Financial risk

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Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. [1] [2] Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent. [3] [4]

Risk is the possibility of losing something of value. Values can be gained or lost when taking risk resulting from a given action or inaction, foreseen or unforeseen. Risk can also be defined as the intentional interaction with uncertainty. Uncertainty is a potential, unpredictable, and uncontrollable outcome; risk is a consequence of action taken in spite of uncertainty.

Finance academic discipline studying businesses and investments

Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.

Financial transaction agreement, or communication, carried out between a buyer and a seller to exchange an asset for payment

A financial transaction is an agreement, or communication, carried out between a buyer and a seller to exchange an asset for payment.

Contents

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". [5] In modern portfolio theory, the variance (or standard deviation) of a portfolio is used as the definition of risk.

Financial risk management is the practice of economic value in a firm by using financial instruments to manage exposure to risk: operational risk, credit risk and market risk, foreign exchange risk, shape risk, volatility risk, liquidity risk, inflation risk, business risk, legal risk, reputational risk, sector risk etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them.

Modern portfolio theory (MPT), or mean-variance analysis, is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. It is a formalization and extension of diversification in investing, the idea that owning different kinds of financial assets is less risky than owning only one type. Its key insight is that an asset's risk and return should not be assessed by itself, but by how it contributes to a portfolio's overall risk and return. It uses the variance of asset prices as a proxy for risk.

Harry Max Markowitz is an American economist, and a recipient of the 1989 John von Neumann Theory Prize and the 1990 Nobel Memorial Prize in Economic Sciences.

Types

Asset-backed 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.

Asset-backed security Security with value derived from a commodity or asset

An asset-backed security (ABS) is a security whose income payments and hence value are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets which are unable to be sold individually. Pooling the assets into financial instruments allows them to be sold to general investors, a process called securitization, and allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the diverse pool of underlying assets. The pools of underlying assets can include common payments from credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments and movie revenues.

Prepayment is the early repayment of a loan by a borrower, in part or in full, often as a result of optional refinancing to take advantage of lower interest rates.

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. [6] 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. [7] 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. [8]

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. [9]

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. [10] [11] [12] [13]


    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

    Main Article: 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. [14]

    1. Commodity prices,
    2. Interest rates,
    3. Inflation, and
    4. Exchange rates.

    Three main types of Exchange Rate Risk

    According to Shapiro, 2014, there are three main types of exchange rate risk: [15]

    1. Transaction risk,
    2. Translation risk,
    3. 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). [16]

    --- 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. [17]

    1. Pre-Hedging
    2. 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 expose 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. [18]

    Liquidity risk

    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:

    Market risk

    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 [19] 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. [20] Interest rate risk can affect the financial position of a bank and may create unfavorable financial results. [20] 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 affect on domestic and foreign goods, as well as the value of foreign currency denominate assets and liabilities. [21] 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. [22]

    Operational risk

    Operational risk means the risk that a company or individual has to face due their own operation and decisions made for the investment

    Other risks

    Model risk

    Diversification

    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, [23] but negatively impact the business of a firm such an airline whose variable costs are heavily based upon fuel. [24] 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 [25] 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. [26]

    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

    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. [27]

    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. [28]

    According to the efinancemanagement.com, depending on these areas, there are three types of HEDGING: forward, future, and money market. [29]

    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.

    Money Market:

    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. [30]


    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

    See also

    Related Research Articles

    In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the opportunity to instantaneously buy something for a low price and sell it for a higher price.

    Derivative (finance) financial instrument whose value is based on one or more underlying assets

    In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying." Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the New York Stock Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges. Derivatives are one of the three main categories of financial instruments, the other two being stocks and debt. The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales, who made a profit in the exchange. Bucket shops, outlawed a century ago, are a more recent historical example.

    Bond (finance) instrument of indebtedness

    In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. The most common types of bonds include municipal bonds and corporate bonds.

    Futures contract standardized legal agreement to buy or sell something (usually a commodity or financial instrument) at a predetermined price (“forward price”) at a specified time (“delivery date”) in the future

    In finance, a futures contract is a standardized forward contract, a legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price the parties agree to buy and sell the asset for is known as the forward price. The specified time in the future—which is when delivery and payment occur—is known as the delivery date. Because it is a function of an underlying asset, a futures contract is a derivative product.

    In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.

    Hedge (finance)

    A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

    A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.

    Fixed income

    Fixed income refers to any type of investment under which the borrower or issuer is obliged to make payments of a fixed amount on a fixed schedule. For example, the borrower may have to pay interest at a fixed rate once a year, and to repay the principal amount on maturity. Fixed-income securities can be contrasted with equity securities – often referred to as stocks and shares – that create no obligation to pay dividends or any other form of income.

    Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.

    Collateralized debt obligation financial product

    A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a PD derived from ratings on those bonds or assets. The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA ; Junior AAA; AA; A; BBB; Residual.

    Prime brokerage is the generic name for a bundled package of services offered by investment banks, wealth management firms, and securities dealers to hedge funds which need the ability to borrow securities and cash in order to be able to invest on a netted basis and achieve an absolute return. The prime broker provides a centralized securities clearing facility for the hedge fund so the hedge fund's collateral requirements are netted across all deals handled by the prime broker. These two features are advantageous to their clients.

    Bond market financial market where participants can issue new debt or buy and sell debt securities

    The bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, but it may include notes, bills, and so on.

    In finance, a currency swap is an interest rate derivative (IRD). In particular it is a linear IRD and one of the most liquid, benchmark products spanning multiple currencies simultaneously. It has pricing associations with interest rate swaps (IRSs), foreign exchange (FX) rates, and FX swaps (FXSs).

    Foreign exchange risk is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company. The exchange risk arises when there is a risk of appreciation of the base currency in relation to the denominated currency or depreciation of the denominated currency in relation to the base currency. The risk is that there may be an adverse movement in the exchange rate of the denomination currency in relation to the base currency before the date when the transaction is completed.

    Currency overlay is a financial trading strategy or method conducted by specialist firms who manage the currency exposures of large clients, typically institutions such as pension funds, endowments and corporate entities. Typically the institution will have a pre-existing exposure to foreign currencies, and will be seeking to:

    The following outline is provided as an overview of and topical guide to finance:

    Initially pioneered by financial institutions during the 1970s as interest rates became increasingly volatile, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities.

    In financial economics, a liquidity crisis refers to an acute shortage of liquidity. Liquidity may refer to market liquidity, funding liquidity, or accounting liquidity. Additionally, some economists define a market to be liquid if it can absorb "liquidity trades" without large changes in price. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price, deterioration in external financing conditions, reduction in the number of market participants, or simply difficulty in trading assets.

    This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.

    Credit valuation adjustment (CVA) is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA is the market value of counterparty credit risk. This price depends on counterparty credit spreads as well as on the market risk factors that drive derivatives’ values and, therefore, exposure. CVA is one of a family of related valuation adjustments, collectively xVA; for further context here see Financial economics #Derivative pricing.

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