High-risk investments mean volatility associated with the returns on investments and stock prices change. Any investment transaction has a risk element. Moreover, the major proportion of the investment theory states that the potential profitability is inversely proportional to the risk level . At this, it is not important whether it goes about the passive investment, active stock transactions or new business projects. Risk allows earning much and provokes losing much because associated with potential losses even in the case of success. It is extremely important to understand quantitative and qualitative characteristics of risks, which affect the amount of the invested capital
In order to understand why some investors are lured by the opportunity to earn good profits from high-risk investments, it is important to outline the classification of the investor types. According to Ślepaczuk, at al. (2012), all investors may be divided into:
Strategic investors, who try to get a full control over a certain joint-stock-company;
Portfolio investors, who form an own portfolio of financial instruments considering the risk level, terms, and liquidity. They invest to increase own capital;
Speculative investors, who participate in the turnover of financial instruments on stock exchange investing in short-term deals with derivatives, global funds, binary options and other high-risk short-term transactions.
Thus, the speculative investors choose the highly volatile portfolios at their own risk selecting the gainful short-term financial instruments, consciously investing the cash assets into them. Considering this approach, two opposite outcomes are possible: either the investor gains maximal returns from investments or loses all cash assets altogether. “A feast or a famine” principle is rather attractive for certain types of investors allowing to get significant profits in case of a successful investment. From this perspective, speculative investors prefer foreign exchange market (FOREX), derivatives market, various funds and options while financial instruments here can be characterized by the significant earning power due to a higher ratio of own and borrowed resources or bigger leverage potential. Besides, investors place their stake on a positive event (raise or fall) and this stake may either win or lose. In any case, there are always financial and monetary risks associated with volatile markets and investments .
Among the riskiest investments, experts outline exchange-traded derivatives (futures and options). These derivatives are extremely beneficial due to their liquidity characteristics. Moreover, options and futures can be most advantageously used for hedge exposure or speculations with commodities, interest rates, currency ratios, and other financial assets. The derivatives represent a kind of contract between the trading agents; however, the underlying risk may exceed potential gains especially on the volatile market .
According to Picciotto & Haines (1999), market risks provoke investors to make their decision basing on subjective assumptions and technical analysis of previous trends. Such analytics may give clues of a certain investment outcome; however, the probability of a profitable investment as well as loss/gains ratio is extremely vague . Another issue uprising with futures and options investments is the counterparty risk, which emerges if any of the market agents default on the contract. There are only two options helping to eliminate such a risk: to adjust margin deposits on a daily basis to reflect their actual value and deal only with the trustworthy agents .
Exchange traded derivatives are highly subject to liquidity risks as well. It arises when investors withdraw the derivatives from the market or close out the trade prior to maturity. In this case, the investors have to consider the multitude of the bid-ask spread not to sustain a significant loss . Besides, there is a substantial interconnection risk associated with futures and options trade emerging due to peculiarities of a dealer’s derivative trade, which might directly affect the investor. This risk is often compared to a snowball or chain reaction effect happening when a large dealer (bank or financial institution) causes problems on the derivative market-making unreasonable deals. There is no much advice in how to minimize the risks on exchange-traded derivatives for the investors; however, some rules still have to be followed (JP Morgan, 2013):
Before investing in high-risk financial instruments it is important that the broker informs on all the possible risks concerned futures and options trade, especially on foreign markets due to high volatility of currency exchange rates;
Broker’s information on purchases and sales should come to the investor on daily basis to ensure timely evaluation of all possible risks and gains;
It is necessary to segregate all the money deposited by investor on the account in order to make sure that at least some funds are reimbursed after the brokerage company becomes insolvent;
If the issue with brokerage firm is not resolved, the investor still has an option to appeal to the Commodities Futures Trading Commission to demand arbitration. The last option is, however, to bring the broker to court;
The risk for the broker is always high. Therefore, there is a number of options to provide a minimal insurance against uprising risks (JP Morgan, 2013):
It is optimal to analyze all the derivatives the broker is trading and check all the investors ready to deal on the market. It is a rule of thumb that all the individuals or companies trading with futures and options have to be registered with the Commodities Futures Trading Commission;
It is necessary to inform the investor of all the charges, commissions, and other extra payments before the deal takes place. Explain in detail all the services the company is offering for their clients;
The broker is required to calculate all the break-even prices for any futures or options purchased in order to estimate the profitability and justify the premium cost of any deal;
The broker must be reasonable about the choice of any futures or options contract because at any case the risk of losing an entire value of a trade is always present;
The broker must come up with a clear plan of a trade such as what should be traded, why and what is expected of that trade. All the holdings should be well diversified in terms of time and asset type;
The broker has to possess a diversified trade portfolio investing capital into a variety of markets while it is not wise to invest all the cash into one position losing good trading opportunities due to money shortage;
The trading decision should never be taken in a rush with the intention to make lots of money because that most likely will never happen.
These simple rules might help the broker to secure his position on the exchange-traded derivatives market and minimize the risk to investors.
Global Corporations and Regulatory Issues
Global corporations such as Airbus, GE, IBM, Apple, Ford, Volvo, Vodafone, etc. represent global businesses able to influence the market situation. However, lately, the existing regulations for derivatives trading were significantly criticized as being unfair to global firms . The corporations claim that the regulations for exchange traded derivatives push up the costs for all market participants despite their role in the global financial crisis. The regulatory bodies look up for an opportunity to improve the financial system by implementing stricter rules for derivatives; however, these efforts are not always successful. The primary goal of the present regulations is to protect the companies’ earnings from unexpected shifts in oil prices, commodities, currencies, and swaps .
Thus, the existing rules place an onerous burden on non-financial corporations concerning derivatives not considering the fact that these companies do not provoke a financial crisis and are not exposed to systematic risks trading derivatives (JP Morgan, 2013). Moreover, the tough regulations create unnecessary tension between the corporations and regulatory officials trying to monitor the global markets. It should be noted that the regulators’ position is based on the concept that taxpayers do not have to bail out banks in case of emergency in the future. Moreover, banks have a series of tough rules demanding that their transactions on derivatives should be limited. Regulators require higher transparency, clear risk management strategies and obligatory cooperation with the centralized clearing houses . The market experts underline that the global firms trading derivatives mainly for hedging purposes are burdened with complex and unreasonable regulatory requirements. The need for regulatory measures improvement dictates the regulators to change certain rules easing the trading process for global firms. Among such improvement measures the following can be outlined :
The threshold for derivatives trading should be raised for all globally competing corporations;
The transparency in derivatives reporting increasing the regulators’ trust in such transactions. Special trade repositories have to be established in all countries to report the derivative transactions;
Elaborate the global standardization reporting procedures across all jurisdictions to make derivatives trade more transparent and harmonized for regulators worldwide;
Introduction of legal entity identifiers such as unique global trade and product identifiers to ease the reporting requirements across the regimes;
There should be a secure agreement on cross-border harmonization in case global reporting standards are not adopted in some countries.
In any case, the provided data on derivatives trade has to be measured and safely communicated to all market participants and regulators to track its progress and transparency .
Ethical Violations. However, despite the attempts of regulatory bodies to eliminate the difficulties in dealing with derivatives market, global firms commit at times ethical violations trespassing the established procedures. In this connection, the Enron example is very vivid. The desire to derive maximum profits by using improper means of trading has resulted in significant manipulation of accounting rules misreporting the volumes of losses and liabilities. Another ethical violation deals with the money laundering operations undertaken by the Enron senior management (JP Morgan, 2013). Such activities became possible due to extensive use of bank fraud, conspiracy and active insider trading forbidden by all regulatory legislation worldwide. The Enron CEOs received long-term imprisonments and penalty charges. While the legislation states that in the case of severe ethical violations in trading, the most suitable consequences should follow in terms of confinement; the pre-crime measures and mulcts should also be paid a special attention. The senior management should be able to reimburse the damage their unethical activities, fraud, and insider trading caused to the state. The legislation utilizes the “diversion” concept pointing out the possibility for lawbreakers to exchange the imprisonment by alternative ways of correctional treatment such as free-of-charge work and consulting of law enforcement bodies on fraudulent issues.
It should be noted that the senior management of such companies as Enron represents a pool of extremely experienced experts, whose knowledge and skills can be successfully used for the benefit of the state. Their advice can help the regulators to improve the existing legislation with the exchange-trade derivatives. Therefore, the appropriate consequences for CEOs in the case of malpractice in trading should be more related to monetary punishment rather than penal servitude. It would give the brokers proper understanding of the future implications concerning the high-risk investments trade. Traders should know that moneymaking on the stock exchange and other markets has nothing to do with the ability to win but rather with the ability to manage risks doing it legally.
The question of whether a trader can earn significant profits on high-risk investments using only ethical and legally justified methods remains open. However, there is a proved scenario, which might help the trader to accumulate beneficial financial instruments without losing significant profits. The logic of the scenario is to diversify high risky assets with less risky instruments in several investment schemes such as :
Equity mutual funds scheme, which is most suitable for the blue chip companies. Regulatory bodies, clearing houses and other law enforcement agencies can easily manage and process equity funds operations. Expected returns on investment from using this financial instrument is 12-20%;
Equity/Debt Funds or Balanced Funds scheme, which is distinguished by less risky and more advantageous market movements. Such a fund may become a good choice for investors, who feel less comfortable with pure equity and high-risk investments due to their increased volatility. Expected return on investments in this scheme is 8-15%;
Employee vs Public Provident Fund scheme, which, if mixed with high risky investments, may prove to be risk-free instrument offering an annual average return of 9-10%. The government usually backs up this tax-free instrument;
Government Bonds vs high-risk investments combination may serve as z guarantee of a positive outcome while government supports such bonds and does not default on payments. However, corporate bonds are more preferable than the government ones due to higher profitability. Expected return on investments in this scheme is 7-10%;
Real Estate investments can be combined with the high-risk investment portfolios. This scheme is more vulnerable due to some disappointment in existing real estate sector mixed with corruption and controversies; however, an obvious economic and real estate growth give clues to future beneficial investments in the sector;
Foreign Mutual Funds diversifying the high risky portfolio may prove to be efficient if focused on the countries with intensive economic growth. Such mutual fund companies as Franklin Templeton or Black Rock invest in various countries depending on the fund’s nature. For instance, manufacturing capacities in China or Vietnam may represent a good investment option while the US or Saudi Arabia are good target markets for shale oil or oil exploration investment.
Thus, the rationale for a beneficial use of high risky investments centers around the diversification idea when more risky instruments are combined with less risky ones, which can give a guaranteed return on investments and are supported by relatively safe financial basis. The described scheme is represented in the table below (Table 1).
It should be noted that investment process is vitally important, which means the trader has to check the stock prices and funds’ trends. A comprehensive look should be taken on all investment portfolios at least every month. Regular assessments may help to find the most beneficial investment paths or discard the unprofitable investment schemes.
Reference
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Morgan, J. P. (2013). Derivatives and Risk Management Made Simple. NAPF, pp. 2-24.
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Picciotto, S., & Haines, J. (1999). Regulating Global Financial Markets. Journal of Law & Society Vol. 26(3) , pp. 351-368.
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