1) Risks associated with the financial assets & what affects that risk

A brief understanding of the concept of risk and what affects it

With any kind of investment or business, there is always risk involved, somehow. Risk is the possibility that an outcome will not be as expected, in reference to returns on investment.
In investing, risk is measured by the standard deviation equation. The equation measures how volatile the stock is (its price swings) compared to its average price. The higher the standard deviation, the higher the risk for a stock or security, and the higher the expected returns should be to compensate for taking on that risk.
Low-risk stocks tend to have fewer swings in price and therefore more modest returns on investment. However, high-risk stocks typically swing randomly (or are expected to) in price and can often see huge returns. However, because they are more risky, the investor is taking more of a chance that the return on their investment won't be what they expect (and may in fact cause them to lose their entire investment).
A major factor that comes into play when evaluating risk in a portfolio is the time horizon. Essentially, a time horizon is how long an investor is able to keep his money in the market or the individual stock. If he has a long time horizon, he can generally invest in higher risk stocks because he has got more time to ride out any dips in the market. However, if the investor has a short time horizon (meaning he can only keep money in the market or the stock for a short period of time), he may need to pick lower risk investments that have less of a chance of dipping dramatically.
For example, a U.S. Treasury bond is considered one of the safest (low risk) investments.

Volatility - Volatility is the speed of movement in the price of an asset. A higher level of volatility indicates larger moves in the value of an asset. Volatility is a non-directional value—a higher volatility asset has an equal likelihood of making a larger move up as it does down. Some investors like volatility, while others try to avoid it as much as possible. Either way, a high volatility instrument carries greater risk.

Averages - While historic averages over long periods can guide decision-making about risk, it can be difficult to predict whether, given specific circumstances and with the investor's particular goals and needs, the historical averages will play in his favor. Even if someone holds a broad, diversified portfolio of stocks such as the S&P 500 for an extended period of time, there is no guarantee that they will earn a rate of return equal to the long-term historical average.

The timing of both the purchase and sale of an investment are key determinants of your investment return (along with fees). If you buy a stock or stock mutual fund when the market prices are high, you will have greater losses if the price drops for any reason compared with an investor who bought at a lower price. That means your average annualized returns will be less than theirs, and it will take you longer to recover.

Holding a portfolio of stocks even for an extended period of time can result in negative returns. Investors holding individual stocks for an extended period of time also face the risk that the company they are invested in could enter a state of permanent decline or go bankrupt.

General Risk factors of a financial asset :-

• Market Risk: the risk that changes in market prices have an adverse effect on asset values. Market risks are of two types. They are systematic risks which is non diversifiable or unavoidable risk (e.g. - natural disaster, political instability) and unsystematic risk or diversifiable risk or company / industry specific risk (e.g. - strike, bad management, location risk & succession risk).
• Interest Rate Risk: the risk that changes in interest rates have an adverse effect on asset values.
• Currency Risk: the risk that exchange rate movements can affect values where the asset price is denominated in a foreign currency.
• Liquidity Risk: the risk that an investment may be difficult to sell in adverse market conditions.
• Economic Risk: the risk that adverse economic developments may affect asset values.
• Country Risk: the risk that the value of an asset located in a particular country may be adversely affected by political or economic developments in that country.
• Legal Risk: the risk that changes to the law could affect the value or marketability of a particular investment.
• Inflation Risk: the risk that price inflation coul affect the real value of an investment.
• Counterparty Risk: the risk that a counterparty may not meet its contractual obligations in full.

In addition to the general risks above, there are also risks which pertain specifically to separate asset classes. They are :-

1. Equities (Shares)

Investing directly in shares may involve the following risks:

• Company Risk: company shareholders are directly exposed to all matters affecting the business and operations of that company and in the extreme could lose all of their investment.
• Price Risk: the price of a company’s shares can be affected by market factors which are independent of the underlying performance of the company.
• Dividend Risk: future dividend payments can be affected by a range of influences and the level of such payments cannot be relied upon by investors.

2. Bonds - The risks associated with bonds can be very different from shares. Among the specific risks are the following:

• Default Risk: the risk that the bond issuer may not be in a position to pay interest or repay capital or both.
• Interest Rate Risk: most bonds pay a fixed rate of interest and as a result their market values are negatively by rises in market interest rates.

3. Funds

Funds are collective investments and the category can include can include quite a wide range of structures. Most funds available to to retail investors are open ended offering a high degree of liquidity. However, the category also includes closed-end funds which may be listed offering good liquidity or may be unlisted with very limited liquidity. Among the specific risks pertaining to funds are the following:

• Redemption Risk: while open ended funds offer regular liquidity (usually daily), this feature can often be withdrawn temporarily in adverse market conditions.
• Regulatory Risk: funds located outside of the EU may be subject to lower investor protections and/or varying regulatory issues compared to funds regulated inside the EU.
• Gearing Risk: some funds are authorised to use gearing or to invest in derivatives which may substantially increase the underlying risk.
• Diversification Risk: funds investing in a very narrow range of assets may carry a much lower degree of diversification than might be expected by the investor.
• Evaluation Risk: funds investing in illiquid assets may be difficult to value, particularly in adverse market conditions.
• Management Risk: the performance of a fund will depend to a great degree on the competence of its management. Poor decision making by the management or the loss of particular individuals may have a significant influence on the performance of that fund.

2)  30 - year Treasury Bond will have greater risk as compared to 30 - year BB corporate bond. Because, all other factors remaining constant, treasury security will have lower coupons because of its lower default risk and hence it will have a greater interest rate risk.
Although Treasuries are considered to have very low credit risk, they are affected by other types of risk, mainly interest-rate risk and inflation risk. While investors are effectively guaranteed to receive interest and principal payments as promised, the underlying value of the bond itself may change depending on the direction of interest rates.

As with all fixed-income securities, if interest rates in general rise after a U.S. Treasury security is issued, the value of the issued security will fall, since bonds paying higher rates will come into the market. Similarly, if interest rates fall, the value of the older, higher-paying bond will rise in comparison with new issues.

3) A rating agency is a company that assesses the financial strength of companies and government entities, especially their ability to meet principal and interest payments on their debts. The rating assigned to a given debt shows an agency’s level of confidence that the borrower will honor its debt obligations as agreed. Each agency uses unique letter-based scores to indicate if a debt has a low or high default risk and the financial stability of its issuer. The debt issuers may be sovereign nations, local and state governments, special purpose institutions, companies, or non-profit organizations.

The credit rating industry is dominated by three big agencies, which control 95% of the rating business. They are - Moody’s Investor Services, Standard and Poor’s (S&P), and Fitch Group.

Criteria that rating firms use to rate different financial assets

1) Bonds are rated at the time they are issued, and both bonds and their issuers are periodically reevaluated to see if a ratings change is warranted. Bond ratings are important not only for their role in informing investors, but also because they affect the interest rate that companies and government agencies pay on their issued bonds.

2) A business’s credit rating is a review of the company’s transaction history. Such a rating is used to measure the level of financial risk of the business to a lender and the probability of the business defaulting on the loan.

3) The information used to create a rating is gathered from companies with which the business has had financial relationships, such as suppliers, lenders. Additional data can be collected from corporate finance reports, business filings, or lawsuits, as well as liens and judgments filed against the company.

4) Among the primary determining factors of a business’s credit report is how prompt the business is in meeting its payment obligations, such as paying suppliers, repaying loans, and paying monthly leases and bills.

5) What is the structure of the company’s debt? Are loans secured or unsecured? How much debt is the business carrying?

6)  Along with the payment history, strong consideration is also given to cash flow, the financial resources of the company, working capital, and net worth.

7) The business profile is also looked into, including the business’s size, history, and reputation, along with the background of the principals and company stock, number of employees, and structure of the business. By factoring in the business profile, the rating will also reflect the size and scope of the business.

All these factors are included in a mathematical formula that comes up with a credit rating. The credit rating illustrates whether a business:

• Is responsible in its payment procedures;
• Has the assets to repay debts or provide collateral if necessary;
• Has the strength and background to stand behind its business transactions.

4) Explanation of why does the value of a share of a stock depends upon the dividend

Through dividend payments, companies share their profits with stockholders.
Dividend payments increase demand for a stock and consequently result in a higher stock price. Dividend payments also send a strong message to the investor community and boost the confidence of potential buyers.

• Increased Demand
  A dividend paying stock produces a regular income stream for the investor, thereby reducing the impact of stock market fluctuations on a portfolio. Assume you have $200,000 to invest and must produce $10,000 from your stock investments every year to help cover your living expenses. If you can identify numerous stocks that pay an average of 5 percent dividend per year, then your $200,000 investment will return $10,000 in dividend payments. This will eliminate the need to periodically sell stocks to raise enough cash. If, on the other hand, you invest in non-dividend paying stocks and must frequently liquidate part of your stocks to obtain cash, you may be forced to sell shares when the stock market is going through a downturn. Therefore, investors often prefer dividend paying stocks, which boost demand and thus result in higher prices for such shares.

• Confidence
  Even investors who do not need a regular stream of income prefer dividend-paying stocks, since regular dividends send a strong message about the financial viability of the corporation. As such, dividend payments improve investor confidence and increase the demand for the stock.

• Dividend Record Date
  In addition to the long-term increase in demand and the consequent rise in the stock price as a result of dividends, there is also a short-term fluctuation in the share price depending on the dividend cycle. Since shares of public corporations change hands very frequently, the issuing company only pays dividends to the investor who is holding the shares as of a certain date during the year. This is referred to as the dividend record date. The stock is said to go "ex-dividend" after this date, meaning the investor who purchases shares thereafter will not be entitled to receive that particular dividend. As a result the price of a stock declines on the ex-dividend date.

• Reinvesting Earnings
  The increase in demand for dividend-paying stocks should not lead to the conclusion that receiving dividends is always better for the stockholder. Stockholders often prefer those companies with attractive growth prospects rather than receiving some dividends and would instead want those companies to reinvest their profits into the business for maximum long-term growth. Shares of companies that pursue such a strategy are known as growth stocks. If most competitors are investing heavily to increase capacity or innovate cutting edge products, paying too much in dividends -- thereby not investing enough in the future -- can result in losing market share.

Reasons to Buy Non-Dividend Paying Stocks

In the past, the market considered non-dividend-paying stocks to mainly be designated as growth companies since expenses from growth initiatives exceeded their net earnings. However in the modern market scenario, firms have decided not to pay dividends under the principle that their reinvestment strategies will—through stock price appreciation—lead to greater returns for the investor.

Thus, investors who buy stocks that do not pay dividends prefer to see these companies reinvest their earnings to fund expansion and other growth projects which they hope will yield greater returns via rising stock price.Many small, medium & large cap cos. have decided not to pay dividends in the hopes that management can provide greater returns to shareholders through reinvestment.

A non-dividend paying company may also choose to use net profits to repurchase their own shares in the open market in a share buyback.

Well-established companies often reinvesting their earnings, in order to fund new initiatives, acquire other companies, or pay down debt. All of these activities tend to spike share price.