Diana Carolina SARMIENTO PACHON

Supply and Demand

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Supply and Demand

Diana Carolina SARMIENTO PACHON

In this article, Diana Carolina SARMIENTO PACHON (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2021-2022) explains the economic concept of supply and demand, which is key to understand the way markets work.

Supply and demand are the fundamental concepts that shape the way we make business and operate in the world. They construct both simple transactions such as the purchase of coffee or more compounded transactions such as the operations in the financial world. For this reason, it’s crucial to understand and uncover them deeper.

The basic concepts

Supply is referred to the amount available of a product that firms offer, whereas demand is the amount desired by consumers or households. When these quantities are equal, an equilibrium is reached and consequently a transaction takes place, leading to the well-known law of supply & demand which shapes the behavior of daily transactions and shifts in the economy. If price increases, then supply also increases; nonetheless, demand decreases as it’s more expensive for consumers to a buy good; on the contrary, if prices decline then supply also decline since producers would make less revenue whereas demand goes up as it is cheaper to buy. This dynamic takes place until the quantities of supply and demand are equal so that the optimum equilibrium is found.

Figure 1. Supply and demand.
img_Simtrade_risk_reduction_stocks
Source: computation by the author.

From another perspective, if demand escalates then price rises due to the high desirability of the good, meanwhile when demand drops it can create a surplus of supply which can drag the price down. Likewise, this scenario can be applied in financial markets e.g., in the case of a bullish sentiment in the market, there can be a positive speculation which creates a higher desirability for certain stock resulting in a decrease in price; nevertheless, when demand is low the price may drop because of a low or negative speculation on a specific stock.

Furthermore, the fundamental law of supply and demand can also explain the price movements seen in the financial markets. To illustrate, for a commodity such as coffee, if the surface of cultivation expands or if the harvest is good, it is very likely that the coffee price will sink as its supply will be abundant. Therefore, it is essential to consider the information about the market regularly as it can have a significant influence on the speculation of investors which will eventually define their demands and so the price of a stock. Consequently, it is very important to be able to determine how an announcement or any kind of information can affect the demand or even the supply of a stock, commodity, or financial instrument since this will define how markets will behave.

Special cases

However, it’s also important to mention that there are industries and situations in which the law of supply and demand does not apply. An instance of this is the luxury industry, in which the higher the product price set by firms, the higher the demand from consumers. This may be due to the value that costumers perceive by purchasing such items. Alternatively, oil is another example to be mentioned as its price has a low-price sensitivity which means that any change in its price won’t result in any significant demand changes, this could be due to the high necessity of oil in all industries which makes it crucial for daily operations.

Useful resources

Krugman, P. & Wells, R. (2012) Economics. 3rd edition. United States: Macmillan Learning.

Mankiw, G. (2016) The Market Forces of Supply and Demand (table of content) Principles of Economics. 8th edition. Boston: Cengage Learning.

Mankiw, G. (2016) The Market Forces of Supply and Demand (slides) Principles of Economics. 8th edition. Boston: Cengage Learning.

Deskara Supply and Demand: Law, Curves, and Examples

International Energy Agency (IEA) Supply and demand for oil

Sabiou M. Inoua and Vernon L. Smith The Classical Theory of Supply and Demand

About the author

The article was written in April 2022 by Diana Carolina SARMIENTO PACHON (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2021-2022)

Risk Aversion

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Risk Aversion

Diana Carolina SARMIENTO PACHON

In this article, Diana Carolina SARMIENTO PACHON (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2021-2022) explains the economic concept of risk aversion, which is key to understand the behavior of participants in financial markets.

Risk Aversion refers to the level of reluctance that an individual possesses towards risk. Specifically, it refers to the attitude of investors towards the risk underlying investments which will directly determine how portfolios are allocated or even how a stock may behave depending on market conditions. To elaborate, when market participants have higher risk aversion due to unfavorable market shocks e.g., natural disasters, bad news or scandals that affect a company or a security, this situation will cause a perception of higher risk leading to many selling, and thus decreasing prices. Therefore, risk aversion should be analyzed carefully.

Risk aversion and investor’s characteristics

It’s important to note that risk aversion can be highly variable over time as this notion changes along with investor profile, in other words with age, income, culture and other key factors, making it even more complex to evaluate than it appears in the traditional economics literature. To illustrate more accurately some of the factors that define an investor profile are:

Age

The older the person is, the more risk averse he or she is. On the contrary, younger individuals tend to be less risk averse which may be due to their high expectations and eagerness to attempt something new as well as the longer timeframe they have, whereas older people prefer safety and stability in their lives.

Income

Individuals with a smaller budget tend to have a higher risk aversion since they have fewer resources, and a loss would make a greater impact on them than a wealthy individual.

Past Losses

When an individual has already experienced some loss, she or he will be more wary of it since it’s now too costly to bear another loss; therefore, risk aversion will be significantly higher. An example of this is the post-crisis, as people have lost so much and this has had a negative impact on their lives, they tend to become more cautious of risk.

Investment Objective

For crucial events such as retirement or education, risk version tends to be higher as the individual cannot bear to risk for such a fundamental matter of his or her life.

Investment Horizon

Investors focused on short-term horizon tend to be more risk averse as they cannot take too much risk due to the short timeline.

Risk aversion and financial investments

Furthermore, risk aversion also takes into account more factors apart from those mentioned above, for this reason most of the time before creating the respective portfolio for an investor, financial advisors shape their client’s risk preferences in order to adjust the portfolio allocation to them. Many times, these can be conducted by questionnaires and tests that will accordingly assign a risk profile concluding with certain risk categories:

  • A Conservative profile refers to more risk averse individuals, the portfolios assigned for this type are mainly composed by both more secure & less volatile securities such as bonds, meanwhile stocks have a minimal participation.
  • A Moderate profile is attributed to more risk averse individuals who are willing to take more risk, however he or she does not want to step too much further. These portfolios are usually more diversified as they contain more types of securities in different percentages such as government & corporate bonds, and stocks.
  • An aggressive profile which is allocated to portfolios mainly composed in the highest percentage by the risky securities. For instance, the main securities could be stocks, specifically growth stocks or even crypto.

Due to all sensitive and private information used by financial institutions, financial regulatory entities are important to ensure the protection and transparency of information, thereby the Mifid (The Markets in Financial Instruments Directive) has been created in the European Union to fulfill such task through the use of rules and general standards.

Measure of risk of financial assets

Additionally, there are other mathematical metrics that can interfere in the risk profile, and depending on these the portfolio may be constructed:

Standard Deviation

It refers to the volatility of historical data, in other words how dispersed the data is over time which illustrates how risky the security may be. The higher the standard deviation, the higher the risk since this is suggesting that the stock is more variable and there is more uncertainty, thus a risk averse individual prefers a lower standard deviation.

Beta

It is linked with the systematic risk that comes with a stock, that is to say it illustrates the volatility compared to the market. Firstly, a beta equal to 1 indicates a volatility and movement equalizing the market, secondly a beta higher than 1 is referred to a security that is more volatile than the market, to illustrate B= 1.50 specifies 50% more volatility than the market. Thirdly, a beta less than 1 stipulates less volatility than the market. Therefore, the lower the beta the less risk exposure is found.

Modern Portfolio Theory & Risk

Introduced by Harry Markowitz in 1950s, the Modern Portfolio Theory illustrates the optimum portfolio allocation that maximizes return given a specific level of risk, in which risk is measured by the standard deviation and the return by the average mean of the portfolio. This explanation also leads to the one- single period mean-variance theory which suggests various portfolio allocations depending on the trade-off between return and risk. However, there are more advance models which explain this scenario in a multiperiod by rebalancing or diversifying further.

Risk aversion and economic conditions

Risk aversion does not only shape the portfolio allocation and its diversification, but it also may have a significant impact on the market as a result of expectations. When there are booming economic times, individuals usually feel more confident and thus less risk averse as a consequence of positive expectations of future cash flows; however, when a recession is coming investors may shift to a more risk averse behavior making them feel afraid of the future which influences them to sell certain stocks and, in this way, making the price plump. Although it may be seen as a simple emotion that defines the fear of risk, it still impacts in a very large extent the financial market as it dictates the roles and strategies behind investing, and thereby it is crucial analyze it carefully.

Related posts

   ▶ Youssef LOURAOUI Markowitz Modern Portfolio Theory

   ▶ Youssef LOURAOUI Implementing Markowitz asset allocation model

   ▶ Jayati WALIA Capital Asset Pricing Model (CAPM)

Useful resources

Díaz A and Esparcia C (2019) Assessing Risk Aversion From the Investor’s Point of View Frontiers in Psychology, 10:1490

Desjardins Online brokerage The Risk Aversion Coefficient

Coursera course Investment management

Crehana course Trading: How to invest in stocks (Trading: Como invertir en Bolsa)

About the author

The article was written in April 2022 by Diana Carolina SARMIENTO PACHON (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2021-2022)

My experience as a junior market research analyst at Procolombia

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My experience as a junior market research analyst at Procolombia

Diana Carolina SARMIENTO PACHON

In this article, Diana Carolina SARMIENTO PACHON (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2021-2022) shares her experience as a junior market research analyst in the investment department at Procolombia.

The company: Procolombia

Procolombia is the Colombian government entity that promotes direct investment, exports, and tourism into Colombia. The entity has several offices both in Colombia and in different countries around the world in order to reach to other governments, and thus facilitate negotiations. Examples of the locations of these offices are Paris, New York, London, Tokyo, Beijing, Dubai, Mexico, among others.

Procolombia is divided into the three departments: investment, exports and tourism.

Investment

Investment department whose main mission is to promote and bring into Colombia direct foreign investment. Examples of investments executed by the promotion of Procolombia are Amazon, Softbank, and Harley-Davidson.

Exports

Exports department with the main objective of promoting Colombian good across the world, and its main mission is accompanying and support exporters as well as contacting different public and private entities interested in Colombian products.

Tourism

Tourism department main focus is promote tourists into Colombia and expand the market share of the country in the Latin-American tourism.

The investment department organization and execution

Firstly, the investment department is divided into four regional hubs: North-America & the Caribbean, Latin-America, Europe-Middle East & Asia. Each hub is specialized in its respective region and market. Secondly, each hub has a general manager and usually 4/5 advisors specialized in a specific industry (Chemicals, Industries 4.0 which refers to AI/IoT/digitalization, Investment & Real Estate, Agro, Energy, etc.) which would facilitate the operations of the department so that every person is assigned with a specific region and industry.

The process of bringing investment

  • First of all, the investment advisors from Procolombia contact the respective firm/investor to create a very first contact, or the investor may contact Procolombia to obtain the very first information.
  • In the second place, if the investor is interested, he or she will ask for further information and probably require the specific opportunities available. For this purpose, the Colombians firms or projects looking for investing usually provide their basic financial information such as EBITDA, debt ratios, and the amount of money required, so that investors can have the primary financial information.
  • Once the investor shows more interest after having analyzed the basic financial metrics, there will be some factories and free-trade visits alongside meeting with the respective companies in order to gain deeper insight, and if they finally decide to invest, Procolombia will be supporting them in legal and tax matters to facilitate their investment journey in Colombia.

My internship Experience

I was specifically an intern of the North America management team. My main mission was supporting the team by providing market research of the potential investment opportunities as well as the possible investors that could be reached in order to promote the country in North America (US, Canada, and Caribbean countries). Additionally, I provided the consolidation of financial data about different Colombian companies and consolidated such information in such a way that it was understandable by potential investors.

Furthermore, I also had to support the logistics of the various events in which Procolombia looked to promote the country usually with very important high-level guests such as ambassadors, officials or investors looking for large investments, experience that showed how negotiation among different countries were conducted and how was the planning of such plans executed.

Skills needed

This internship required computational abilities with the purpose of comprehending the data and financial information of companies along with rapid analytical skills that can synthetize and summarize such information efficiently.

Regarding soft skills: team oriented and adaptability are crucial as operations are most of the time executed by sharing diverse opinions and agreeing with others which requires the wiliness to work and listen carefully. Besides, confronting different situation which may be one’s out of comfort zone is also a very common situation in the workplace, thereby it’s essential to be open to different challenges and situations as new issues can arise at any moment.

Financial Concepts

Even though my internship was more focused on the promotion of foreign direct investments in Colombia, I was still able to have direct contact with some financial concepts that were used regularly in the running of the entity, such as Ebitda and Debt Ratio.

Foreign direct investment (FDI)

Foreign direct investment (FDI) indicates the transfer of foreign capital into an entity or organization with a long-term vision. For instance, when an American or European multinational corporation invests in Colombia with the aim of opening facilities in this country in order to facilitate the operations in the region, and probably improve profitability. An example of this is P&G, Henkel or L’Oréal, companies that invested in the country in such a way that the performance both in Colombia and Latin America becomes more efficient in addition to providing employment, development and technology .

EBITDA

EBITDA refers to Earnings Before Interest, Taxes, Depreciation & Amortization. In other words, it’s the operating income however the non-cash costs such depreciation & amortization are added. It is usually used because it reflects the earnings from operations and the efficiency of them.

Net debt

All the debt (long-term + shot-term) – all cash & equivalents which would indicate what they company still owed in case of liquidation

Solvency ratios

Solvency ratios were usually used so that the investor could know the debt state of the company such as debt ratio = Total obligations/ Total Liabilities indicating how much financial leveraged the company has. The higher it is, the riskier the company may be, e.g., a 0.5 debt ratio indicated that 50% of the firm assets are financed by debt.

Thus, this experience also helped to shape some basic financial knowledge in real life situations and even taught me the importance of understanding financial concept as even if they are not directly in our expertise, they will always be the base of discussions in the business world.

Related posts on the SimTrade blog

   ▶ All posts about Professional experiences

   ▶ Anna BARBERO Career in finance

   ▶ Akshit GUPTA Green bonds

Useful resources

Procolombia

About the author

The article was written in April 2022 by Diana Carolina SARMIENTO PACHON (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2021-2022)