Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.
A science has evolved around managing market and financial risk under the general title of modern portfolio theory initiated by Dr. Harry Markowitz in 1952 with his article, “Portfolio Selection”. In modern portfolio theory, the variance (or standard deviation) of a portfolio is used as the definition of risk.
Asset-backed risk is the risk that changes in one or more assets that support an asset-backed security will significantly impact the value of the supported security. Risks include interest rate, term modification, and prepayment risk.
An asset-backed security is a security backed by the cash that comes from numerous assets. The financial security is backed by student debt, leases, car loans, credit card debt, and more. Typically, the assets of an asset-backed security are not liquid and can’t really be sold on their own. However securitization, is the process of pooling the assets together to create a security allows the owner of the assets to make them marketable. The creation of asset-backed securities start when lenders sell their collateralized loans to a large financial institution which then creates and places the loans into a trust. Cash flow then goes into the trust as the loans are being paid off while cash flows out as payments to the investors who bought the securities from that trust.
It has many advantages to both the lenders and investors. For example, it allows lenders to make a profit by increasing the lending and at the same time it encourages investors to invest their money into different assets that will benefit them. Lenders are able to create a pool of assets that would have resulted to be more challenging to trade individually. Asset-backed securities are fixed-income assets whose risk and return can be tailored to meet the needs of distinct investors.
The disadvantages of asset-backed securities are that they are as overvalued when compared to other security markets. Investors must take very high precautions when choosing which ABS to invest in. Also, asset-backed securities are susceptible to prepayment risks, interest rates, and term modification. For example, declining interest rates might prompt borrowers to refinance their loans at more favorable rates. Another disadvantage is if the borrower files bankruptcy, the loan could be lost to bankruptcy.
Credit risk management
Credit risk management is a profession that focuses on reducing and preventing losses by understanding and measuring the probability of those losses. Credit risk management is used by banks, credit lenders, and other financial institutions to mitigate losses primarily associates with nonpayment of loans. A credit risk occurs when there is potential that a borrower may default or miss on an obligation as stated in a contract between the financial institution and the borrower.
Attaining good customer data is an essential factor for managing credit risk. Gathering the right information and building the right relationships with the selected customer base is crucial for business risk strategy. In order to identify potential issues and risks that may arise in the future, analyzing financial and nonfinancial information pertaining to the customer is critical. Risks such as that in business, industry of investment, and management risks are to be evaluated. Credit risk management evaluates the company’s financial statements and analyzes the company’s decision making when it comes to financial choices. Furthermore, credit risks management analyzes where and how the loan will be utilized and when the expected repayment of the loan is as well as the reason behind the company’s need to borrow the loan.
Expected Loss (EL) is a concept used for Credit Risk Management to measure the average potential rate of losses that a company accounts for over a specific period of time. The expected credit loss is formulated using the formula:
Expected Loss = Expected Exposure X Expected Default X Expected Severity
Expected Exposure refers to exposure expected during the credit event. Some factors impacting expected exposure include expected future events and the type of credit transaction. Expected Default is a risk calculated for the number of times a default will likely occur from the borrower. Expected Severity refers to the total cost incurred in the event a default occurs. This total loss includes loan principle and interests. Unlike Expected Loss, organizations have to hold capital for Unexpected Losses. Unexpected Losses represent losses where an organization will need to predict an average rate of loss. It is considered the most critical type of losses as it represents the instability and unpredictability of true losses that may be encountered at a given timeframe.
Foreign investment risk
Foreign investment risk is the risk of rapid and extreme changes in value due to: smaller markets; differing accounting, reporting, or auditing standards; nationalization, expropriation or confiscatory taxation; economic conflict; or political or diplomatic changes. Valuation, liquidity, and regulatory issues may also add to foreign investment risk.
Foreign Exchange Risk
Foreign Exchange Risk, also as known as FX Risk, Exchange Rate Risk, and Currency Risk, can be occur when a company is having a transaction with a foreign company under the situation when one currency is stronger than the other. It doesn’t matter if a business is big or small. As long as a company is dealing with a foreign company, there is always an exposure of foreign exchange risk more or less. There are a couple of factors that are causing the risk.
- Commodity prices,
- Interest rates,
- Inflation, and
- Exchange rates.
Three main types of Exchange Rate Risk
According to Shapiro, 2014, there are three main types of exchange rate risk:
- Transaction risk,
- Translation risk,
- Economic risk.
Transaction risk means a cash flow risk, such as the one mentioned earlier, losses that are likely to occur when dealing in different currency.
Translation risk is not a risk caused by different languages but it’s about balance sheet, assets, equities, and liabilities. Translation exposure is also called Accounting exposure.
Economic risk is a risk that a firm has to face. It can be a different political policy, different regulation between countries, or a current economic situation in the world (i.e., Brexit).
— Some people might think that Foreign Exchange Risk will only cause trouble or loss; however, some people can actually earn some profit from it. —
How to prevent
It is almost impossible to eliminate the risk; however, a company can minimize their risks when they have a business with other company in different country by using two options.
- Dynamic Hedging
A Dynamic Hedging will prevent an exchange rate risk and allows company to manage automatically.
You can also calculate the potential lost or how much risk your firm is exposed to by looking at your accounts. Simply look at your record and take an inventory from it. Basically, pay attention to whatever you’ve spent money for any oversea action. It can be any expenses that you’ve made, such as a paycheck you gave to a person who’s working for you abroad, or any investments in global bonds, funds, and stocks.
This is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). There are two types of liquidity risk:
- Asset liquidity– An asset cannot be sold due to lack of liquidity in the market – essentially a sub-set of market risk. This can be accounted for by:
- Widening bid-offer spread
- Making explicit liquidity reserves
- Lengthening holding period for VaR calculations
- Funding liquidity– Risk that liabilities:
- Cannot be met when they fall due
- Can only be met at an uneconomic price
- Can be name-specific or systemic
The four standard market risk factors are equity risk, interest rate risk, currency risk, and commodity risk:
Equity risk is the risk that stock prices in general (not related to a particular company or industry) or the implied volatility will change. When it comes to long-term investing, equities provide a return that will hopefully exceed the risk free rate of return The difference between return and the risk free rate is known as the equity risk premium. When investing in equity, it is said that higher risk provides higher returns. Hypothetically, an investor will be compensated for bearing more risk and thus will have more incentive to invest in riskier stock. A significant portion of high risk/ high return investments come from emerging markets that are perceived as volatile.
Interest rate risk is the risk that interest rates or the implied volatility will change. The change in market rates and their impact on the probability of a bank, lead to interest rate risk. Interest rate risk can affect the financial position of a bank and may create unfavorable financial results. The potential for the interest rate to change at any given time can have either positive or negative effects for the bank and the consumer. If a bank gives out a 30-year mortgage at a rate of 4% and the interest rate rises to 6%, the bank loses and the consumer wins. This is an opportunity cost for the bank and a reason why the bank could be affected financially.
Currency risk is the risk that foreign exchange rates or the implied volatility will change, which affects, for example, the value of an asset held in that currency. Currency fluctuations in the marketplace can have a drastic impact on an international firm’s value because of the price effect on domestic and foreign goods, as well as the value of foreign currency denominate assets and liabilities. When a currency appreciates or depreciates, a firm can be at risk depending on where they are operating and what currency denominations they are holding. The fluctuation in currency markets can have effects on both the imports and exports of an international firm. For example, if the euro depreciates against the dollar, the U.S. exporters take a loss while the U.S. importers gain. This is because it takes less dollars to buy a euro and vice versa, meaning the U.S. wants to buy goods and the EU is willing to sell them; it’s to expensive for the EU to import from U.S. at this time.
Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) or implied volatility will change. There is too much variation between the amount of risks producers and consumers of commodities face in order to have a helpful framework or guide.
Operational risk means the risk that a company or individual has to face due their own operation and decisions made for the investment
- Reputational risk
- Legal risk
- IT risk
Financial risk, market risk, and even inflation risk can at least partially be moderated by forms of diversification.
The returns from different assets are highly unlikely to be perfectly correlated and the correlation may sometimes be negative. For instance, an increase in the price of oil will often favour a company that produces it, but negatively impact the business of a firm such an airline whose variable costs are heavily based upon fuel. However, share prices are driven by many factors, such as the general health of the economy which will increase the correlation and reduce the benefit of diversification. If one constructs a portfolio by including a wide variety of equities, it will tend to exhibit the same risk and return characteristics as the market as a whole, which many investors see as an attractive prospect, so that index funds have been developed that invest in equities in proportion to the weighting they have in some well-known index such as the FTSE.
However, history shows that even over substantial periods of time there is a wide range of returns that an index fund may experience; so an index fund by itself is not “fully diversified”. Greater diversification can be obtained by diversifying across asset classes; for instance a portfolio of many bonds and many equities can be constructed in order to further narrow the dispersion of possible portfolio outcomes.
A key issue in diversification is the correlation between assets, the benefits increasing with lower correlation. However this is not an observable quantity, since the future return on any asset can never be known with complete certainty. This was a serious issue in the late-2000s recession when assets that had previously had small or even negative correlations suddenly starting moving in the same direction causing severe financial stress to market participants who had believed that their diversification would protect them against any plausible market conditions, including funds that had been explicitly set up to avoid being affected in this way.
Diversification has costs. Correlations must be identified and understood, and since they are not constant it may be necessary to rebalance the portfolio which incurs transaction costs due to buying and selling assets. There is also the risk that as an investor or fund manager diversifies, their ability to monitor and understand the assets may decline leading to the possibility of losses due to poor decisions or unforeseen correlations.
Hedging is a method for reducing risk where a combination of assets are selected to offset the movements of each other. For instance, when investing in a stock it is possible to buy an option to sell that stock at a defined price at some point in the future. The combined portfolio of stock and option is now much less likely to move below a given value. As in diversification there is a cost, this time in buying the option for which there is a premium. Derivatives are used extensively to mitigate many types of risk.
According to the article from Investopedia, a hedge is an investment designed to reduce the risk of adverse price movements in an asset. Typically, a hedge consists of taking a counter-position in a related security, such as a futures contract.
The Forward Contract:
The forward contract is a non-standard contract to buy or sell an underlying asset between two independent parties at an agreed price and date. It includes various contracts such as foreign exchange forward contracts for currencies, commodities, etc.
The Future Contract:
The futures contract is a standardized contract to buy or sell an underlying between two independent parties at an agreed price, quantity and date. It includes various contracts such as forward exchange contracts, etc.
It is now one of the main components of the financial markets where short-term lending, borrowing, buying and selling with a term of one year or less are conducted. Money markets include a variety of contracts, such as money market money, interest rate money market, covered equity, etc.
As said by The Balance, gold is a hedge if you want to protect yourself from the effects of inflation. That’s because gold retains its value when the dollar falls. In other words, if the prices of most things you buy rises, then so will the price of gold.Gold is attractive as a hedge against a dollar collapse. That’s because the dollar is the global currency of the world and there is currently no other good alternative. If the dollar were to collapse, then gold might become the new unit of world money. That’s unlikely because there is such a finite supply of gold. The value of the dollar is mainly based on credit rather than cash. But it was not too long ago that the world was on the gold standard. This means that most of the major forms of currency were backed by their value in gold.
Financial / credit risk related acronyms
ACPM – Active credit portfolio management
EAD – Exposure at default
EL – Expected loss
LGD – Loss given default
PD – Probability of default
KMV – quantitative credit analysis solution developed by credit rating agency Moody’s
VaR – Value at Risk, a common methodology for measuring risk due to market movements
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