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You are here: Home > Current Topics > Mind your Business > 24 May 2004 |
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Financial services work carried out by phone and computer. © Photolibrary Group The last 5 years have been troubled times for those involved in financial markets. Share prices have risen then tumbled with the general trend being down! With tumbling share prices, businesses have faced increasing difficulties with a number of high profile firms facing serious problems. What happens on the Stock Exchange itself does not have a direct impact on firms - the stock exchange is after all the market for second hand shares, but it does affect perceptions of the business and therefore the potential of that business to raise funding in the future, and the value of the business. In October 2000, the FTSE 100 index stood at nearly 7000, at the time of writing it stands at 4300. What this means in layman's terms is that on average, company values are about 38% lower now than they were 4 years ago. Equally, if you held shares in any of these 100 companies, the price would be, on average 38% lower than four years ago. For both companies and shareowners therefore, movements on the stock market can be highly volatile and difficult to predict. This week (17th May 2004) British Airways (BA) announced a rise in profits over the last year by 70%. BA has been in financial difficulties for some years and has made massive strides to improve their performance. You might think that the announcement of such encouraging profit figures would cause the share price to rise. Think again! In the hours after the announcement the value of their shares fell by 4%! Share prices are affected by a wide range of things. Primarily, investors are looking for signs that a company is trading profitably, that means it has costs under control, is selling more to its customers, is likely to make profit and continue increasing that profit and that the future prospects look healthy. Lots of things could affect each and every one of those general variables however. In the case of BA, the company is still perceived as being over-staffed despite making 13,000 redundancies and having plans to cut a further 3,000 jobs - it has not quite got its costs under control therefore as far as the market is concerned. It still faces competition from the no-frills airline industry, which has been and continues to eat into its market. BA still has a huge level of debt - £4.2 billion - and investors will be looking to see whether BA will be in a position to pay off part of that debt with the revenues generated. But most of all, perhaps, the concerns over the international political situation may give cause for concern. 
BA has to improve its image if it is to retain and grow the business travel segment of its market. © Photolibrary Group BA is in the business of ferrying people to and from worldwide destinations. Those customers fly because they have business commitments or for pleasure. If the international economy is slowing down, business trades less and fewer business people will use planes. Equally, people may not have the money to fly to such destinations and choose less 'exciting' holidays but overriding all this might be the political situation in the Middle East and Iraq. The problems in these areas have helped in part to drive oil prices to a record high. For BA, the oil price rise might add £100 million to their costs. In response, they have announced a £5 surcharge but this will nowhere near cover the full cost! 
Volatility in the oil market can be caused by shortages due to a range of factors. © Photolibrary Group So all in all, despite encouraging figures, investors may feel that BA's future prospects do not look healthy and so decide to sell their shares and buy others that they think will give them a better return. Who are these investors?Some investors are individuals who for some reason have bought shares or maybe inherited them. For the most part, they represent only a small proportion of those involved in share trading. In an indirect way however, many of us have shares through the insurance policies and pension schemes we own. The premiums we pay to these policies are invested on our behalf in shares, amongst other things, by the so-called 'institutional investors'. The sums of money involved are huge. Each day, the market trades an average of around £14,000,000,000 (£14 billion) worth of shares in UK and International companies on its various markets. This represents a daily average of 7,790,000,000 (7.79 billion) shares traded. The biggest UK company in terms of value on the market is BP, valued at £100 billion, whereas Lloyds TSB comes in at number ten valued at £23 billion. One of the most actively traded companies is currently Vodafone, within the first few hours of trading at the time of writing, forty nine and a quarter million shares had been traded in the company. Tesco meanwhile had £568 million pounds worth of its shares traded during the same period. The stock market carries out a vital function in allowing firms to be able to raise often large-scale funds for expansion and development. Without a market for trading company shares, the opportunities for companies to grow and contribute to the economic well being of the country as a whole would be seriously impaired. It may not be perfect and it may take some understanding sometimes, but it does seem to work! |
The stock exchange operates as a market, putting buyers and sellers of shares in touch with each other. Companies who have their shares listed on the market have to follow rigorous guidelines and rules prior to acceptance. The process of becoming a public limited company involves issuing a variety of detailed pieces of information so that potential investors are able to assess what they are buying into and the risks that are associated.
The main pieces of information are:
The arrangements for the share issue itself are normally handled by a specialist investment bank. Examples of such banks are J.P Morgan, Morgan Stanley, Goldman Sachs and UBS. These banks will normally arrange for the share issue to be underwritten, this means that if any of the shares remain unsold the investment bank will purchase them. Such an arrangement helps to give a degree of certainty to the issue and allows the company concerned to plan ahead with confidence.
Once sold, the shares can be transacted on the stock exchange. Shareholders will be buying shares for two main reasons:
The investor expects the price of shares in (say) BA to fall. They are currently priced at 250p. They contact a broker and arrange to 'borrow' 3 million shares. The investor sells the shares at 250p, therefore receiving a credit of £7,500,000. At some point in the future, the investor will close the deal by buying 3 million shares to pay back the broker. Let us assume that the buy back price is now 200p. The investor has made a profit of £1,500,000.
If, however, the price had not fallen by as much as hoped the profit would have been less and, if the price had risen during that time, the investor would have made a loss. The broker meanwhile gets interest on the value of the shares 'loaned' and if any changes occur during the period of the deal (for example if the company paid a dividend) or if the company announces some new share issue like a bonus issue (basically a two for one type issue), the investor must pay back the requisite number of shares - this could be 6 million shares at half the original value.
Many short traders will pursue this option as a means of hedging against their long positions - a sort of insurance against losses they make elsewhere.
With any type of share transaction, there are risks. Whether you are selling short or long the skill involved in successful trading lies in the ability to make judgements about the movements of prices and the sentiment of the market. Is the trading gossip accurate or just a malicious rumour? How far will that international incident impact on the business? Will the economy get better or worse or stay the same? How will individuals react to a change in interest rates?
There are no right answers to any of these things, which is why some people make spectacular gains - if they are right - and equally spectacular losses if they are wrong. Whatever the factor being analysed, the access to information is essential for the professional investor. But it is that investor who has to make the judgement about whether the factor will cause the share price to rise or fall and if so how much. What tends to happen therefore is that investors will seek to spread their risks by investing not only in shares (equities) but also other forms of security - bonds, government stock or commodities, for example. Equally, within the market, there are ways of putting funds into other investments that help to protect the risk from normal share dealing.
Image: Share price movements can be volatile and unpredictable - is there a way of protecting against such risks? Copyright: Simon Stratford, available from stock.xchng.
Developing ways of protecting against adverse share price movements (whichever direction that might be) has been carried out on a more and more sophisticated level in recent years. One method for example would be to enter into a contract to have the right or the option to buy an asset at a particular price on or before an agreed date. Let us look at an example:
Assume you are considering buying 3 million shares of a stock priced at 250p but you are unsure of whether the price is going to rise or fall. You take out an option to buy 3 million shares in three months time at the price of 300p. This option, remember, is a right to buy and as such at the end of the three month period you could refuse the right and not buy. There is a cost for purchasing the option, let us assume in this example that it is £20,000.
At the end of the 3-month period, the shares have in fact risen to 350p. You exercise the option to buy the shares at the agreed price of 300p. You now have 3 million shares bought for 300p (£9,000,000) but valued at 350p (£10,500,000). You have made a profit of £1,500,000 less the £20,000 it cost to arrange the option contract.
If, however, at the end of the three-month period, the share price had fallen to 200p, you could refuse the option to buy. You will, of course lose the £20,000 it cost to set up the option but it could have been worse, if you had bought the shares at 250p (£7,500,000) and the share price had fallen to 200p, you could have made losses of £1.5 million!
It can be seen from this example that there are massive risks involved with such strategies for both parties to the arrangement. But at the same time there is a huge potential for gain and protection from underlying movements in prices. These financial instruments are called 'derivatives' and are based around all manner of different financial securities.
There could be derivatives markets in commodities, currencies, interest bearing loans, bonds and so on. The key to such markets is that each player is gambling on anticipated movements, one effectively gambles one way and the other party bets on the opposite movement. Because you are not actually buying anything physical - like a share or bond - the 'bet' could be on anything linked to the security concerned. For example, fluctuations in share prices could be protected by 'betting' on the movements in the Financial Times Stock Exchange Index (FTSE) or the Dow Jones Index.
These indexes are ways in which the price movements in the market are averaged out for the securities in the index. The FTSE 100 is an index comprising the top 100 companies on the London Stock Exchange. Prices of each company will be rising and falling and at different rates. The price movements are averaged out to get an idea of the general trend of the market. If the FTSE 100 falls by 3% it indicates that prices of these top 100 shares have, on average, fallen by that amount. Of course, some in the index will have fallen by more than 3% while others will have not fallen at all, but risen.
The existence and growth of instruments like derivatives show the flexibility and diversity of the stock market and provide incentives for the market to become more efficient and responsive to changes in the needs of investors, dealers and companies themselves.
When tackling these questions, use the information in the 'News' section above to help you.
The factors that will influence the share price will depend on the type of business chosen. The example given was of BA. Their share price could be affected by major international events like 9/11 which put a lot of people off flying, rising fuel costs, increases in technology reducing the need for business meetings, moves by businesses to cut costs when faced with economic slowdown (cutting back on the number and frequency of business travel), the decision by people to holiday in the UK rather than abroad, the weather (if the summer is bad in the UK, more people tend to choose late holidays abroad), the time of year, the war in Iraq and so on. Try to explain your reasoning using appropriate economic theories and terminology; for example, holidays abroad may have a relatively high income elasticity of demand.
Depending on the direction of the share price movement you have decided upon, the decision of using the FTSE Index will have to be focussed on whether you think the Index will rise or fall and, crucially, by how much. You will then have to decide which way to buy your option. A 'call option' refers to the right to buy in the future; a 'put option' refers to the right to sell.
Working through a numerical example is a good way of ensuring you understand the mechanics of the process.
