Introduction
High-risk investments refer to the type of investments whereby the investor is exposed to a higher risk of losing their investment capital given the volatile nature of performance of their investment asset in either the capital or financial market (Liu & Yang, 2017). Investment assets are exposed to different types of risk, which emanate inherently from the asset itself, and from other external factors (Trang & Thong, 2017). For instance, the performance of a stock asset might be affected by the performance of the individual stock company, or external factors such as inflation. Apart from stocks, other high-risk instruments include ETFs, derivatives, and global funds. Investors get attracted to these instruments for three primary reasons, that is, the high return associated with the assets, the flexibility to hedge the associated risk, and their ability to caution against risks such as inflation. Additionally, the paper will present the specific risks associated with high-risk investments and how investors minimize them, challenges of regulating complex global firms, a case of an ethical violation by a brokerage firm, and situations where high-risk investments are beneficial.
Reasons why Investors May Be Attracted to High-risk Investments
Based on portfolio theory, the high risk associated with a particular asset is meant to be compensated with a higher return up to the level of risk taken by an investor (Platanakis & Urquhat, 2020) . Therefore, the higher the risk, the higher the return based on a strategic investment plan applied on the asset in question. Investors choose ETFs for this major reason. There is always chance for loss of capital by the investor, but at the same time, if the investor wins a trade on the asset, the returns are enormously rewarding (Liu et al., 2019). For instance, there are approximately 25 risk types associated with ETFs, which might include collateral risk, volatility risk, tracking errors, liquidity, mandatory call risk, market risk, among other types which increase the exposure to loss for the investor.
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The compensation for holding such risks is higher. On the other hand, most of high-risk investments are linked with hedging facilities to help cushion the eminent risk in the asset. Different hedging strategies are employed by investors in the capital and financial markets, which mostly utilize assets such as options and futures to compensate the loss made, or reduce the loss incurred. Compared to low-risk and medium-risk investments, investors feel safer with their trading positions on these types of assets. Instruments such as global funds offer a more diverse hedge, given its ability to balance losses with gains from different countries, and even maximize the returns in some cases. Last, since inflation risk is among the risk profile for investment assets, investors get attracted to high-risk investments due to their ability to beat the effect of inflation, hence minimizing losses in extreme financial situations.
Risks Associated with ETFs Such as Options and Futures, and What Brokers Might Do to Minimize the Risks
The most common types of risks associated with ETFs include market risk, gearing risk, and price risk (Shevchenko, 2018). ETFs are leveraged assets; hence, their value can easily change based on the gearing ratio attached to a particular underlying asset. For the case of future contracts, the binding agreement between the buyer and seller dictates a particular price for transaction regardless of the price level at maturity of the contract. Therefore, both the buyer and the seller of the contract are exposed to unlimited losses, hence high risk. The initial margin amount is usually small vis-à-vis the value of the contract. In that case, a small market movement impacts the agreed amount for transaction at a future date by a larger proportion. If the movement is against an investor’s position, they are required to pay additional funds to maintain their margin, or else they face liquidation at a loss. However, investors have devised several ways to minimize this risk, for instance, through investing in low-beta assets and embedded contracts with assets such as Dividend ETFs. Dividend ETFs such as the REIT ETFs provide real return to the investors, which in turn compensates for the loss event.
Price risk is associated with unexpected price movements of the futures and options contracts. For futures and options, the normal pricing relationship between the underlying assets and the contract in question might not exist, which makes it difficult to professionally judge the fair value of a contract (Shevchenko, 2018). For instance, future contracts underlying options might be subject to price limits while options might not. Therefore, to minimize this type of risk, most investors use diversification strategy and short selling. In diversification, the risk is minimized by spreading a higher risk across other instruments based on the allocation strategy applied (Bogdan et al., 2016). On the other hand, short selling is basically the sale of an asset whereby the seller is not the owner: the investor might borrow a stock, sell it, buy it, then return to the owner through which the return collected compensates for any unexpected losses as a result of price movements.
Market risk emanates from the possibility that the interaction between supply and demand within the market might not favor the trading position of an investor. It affects the price movement of the underlying asset for futures and options, which might cause an erosion of returns (Han et al., 2017). Investors minimize market risk through diversification strategies and use of portfolios. In these portfolios, they mix these ETFs with other low-risk and medium-risk assets to cushion the risk associated with the derivatives.
Challenges of Regulating a Complex Global Financial Firm
Regulation practices for any financial firm encompass aspects such as taxation, capital requirements, and general ethical standards of fair play among others. However, when a financial firm is global, aspects such as taxation and capital requirements change from one country to the other. In that case, it becomes difficult for the regulatory body of origin of the company to regulate the firm. A complex global financial firm is exposed to different tax practices, which are country-specific. At the same time, there is always a conflict of double taxation for the regulatory bodies of the country of origin given that revenues earned from other countries are usually taxed already. The same situation applies to capital requirements which are different from one country to the other, thus, it might be difficult for a regulatory body of the country of origin to stipulate a one-size-fits-all capital requirement level. Additionally, a complex global financial company is exposed to different market dynamics, especially for risk. Therefore, regulatory practices regarding ethical practices in risk management might be difficult to apply. To solve these issues, an approach similar to that taken by accounting and financial reporting standards should be used. International standards similar to the IFRS and GAAP should be implemented regarding conflicting issues of regulation for global firms. Based on the international standards, it would become easier to have fair regulation for these firms.
Ethical Violation by Leeson Futures and Options Brokerage in Singapore
Capital and financial markets are run by information in the sense that technical and fundamental information within the market form a significant part of the price of an asset. This assertion is based on the efficient market hypothesis, that the price, or value of an asset reflects the information within the market. Therefore, knowledge of information regarding a particular asset, which is not yet in the public domain might give an investor an advantage over those who are uninformed, thus leading to a malpractice. In the same vein, manipulation of this information to suit an investor’s position or margin within the market is unethical. Nick Leeson’s brokerage for futures and options in the Singapore market was found guilty of price manipulations and taking of unauthorized trades within the derivatives market to make huge profit for Barings Bank, and hide his losses on lost trades (Rafeld et al., 2017). In this case, the manipulations of the price were done through use of insider information to gain advantage in the market movement as well as staking high risk positions unauthorized by the regulators, hence making enormous profits for Barings bank among other clients. Leeson was discovered and sentenced to a six-year imprisonment, while Barings bank became bankrupt after compensations in 1995.
Consequences for Senior Management and Implications for Brokers
The most appropriate action to be taken against the senior management of a brokerage firm found with ethical violation practices is a withdrawal, or suspension of their asset management licenses and rights to perform any investment as a third party, or transact on behalf of the authority guarding the capital markets. The licensing for the management of most brokerage firms is done by the respective capital market authorities based on a legal agreement to conditions set by the regulator ( Trang & Tho, 2017) . Therefore, violation of these conditions automatically implies violation of the licensing terms, hence, it is not logical to let them keep their licenses for practice until further investigations are done. Apart from that, since ethical violation under this situation is a legal violation, the senior management are to be sued in a court of law for fraudulent activities and breach of a contractual agreement between the brokerage firm and the regulator.
Under such circumstances, the senior management might have to pay hefty fines in compensation for unscrupulous returns earned from the manipulated positions in the market, among other court fines. The implication of these consequences for the brokerage firm are liquidation due to insolvency emanating from payment of law suit fines and compensations, and business license among other trading licenses termination, and lastly business closure. However, if the brokerage firm manages to survive the financial implications of ethical violation, the reputational capital of the firm will be compromised hence deteriorating performance in the stock market as well as loss of trust by its clients, which implies loss of business and market share.
Scenario Where Use of High-Risk Investment Would be Beneficial
ETFs are high-risk investments. However, their nature to hedge against financial losses has made them attractive to investors over years since their introduction in the capital markets. High-risk investment vehicles such as exchange traded derivatives are most beneficial in hedging transactions that involve highly precious items such as gold, oil, and agricultural produce whose price fluctuations is extremely volatile ( Trang & Tho, 2017) . ETFs such as futures and options are the most appropriate in these scenarios. Two parties transacting barrels of oil or agricultural produce need protection from the possible financial loss from a fall in the prices of these items at the time of their transaction in future. Losses from goods such as oil, gold, and agricultural produce arise from risks such as exchange rate fluctuations, and price risk. Therefore, through purchasing an option, say a put option, a farmer protects a given amount of his produce against price fall up to a certain level, at the time they will need to sell their produce. If the event of loss fails, the farmer enjoys the profits as well as the returns from their holding position on the option contract.
Conclusion
High-risk investments have a high chance of financial loss especially if the downside is not accurately managed by an investment professional, or an experienced trader. Therefore, assets such as ETFs expose traders and investors to both huge losses and massive profits at the same time, where the outcome is dependent on the skill of the investor to choose an informed margin or position. Given the risk involved, some investors get tempted to indulge in manipulation of the market to gain profits after experiencing huge losses. An example is the Leeson brokerage firm which led to the eventual bankruptcy of Barings bank in 1995. Such ethical violations are usually punished both legally and business-wise. Despite such caveats in high-risk investments, investors can still make money by strategizing on areas that are most beneficial to use these financial instruments, that is, in trading of gold, oil, and agricultural produce.
References
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