Research into the Uncertainty Within the Financial Markets Finance Essay

The financial market environment in an economy is of strategic relevance in most of the corporate decision-making. Most of the developed and even emerging economies have market-based financial system. Instability within the stock market brings uncertainty in the financial system that adds complexity to corporate decision-making.

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The major cause of uncertainty within the financial market environment is change in structure, regulations, and market sentiments. The financial crisis 2007 further increased the uncertainty within the market and resulted in high lending rates and crisis of confidence. This uncertainty influences the investment, financing and other financial decisions of the corporate. It is argued that the managers might deploy some extra risk factors to estimate the cost of capital. Furthermore, the complexity in decision-making is briefly explained with the impact of giant mining BHP Billiton bid to take-over the fertilizer company Potash Corporation of Canada. The paper also highlights the acquisition plan of Kraft to take-over Cadbury in early 2010 influence its stock performance. Furthermore, the paper illustrates the principles to manage uncertainty and reduce complexity in decision-making.

Introduction

Uncertainty can be regarded as a situation where both future and probability of possible future is unknown whereas, risk is a state of uncertainty where the future is unknown but the probability of possible future outcome is known. However, the distinction does not have much relevance today as decisions are made on the basis of the estimates of possible probabilities. Though, it might be relevant in understanding the essay effectively. The future is always unpredictable or uncertain that adds complexity to the decision making. However, some academicians regard uncertainty as essence of business environment. “Without the element of uncertainty, the bringing off of even, the greatest business triumph would be dull, routine, and eminently unsatisfying.”James Paul Getty (https://strategicbusinessteam.com/famous-small-business-quotes/j-paul-gettys-quotes-famous-business-quotes-from-oil-billionaire-jean-paul-getty/)

Uncertainty within the financial markets

The financial market environment is the nuclei around which most of the corporate decisions revolve as it is either directly or indirectly associated with the profitability of the business. The financial market comprises of banks, building societies, stock market, money market, foreign exchange market and derivative market. Source: Oxford review of economic policy, vol.20, No. 4 The corporate are dependent on the financial market to finance their business either through equity or debt. The US financial market has a large amount of bank loans outstanding, but there is also a large stock market and bond market. The United States is also said to have a market-based financial system. The stock market value is also high in United Kingdom and Asia, although the bank loans are of greater relevance than the bond market in these countries (Brealey.A.R, Myers. C.S, & Allen. F, p.931). Currently, the global financial market reciprocates variations in the short-run along with the prominent changes in the long-run. It may be argued that the instability in stock market in an economy has its influence on the marco-environment level. The uncertainty in stock market is the result of geopolitical events, economic changes and market sentiments. It is also said that “Uncertainty and centrality go hand-in-hand” (Webber 1972; Code 1991). In times of uncertainty certain geocities tend to gain strategic importance as in some cases the holders of capital acquire labour from one country against others through demonstration of the spatial fluidity of capital. (Ronald L. Mitchelson and James O. Wheeler) More precisely change in political structure, rules and laws, demutualisation, changing roles, globalisation and integration of markets creates fluctuations in stock prices and gives rise to uncertainty within the capital market.

Financial crisis further increases uncertainty within the financial markets

The global financial crisis 2007 has further increased the uncertainty in the financial market. Its fundamental causes may be regarded as prevalent excess liquidity in global financial markets by the key central banks and the proliferation of mortgages in the United States along with inadequate assets to liabilities ratio, ineffective financial supervisory and regulatory frameworks. The large capital inflows from high saving countries (notably China, India & Japan) to US securities market (particularly government bond market) enhanced liquidity in the economy. The crisis followed a “wandering asset-price bubble” process, began with the housing bubble in the United States which was inflated by the easy availability of mortgage loan. The credit was given without proper documentation to least credit-worthy applicants with low credit scores. “Lick your candy now and pay for it later” – the entire subprime mortgage market seemed to encourage those with a sweet tooth for have-it-now investments. The US mortgage crisis was just a set off to the global financial crisis. When people did eventually start to see problems, confidence fell quickly. Lending slowed, in some cases ceased for a while and even now, there is a crisis of confidence. The mortgage crisis was followed by the global downturn of interbank markets, wholesale capital markets and the securities market. (Willem H. Buiter, p.13). In the United Kingdom, lack of co-ordination between the Bank of England, the Treasury and the FSA (Financial Services Authority), an inefficient insolvency laws and deposit insurance arrangement for the banking sector, weakened liquidity management practices of Bank of England led to the financial dismantle. (Willem H. Buiter, p.1) The stock market witnessed a significant plummeting in the prices of securities during late 2008 and early 2009 resulting in the stock market collapse worldwide. This collapse increased volatility in the stock market and the speculative market became more vulnerable to even small flow of information.

Uncertainty still exists

Despite the fiscal stimulus and monetary policies enforcement by the central banks and the government, though unprecedented; there is still uncertainty in the global financial market. It is believed that the global financial system is still unstable which can fail that emphasises the lack of market confidence in the economy. (W. Max Corden, p.10). Having said that the financial crisis 2007 enhanced uncertainty within the financial markets, it resulted in substantial contractions in economic activity and credit. The interest rates uncertainty has an impact on the liquidity in the economy and substantiates the relationship with the stock market volatility. (Jincai Xu, p.2). The increase in CRR (cash reserve ratio) resulted in fund deficit with the bank and the banks offer credit at high interest rates. The higher interest rates leads to substantially low borrowings as people are sensitive to interest rates. As a result, the liquidity is low in the economy and consumers tend to have less spending power. Thus, the market is more rational and least growth is expected in the stock market.

Uncertainty adds complexity to corporate decision-making

In an uncertain environment any change in strategy/structure would substantially impact the financial market on a whole. Furthermore, uncertainty in an imperfect financial market diminishes the risk-taking capabilities of a business to avoid default. (Patrick Kehoe, p.31). The management strategically involves into decision-making to look for best alternatives that gives high returns with minimal risk. “For many multinational organizations, the financial crisis in major markets and the impact on investment returns were unanticipated, and they paid insufficient attention to risk management activities, such as scenario planning and extreme event modeling,” said Vicki Stokoe, Global Governance Consulting leader at Mercer. The focus of most business people is on the future with regard to investment strategy or the financing strategy. Appropriate decisions are therefore dependent on how effective the managers’ performance and evaluated and rewarded. Hence, it is essential to mitigate the agency problems by monitoring the managers’ effort and by offering them right incentives and fair value to deal with the complexity in decision-making effectively and efficiently.

Raising funds through equity or debt

The firm’s present portfolio of total assets may be regarded as the determinant in evaluating the best alternative investment strategy and then the best financing strategy to be considered. In order to take decision to finance a particular project, the firm needs to decide whether issuing more stock (equity) is beneficial or borrowing (debt). The uncertainty in the market may raise a concern that the shares would not be taken up. The issue is made in the primary stock market and depends on the market confidence in an economy. Since, there is still uncertainty in the stock market and investors lack confidence and hesitate to invest in the market. The decision becomes more complex for a business to raise funds through equity finance. On the other hand, considering the debt finance in the present scenario where the banks and other financial institutions does not have enough liquid strength, there is a risk of fluctuations in interest rate. Under a stable financial market environment, the decision could have been taken on comparing the NPV (Net Present Value) of borrowing and the NPV of the future cash inflows from the investment in the project. Although, some scholars also argue on the human behavioural psychology – “People are not 100 percent rational/risk averse 100 percent of the time (R. Brealey, p.343).

Diversification of portfolio

Despite the insurance market is on the verge to stabilize, the company’s focus is to generate high return through strategic investment plan. In an uncertain financial system, people still tend to opt towards traditional insurance products and can pay premium for security. The insurance company look for the diversified portfolio of investment to mitigate unique risk and yield maximum cost of capital. It is essential to measure the probability of possible future outcome that is uncertain to understand the risk involved in the market. The balanced proportion of investment portfolio between stock market and bond market is advisable depending on the market scenario in that country1. “Don’t put all your eggs in one basket” – Markowitz Portfolio Theory. Further, the investments in stock market can be diversified between the alternative stocks listed in the stock market. As per the CAPM (capital asset pricing model) investors prefer stocks with highest expected return and low standard deviation. Seventy-three percent managers used CAPM to estimate the cost of capital and thirty-four percent used it with some extra risk factors (R.Graham and C.R.Harvey, p.187-243). The uncertainty within the financial markets adds complexity in estimating the cost of capital and the decision regarding diversification of portfolio.

Earnings to be reinvested in its own business or dividend paid to shareholders

Among the most crucial decisions made by the corporate are those related to reinvestment into its own business to expand or offer dividend to shareholders. The reinvestment decision is heavily based the future cash inflows from its business and is measured by the company’s past performance. The NPV of future cash inflows may not be estimated accurately due to volatility in market. The uncertainty in foreign exchange market, inflation and oil prices also influences the stock market and thus it might result in taking absurd discounting rate of return. The discounting rate of return as per the estimate may be different from the actual value. On the other hand, the investor might prefer dividend over capital gain in an uncertain financial market. Hence, in order to retain the investor’s confidence in the company’s performance the company might consider paying off dividends over reinvestment. (McCarthy. A, p. 9-24)

Decision regarding mergers and acquisitions with an example of BHP Billiton & Potash Corporation and Kraft & Cadbury

Mergers and Acquisition decisions in an uncertain environment is complex as there is a risk of stock price will fall as the investor lack market confidence and might react to the merger negatively. The total value of deals post crisis came down by 40% and even the number of deals came down to half. (Sharma. M, 2010) Source: www.euronext.liffe The chart above reciprocates the declining trend in the mergers and acquisitions in an uncertain financial market with swings in foreign exchange, shifts in demand and supply and volatility in stock market. BHP Billiton that is the world’s largest by market value was scrutinised by its investors for its takeover bid of $39 billion in fertilizer group Potash Corporation in August 2010. The Canadian government rejected the offer on 03 November 2010 saying it is not in favour of national interest. Since 2007, BHP Billiton incurred around $900 million in fees for its attempt to buy Potash and Rio Tinto which subsequently failed. This created insecurity among the investor who believed that the company is not utilizing the money efficiently moreover misusing it (Money first, massive M & A deals second, 2010). A similar trend was seen when Kraft completed its $11.6 billion bid for Cadbury in the beginning 2010. However, Cadbury shares were up by 3.5% the day after the proposal bid (Cadbury agrees Kraft takeover bid, 2010) although, Kraft share price underperformed with this information being released in the market. Apart from properly evaluating the net worth of the business to take-over and the estimated future cash-inflows from the investment, decisions should also consider the market sentiments in the economy. Since, most of the investors are risk averse when there is increased uncertainty within the financial market; the decisions should be made more strategically. “We would rather see management teams first have the confidence to invest in their own businesses through capital expenditure, or to return some money to shareholders, than launch big M&A deals at this point in the cycle,” (Johnson. M, 2010)

Dealing with uncertainty within the financial market

According to a report in the Financial Times, “European nations are to draw up radical proposals to improve transparency in financial markets and to change the way credit rating agencies operate in an attempt to prevent any recurrence of the financial turmoil arising from the credit squeeze.” (https://www.nber.org/~wbuiter/lessons.pdf)

Conclusion

Uncertainty

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