Market forces and Equilibrium, Risk, Return and Profits

Economic Equilibrium

Economic equilibrium is a condition or state in which economic forces are balanced. In effect, economic variables remain unchanged from their equilibrium values in the absence of external influences. Economic equilibrium is also referred to as market equilibrium.

Economic equilibrium is the combination of economic variables (usually price and quantity) toward which normal economic processes, such as supply and demand, drive the economy. The term economic equilibrium can also be applied to any number of variables such as interest rates or aggregate consumption spending. The point of equilibrium represents a theoretical state of rest where all economic transactions that “should” occur, given the initial state of all relevant economic variables, have taken place.

KEY TAKEAWAYS

• Economic equilibrium is a condition where market forces are balanced, a concept borrowed from physical sciences, where observable physical forces can balance each other.
• The incentives faced by buyers and sellers in a market, communicated through current prices and quantities drive them to offer higher or lower prices and quantities that move the economy toward equilibrium.
• Economic equilibrium is a theoretical construct only. The market never actually reach equilibrium, though it is constantly moving toward equilibrium.

Economic Equilibrium in the Real World

Equilibrium is a fundamentally theoretical construct that may never actually occur in an economy, because the conditions underlying supply and demand are often dynamic and uncertain. The state of all relevant economic variables changes constantly. Actually reaching economic equilibrium is something like a monkey hitting a dartboard by throwing a dart of random and unpredictably changing size and shape at a dartboard, with both the dartboard and the thrower careening around independently on a roller rink. The economy chases after equilibrium with out every actually reaching it.

With enough practice, the monkey can get pretty close though. Entrepreneurs compete throughout the economy, using their judgement to make educated guesses as to the best combinations of goods, prices, and quantities to buy and sell. Because a market economy rewards those who guess better, through the mechanism of profits, entrepreneurs are in effect rewarded for moving the economy toward equilibrium. The business and financial media, price circulars and advertising, consumer and market researchers, and the advancement of information technology all make information about the relevant economic conditions of supply and demand more available to entrepreneurs over time. This combination of market incentives that select for better guesses about economic conditions and the increasing availability of better economic information to educate those guesses accelerates the economy toward the “correct” equilibrium values of prices and quantities for all the various goods and services that are produced, bought, and sold.

RISK

Risk takes on many forms but is broadly categorized as the chance an outcome or investment’s actual return will differ from the expected outcome or return. Risk includes the possibility of losing some or all of the original investment. Different versions of risk are usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.

A high standard deviation indicates a high degree of risk. Many companies allocate large amounts of money and time in developing risk management strategies to help manage risks associated with their business and investment dealings. A key component of the risk management process is risk assessment, which involves the determination of the risks surrounding a business or investment.

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return. Investors need to be compensated for taking on additional risk. For example, a U.S. Treasury bond is considered one of the safest, or risk-free, investments and when compared to a corporate bond, provides a lower rate of return. A corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return.

There are several ways to measure risk, such as downside deviations, Roy’s safety first ratio, and portfolio standard deviation. Measuring risk allows investors and traders to hedge some of that risk away using various strategies including employing derivatives positions.

KEY TAKEAWAYS

• Risk takes on many forms but is broadly categorized as the chance an outcome or investment’s actual return will differ from the expected outcome or return.
• Risk includes the possibility of losing some or all of the original investment.
• There are several ways to quantify risk including standard deviation, VaR, and the safety-first ratio.
• Risk can be reduced using hedging strategies to insure against some losses.

Types of Financial Risk

Market risk and specific risk are two different forms of risk that affect assets. All investment assets can be separated by two categories: systematic risk and unsystematic risk. Market risk, or systematic risk, affects a large number of asset classes, whereas specific risk, or unsystematic risk, only affects an industry or particular company.

(i) Systematic risk

It is the risk of losing investments due to factors, such as political risk and macroeconomic risk, that affect the performance of the overall market. Market risk is also known as volatility and can be measured using beta. Beta is a measure of an investment’s systematic risk relative to the overall market.

(ii) Market risk

It cannot be mitigated through portfolio diversification. However, an investor can hedge against systematic risk. A hedge is an offsetting investment used to reduce the risk in an asset. For example, suppose an investor fears a global recession affecting the economy over the next six months due to weakness in gross domestic product growth. The investor is long multiple stocks and can mitigate some of the market risk by buying put options in the market.

(iii) Specific risk, or diversifiable risk

It is the risk of losing an investment due to company or industry-specific hazard. Unlike systematic risk, an investor can only mitigate against unsystematic risk through diversification. An investor uses diversification to manage risk by investing in a variety of assets. He can use the beta of each stock to create a diversified portfolio.

For example, suppose an investor has a portfolio of oil stocks with a beta of 2. Since the market’s beta is always 1, the portfolio is theoretically 100% more volatile than the market. Therefore, if the market has a 1% move up or down, the portfolio will move up or down 2%. There is risk associated with the whole sector due to the increase in supply of oil in the Middle East, which has caused oil to fall in price over the past few months. If the trend continues, the portfolio will experience a significant drop in value. However, the investor can diversify this risk since it is industry-specific.

The investor can use diversification and allocate his fund into different sectors that are negatively correlated with the oil sector to mitigate the risk. For example, the airlines and casino gaming sectors are good assets to invest in for a portfolio that is highly exposed to the oil sector. Generally, as the value of the oil sector falls, the values of the airlines and casino gaming sectors rise, and vice versa. Since airline and casino gaming stocks are negatively correlated and have negative betas in relation to the oil sector, the investor reduces the risks that affect his portfolio of oil stocks.

(iv) Business risk

It refers to the basic viability of a business—the question of whether a company will be able to make sufficient sales and generate sufficient revenues to cover its operational expenses and turn a profit. While financial risk is concerned with the costs of financing, business risk is concerned with all the other expenses a business must cover to remain operational and functioning. These expenses include salaries, production costs, facility rent, and office and administrative expenses. The level of a company’s business risk is influenced by factors such as the cost of goods, profit margins, competition, and the overall level of demand for the products or services that it sells.

(v) Credit or Default Risk

Credit risk is the risk that a borrower will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is particularly concerning to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and, as such, the lowest returns. Corporate bonds, on the other hand, tend to have the highest amount of default risk, but also higher interest rates. Bonds with a lower chance of default are considered investment grade, while bonds with higher chances are considered junk bonds. Investors can use bond rating agencies – such as Standard and Poor’s, Fitch and Moody’s – to determine which bonds are investment-grade and which are junk.

(vi) Country Risk

Country risk refers to the risk that a country won’t be able to honor its financial commitments. When a country defaults on its obligations, it can harm the performance of all other financial instruments in that country – as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit.

(vii) Foreign-Exchange Risk

When investing in foreign countries, it’s important to consider the fact that currency exchange rates can change the price of the asset as well. Foreign exchange risk (or exchange rate risk) applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you live in the U.S. and invest in a Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the U.S. dollar.

(viii) Interest Rate Risk

Interest rate risk is the risk that an investment’s value will change due to a change in the absolute level of interest rates, the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. This type of risk affects the value of bonds more directly than stocks and is a significant risk to all bondholders. As interest rates rise, bond prices fall – and vice versa.

(ix) Political Risk

Political risk is the risk an investment’s returns could suffer because of political instability or changes in a country. This type of risk can stem from a change in government, legislative bodies, other foreign policy makers or military control. Also known as geopolitical risk, the risk becomes more of a factor as an investment’s time horizon gets longer.

(x) Counterparty Risk

Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions, espcially for those occurring in over-the-counter (OTC) markets. Financial investment products such as stocks, options, bonds, and derivatives carry counterparty risk. Bonds are rated by agencies, such as Moody’s and Standard and Poor’s, from AAA to junk bond status to gauge the level of counterparty risk. Bonds that carry higher counterparty risk pay higher yields.

RETURN

A return, also known as a financial return, in its simplest terms, is the money made or lost on an investment over some period of time.

A return can be expressed nominally as the change in dollar value of an investment over time. A return can also be expressed as a percentage derived from the ratio of profit to investment. Returns can also be presented as net results (after fees, taxes, and inflation) or gross returns that do not account for anything but the price change.

KEY TAKEAWAYS

• A return is the change in price on an asset, investment, or project over time, which may be represented in terms of price change or percentage change.
• A positive return represents a profit while a negative return marks a loss.
• Returns are often annualized for comparison purposes, while a holding period return calculates the gain or loss during the entire period an investment was held.
• Real return accounts for the effects of inflation and other external factors, while nominal return only is interested in price change. Total return for stocks includes price change as well as dividend and interest payments.
• Several return ratios exist for use in fundamental analysis.

Nominal Return

A nominal return is the net profit or loss of an investment expressed in nominal terms. It can be calculated by figuring the change in value of the investment over a stated time period plus any distributions minus any outlays. Distributions received by an investor depend on the type of investment or venture but may include dividends, interest, rents, rights, benefits or other cash-flows received by an investor. Outlays paid by an investor depend on the type of investment or venture but may include taxes, costs, fees, or expenditures paid by an investor to acquire, maintain and sell an investment.

Real Return

A real rate of return is adjusted for changes in prices due to inflation or other external factors. This method expresses the nominal rate of return in real terms, which keeps the purchasing power of a given level of capital constant over time. Adjusting the nominal return to compensate for factors such as inflation allows you to determine how much of your nominal return is real return. Knowing the real rate of return of an investment is very important before investing your money. That’s because inflation can reduce the value as time goes on, just as taxes also chip away at it.

PROFIT

Profit is a financial benefit that is realized when the amount of revenue gained from a business activity exceeds the expenses, costs, and taxes needed to sustain the activity. Any profit that is gained goes to the business’s owners, who may or may not decide to spend it on the business. Profit is calculated as total revenue less total expenses.

Profit is the money a business makes after accounting for all expenses. Regardless of whether the business is a couple of kids running a lemonade stand or a publicly traded multinational company, consistently earning profit is every company’s goal. As a result, much of business performance is based on profitability in its various forms.

Some analysts are interested in top-line profitability, whereas others are interested in profitability before expenses, such as taxes and interest, and still others are only concerned with profitability after all expenses have been paid.

There are three major types of profit that analysts analyze: gross profit, operating profit, and net profit. Each type gives the analyst more information about a company’s performance, especially when compared against other time periods and industry competitors.