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Financial Markets and Risks

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Financial Markets and Risks

1. Types of Risk 

The two types of risks in financial markets are systematic and unsystematic risks.

Systematic risks are those that affect the entire market with the same intensity. Investors

cannot avoid such risks through diversification or any other form of mitigation. Examples of

systematic risks include interest rate changes, inflation, and other aspects that affect the

economy. These domains affect the whole market. Unsystematic risks affect a specific firm or

industry without affecting other players or industries in the market. Investors can reduce the

impact and severity of these risks through diversification by investing in multiple portfolios

(Damodaran, 2012). They should emphasize these risks because they affect the returns

obtained from their investments, and if not well managed, they can cause financial losses.

Financial analysis measures portfolio risks through covariance Beta, the standard measure of

how much an asset shifts with the market, referred to as covariance. It gives the return of a

portfolio.

2. Market Efficiency 

Market attains efficiency if the prices attached to all securities incorporate all

information available to that specific market. Security markets are efficient, as reflected by

the character of the prices of different securities. This argument is true because, under ideal

conditions, all investors have equal access to information in the market. Information is free,

and every investor can access it and take advantage of such information. Therefore, investors

use this information in making rational decisions regarding the prices attached to different

securities in the same market. The efficiency of security markets is reflected by how security

prices quickly reflect new information that comes into the market. Such information causes
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random fluctuations in prices, leading to market efficiency (Damodaran, 2012). Market

efficiency is important in valuation because the valuation process aims to obtain reasonable

estimates of the true value of securities in the market. Market efficiency, therefore, leads to

adequate and equal information access, which makes all securities reflect the true value.

3. Risk-free Rate 

The risk-free rate refers to an investment’s rate of return within a specific time,

meeting all scheduled payments without loss uncertainties while meeting all payment

obligations (Damodaran, 2012). In a valuation assignment, analysts should calculate the risk-

free rate of investment by subtracting the current inflation rate within a country from the

Treasury bond yield within the same time of the investment. It represents the interest

generated from an investment within that period. However, investors consider various factors

in determining the rate. Its selection depends on the investment period, and the treasury bond

should be within a similar time as the investment for the rate to apply. Therefore, the

forecasting period within which the investment occurs determines the rate because inflation

and treasury bonds can change with time, affecting the rate of return for that investment.

4. Most Important Things Learned 

This week’s assignments and readings have contributed significantly to my understanding

of the functioning of financial markets. I have learned different aspects of investments and the

risks associated with them. In this case, I learned that financial markets have multiple portfolios

that investors can choose based on their rational decisions and expectations over a particular

time. However, these investments can be affected by controllable risks and those not controlled. I

learned that systematic risks are critical for any investor because they cannot mitigate their

impacts through diversification. I also learned that it is essential for investors to evaluate the rate
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of return of any portfolio they wish to invest in to ascertain the benefits they would reap from it

under the risks attached. These readings expanded my knowledge about the significance of

information in the financial markets as it determines the prices of different securities.

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Reference

Damodaran, A. (2012). Investment Valuation (3rd Ed.). John Wiley & Sons, Inc.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/Inv3ed.htm