The Use of Financial Statement to Predict the Stock Market Effect of Systematic Risk

Introduction

The recent financial crisis of 2008 moved the economists and financial experts to understand the nature of financial volatility of financial institution. The volatility is attributed to the systematic risk and it has significant adverse impacts on the whole economy since the inability of one firm to pay off the debts has impact on other firms and it starts the chain of reaction which envelopes rest of the economy. This paper presents our contribution to the literature in this regard since we spent a lot of time carefully and thoroughly going through the financial statements of all these financial firms investigating what could have been used as an early warning signals according to their fundamental characteristics to predict the terrible situations these firms are running to in a pre-crisis event manner. To ensure that we have a reliable and dependable analysis and conclusions theoretically and practically we constructed our study on financial statements data instead of an experimental one thus the risk of human factor would not be involved (David Freedman 2007) (Hinkelmann, 2008).

In normal times and in times when economy is moving on the right path, the operation of financial institutions is typically smooth and the stock market prices tends to be low volatile. But the situation becomes very risky and volatile when economy is faced with some crisis and instability. There is a great marked difference among the economic indicators before and after the crisis (T. a. Adrian 2011). Two types of risk need to be examined because of their low levels during growing periods and all of a sudden uplifted during the crisis. The first is the asset or market liquidity risk when firms cannot sell their assets, and if they can that would be for uncompetitive prices or what commonly referred to fire-sale prices. The second is the funding liquidity risks when firms cannot raise new debts, and if they can that would be for uncompetitive cost or what commonly referred to haircuts and margins.

In the times of crisis, the economy is faced with shortage of liquidity and the demand for more liquidity for firms to generate cash through different options like issuing new shares or buying some assets or firm may go for incurring new debts. In the worst case scenario, the organization might generate negative cash flows for years and to satisfy its expense and to meet basic business requirement, the firm may keep selling its assets or keeping borrowing money from different source like financial institution and creditors. Selling assets and borrowing more cash will negatively impact the financial leverage ratio or low leverage ratio. Therefore, this view leads us to believe in that financial leverage is a key measure to indicate how effective a firm can grow internally and to what extent other financial ratios would reflect the true position and performance.

Aims and Objectives

This study is conducted with the aim to investigate whether items of financial ...