Risk factor (finance)

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In finance, risk factors are the building blocks of investing, that help explain the systematic returns in equity market, and the possibility of losing money in investments or business adventures. [1] [2] A risk factor is a concept in finance theory such as the capital asset pricing model, arbitrage pricing theory and other theories that use pricing kernels. In these models, the rate of return of an asset (hence the converse its price) is a random variable whose realization in any time period is a linear combination of other random variables plus a disturbance term or white noise. In practice, a linear combination of observed factors included in a linear asset pricing model (for example, the Fama–French three-factor model) proxy for a linear combination of unobserved risk factors if financial market efficiency is assumed. In the Intertemporal CAPM, non-market factors proxy for changes in the investment opportunity set. [3]

Contents

Risk factors occur whenever any sort of asset is involved, and there are many forms of risks from credit, liquidity risks to investment and currency risks.

Different participants of risk factors contain different risk factors for each participant, for example, financial risks for the individual, financial risks for the Market, financial risks for the Government etc. [2]

Financial risks for the individual

Financial risks for individuals occur when they make sub-optimal decisions. There are several types of Individual risk factors; pure risk, liquidity risk, speculative risk, and currency risk. Pure Risk is a type of risk where the outcome cannot be controlled, and only has two outcomes which are complete loss or no loss at all. [4] An example of pure risk for an individual would be owning an equipment, there is risk of it being stolen and there would be a loss to the individual, however, if it weren't stolen, there is no gain but only no loss for the individual. [5] Liquidity Risk is when securities cannot be purchased or sold fast enough to cut losses in a volatile market. An example to which an individual might experience liquidity risk would be no one willing to purchase a security you own, and the value of your security significantly drops. [6] Speculative risks are made based on conscious choices, and results in an uncertain degree of gain or loss. [4] An example of speculative risk is purchasing stocks, the future of the stock's price is uncertain, and both a gain or loss could occur depending on whether if the stock price rises or decreases. [7] Currency risk is when exchange rates changes will affect the profitability of when one is committed to it and the time when it is carried out. [8] An example of currency risk would be if interest rates were higher in U.S compared to Australia, the Australian dollar would drop in comparison to the U.S. [9] This is due to the increase in demand for USD as investors take advantage of higher yields, thus exchange rate fluctuates and the individual is exposed to risks in the foreign exchange markets. [9]

Financial risks for the market

Financial Risks for the market are associated with price fluctuation and volatility. Risk factors consist of interest rates, foreign currency exchange rates, commodity and stock prices, and through their non-stop fluctuations, it produces a change in the price of the financial instrument. [10] Market Risk (systematic risk) is the risk an investor experiences when the value of an investment decreases due to financial market factors. [11] The failure of a single company or cluster of companies could lead to the entire market crashing and the way to reduce this risk is through diversification into assets that are not co-related to the market. [11] [12] An example is during the 2007-2008 global financial crisis, when a core sector of the market suffered, the volatile risk created effected the monetary well-being of the entire marketplace. During this time, businesses closed, there was an estimated loss of $6 trillion to $14 trillion, and governments were forced to rethink their economic policies. [13] A similar situation is observed during the COVID-19 global pandemic crisis, where a massive economic fall-out had occurred due to the lack of economic activity. [14] The global economy came to a halt, aggregate demand rapidly decreased, and even oil prices plummeted to almost negative $40, which meant producers paid buyers to take oil off their hands as storing oil was costly. [15]

Financial risks for businesses

Financial Risk for businesses rises due to the need for funding in order to expand and grow the business, or when they sell products on credit. There are several types of financial risks in businesses, including credit risks, specific risks, and operational risks. Credit risk are the dangers of default occurring when a creditor lends money to a borrower. Examples of credit risks include businesses not being able to retrieve their money when they sell products on credit and may experience a rise in costs to collect the debt. Businesses can also experience credit risk as the borrowers, as they must manage cash flows in order to pay back their accounts payable (Chen, 2019) (Maverick, 2020) (LaBarre, 2020). Specific risks a.k.a. unsystematic risks are hazards that are unique and apply only to a certain asset or company. [16] An example of an unsystematic risk is if a company has poor reputation or there are strikes among company employees, only that specific company is affected. [16] [17] Unsystematic risk can be avoided through diversification where, where investors invest in a wide variety of stocks. [18] Companies face operational risks whenever it attempts to do ordinary business activities and can also be classified as a variety of specific risk. Operational risks stem from man-made choices, thus are the risks of business operations failing due to human error. Examples of Operational risks would be keeping a subpar sales staff team as it has lower wage costs, but it comes with higher operational risks as the staff are more likely to make mistakes.

Financial risks in investing

Stock price fluctuation Stock Price Listing Numbers on a Korean Newspaper.jpg
Stock price fluctuation

Investing is allocating money, effort, or time into something in hopes of generating income or profit. A common investment is investing in stocks, purchasing them at a low price then reselling it later at a higher price to earn the difference as profit. Stock investing comes with very high risks as every single piece of information would cause market prices to fluctuate.

Economic risk

One of the most obvious risk is economic risk, where the economy could go bad at any given moment, causing stock prices to plummet. [19]

Commodity price risk

Commodity price risk is the possibility of a commodity price fluctuating, potentially causing financial losses for the buyers or producers of a commodity. As Commodity prices are basic raw materials, it creates a domino effect, affecting all products that require the commodity. For example, oil consumers often face commodity price risk, as oil is a widely used necessity product currently, many producers’ profits are affected by the fluctuation of oil price.

Inflationary risk and interest rate risk

Other risks like inflationary risk and interest rate risks usually go hand in hand, as interest rates are increased in order to combat inflation, which in turn causes businesses operation cost to increase, making it harder to stay in business, which then leads to a reduction in their stock prices. Inflation on its own also destroys value of stocks and creates recessions in the market. [19]

Headline risk

A very transparent risk is headline risk, where any stories in the media that will damage a company's reputation would hurt their business and reduce their stock prices. An example is the Fukushima nuclear crisis in 2011, which punished their stocks and caused excessive backlash against any businesses related to the story.

Obsolescence risk

A risk that arises due to technological advancement is obsolescence risk, where a process, product or technology used by a company to generate profit becomes obsolete as competitors find cheaper alternatives. An example of this are publishing companies, as computers, phones, and devices becomes more advanced, more and more people read news, magazines and books online instead of the printed form as it's cheaper and more convenient, which caused publishing companies to slowly become obsolete.

Model risk

When people rely too much on the assumptions underlying economic and business models is model risk. When the models are inaccurate, all stakeholders that relied on the financial model are exposed to risks as the quantitative information utilized are made based on insufficient information. An example of this is the Long Term Capital Management (LTCM) debacle, which caused them great financial loss because of a small error in their computer models, which was magnified by their highly leveraged trading strategy.

Financial risks for the government

Government involved risk rises in a two-way factor; first is the Government's policies which create interest rate and aggregate demand fluctuations, and the second is investing directly in Government bonds.

Government policies

Government enforces policies and regulations, to which businesses must oblige to be able to fairly compete against each other. [20] From time to time, the government changes these frameworks which creates risks for businesses as they are forced to adapt and change how they operate. [20] The government changes their policies depending on the current economic situation, in order to stimulate economic growth and maintain a healthy level of inflation. [21] [22] The change in interest rates would cause aggregate demand to increase or decrease, forcing the market to adjust to the new equilibrium in the long run. [20] [23] For example, if the government were to increase interest rates, business sales would decrease, due to people more willing to save, and vice versa. Another fiscal policy example would be if the government were to increase their spending, it would increase aggregate demand, and cause business sales to increase. [20] The reserve banks have a role in mitigating the financial risks that would create financial disturbances and systematic consequences. [22]

Government bonds

When an individual or group purchases a government bond, they lend money to the government, and in return they get paid a promised interest rate. [24] Investing in government bonds is generally safer than stocks but still contains risks, e.g. interest rate risks where market rates rise and we could be earning more in investing in other investments, inflation risks where a higher inflation reduces the amount earned from interest, liquidity risks where no one wants to buy the bonds when we want to sell it, and chances that the government loses control of their monetary policy and default on their bonds. [24]

Tools to control financial risk

The most common tools/methods used to control financial risk are risk analysis, fundamental analysis, technical analysis, and quantitative analysis.

Fundamental analysis is a method that looks at a business's fundamental financial level, revenue, expenses, growth prospects and then measures the securities intrinsic value. [25] [26] [27] By measuring the securities intrinsic value, they are able to predict the stock price movements and reduce potential risk factors. [27]

Technical analysis is a method that utilizes past prices, statistics, historical returns, share prices, etc., to evaluate securities. [28] Through technical analysis, investors are able to determine the volatility and momentum of the securities, thus reducing financial risks when they decide on who the invest. [28]

Quantitative analysis is the process of gathering data in numerous fields and evaluating their historical performance through financial ratio calculations. [29] For example certain ratios like debt-to-capital ratio, or capital expenditure ratio are utilized to measure a company's performance and then using the data to determine the risk factors of investing in this company.

Related Research Articles

Finance is the study and discipline of money, currency and capital assets. It is related to and distinct from Economics which is the study of production, distribution, and consumption of goods and services. The discipline of Financial Economics bridges the two fields. Based on the scope of financial activities in financial systems, the discipline can be divided into personal, corporate, and public finance.

<span class="mw-page-title-main">Financial market</span> Generic term for all markets in which trading takes place with capital

A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial markets as commodities.

<span class="mw-page-title-main">Stock market</span> Place where stocks are traded

A stock market, equity market, or share market is the aggregation of buyers and sellers of stocks, which represent ownership claims on businesses; these may include securities listed on a public stock exchange as well as stock that is only traded privately, such as shares of private companies that are sold to investors through equity crowdfunding platforms. Investments are usually made with an investment strategy in mind.

<span class="mw-page-title-main">Bond (finance)</span> Instrument of indebtedness

In finance, a bond is a type of security under which the issuer (debtor) owes the holder (creditor) a debt, and is obliged – depending on the terms – to provide cash flow to the creditor. The timing and the amount of cash flow provided varies, depending on the economic value that is emphasized upon, thus giving rise to different types of bonds. The interest is usually payable at fixed intervals: semiannual, annual, and less often at other periods. Thus, a bond is a form of loan or IOU. Bonds provide the borrower with external funds to finance long-term investments or, in the case of government bonds, to finance current expenditure.

<span class="mw-page-title-main">Speculation</span> Engaging in risky financial transactions

In finance, speculation is the purchase of an asset with the hope that it will become more valuable shortly. It can also refer to short sales in which the speculator hopes for a decline in value.

Investment is traditionally defined as the "commitment of resources to achieve later benefits". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broader viewpoint, an investment can be defined as "to tailor the pattern of expenditure and receipt of resources to optimise the desirable patterns of these flows". When expenditures and receipts are defined in terms of money, then the net monetary receipt in a time period is termed cash flow, while money received in a series of several time periods is termed cash flow stream.

<span class="mw-page-title-main">Government bond</span> Bond issued by a government

A government bond or sovereign bond is a form of bond issued by a government to support public spending. It generally includes a commitment to pay periodic interest, called coupon payments, and to repay the face value on the maturity date.

An economic bubble is a period when current asset prices greatly exceed their intrinsic valuation, being the valuation that the underlying long-term fundamentals justify. Bubbles can be caused by overly optimistic projections about the scale and sustainability of growth, and/or by the belief that intrinsic valuation is no longer relevant when making an investment. They have appeared in most asset classes, including equities, commodities, real estate, and even esoteric assets. Bubbles usually form as a result of either excess liquidity in markets, and/or changed investor psychology. Large multi-asset bubbles, are attributed to central banking liquidity.

An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed. The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, the compounding frequency, and the length of time over which it is lent, deposited, or borrowed.

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.

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 repay the principal amount on maturity. Fixed-income securities can be contrasted with equity securities that create no obligation to pay dividends or any other form of income. Bonds carry a level of legal protections for investors that equity securities do not: in the event of a bankruptcy, bond holders would be repaid after liquidation of assets, whereas shareholders with stock often receive nothing.

Financial risk management is the practice of protecting economic value in a firm by managing exposure to financial risk - principally operational risk, credit risk and market risk, with more specific variants as listed aside. As for risk management more generally, financial risk management requires identifying the sources of risk, measuring these, and crafting plans to mitigate them. See Finance § Risk management for an overview.

Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Here various valuation techniques are used by financial market participants to determine the price they are willing to pay or receive to effect a sale of the business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest.

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.

In finance, an asset class is a group of financial instruments that have similar financial characteristics and behave similarly in the marketplace. We can often break these instruments into those having to do with real assets and those having to do with financial assets. Often, assets within the same asset class are subject to the same laws and regulations; however, this is not always true. For instance, futures on an asset are often considered part of the same asset class as the underlying instrument but are subject to different regulations than the underlying instrument.

A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth but do not necessarily result in significant changes in the real economy.

Foreign exchange risk is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of an unfavourable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed.

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

In finance, relative value is the attractiveness measured in terms of risk, liquidity, and return of one financial instrument relative to another, or for a given instrument, of one maturity relative to another. The concept arises in economics, business and investment.

Asset and liability management is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy in financial accounting.

References

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  2. 1 2 Roncalli, Thierry. "Strategy - Risk factor investing explained". Next Finance. Retrieved 2023-08-09.
  3. ↑ Cochrane, John H. (2005). Asset Pricing (Revised ed.). Princeton University Press. ISBN   9781400829132.
  4. 1 2 Greene, M. (1968). Market Risk. An Analytical Framework. Journal of Marketing, 32(2), 49-56. doi : 10.2307/1248928
  5. ↑ "Pure Risks". TheFreeDictionary.com. Retrieved 2023-08-09.
  6. ↑ "Liquidity Risk" . Retrieved 2023-08-09.
  7. ↑ "6 Examples of Speculative Risk" . Retrieved 2023-08-09.
  8. ↑ Black, John; Hashimzade, Nigar; Myles, Gareth (2013-05-21), Black, John; Hashimzade, Nigar; Myles, Gareth (eds.), "currency risk", A Dictionary of Economics, Oxford University Press, doi:10.1093/acref/9780199696321.001.0001, ISBN   978-0-19-969632-1 , retrieved 2023-08-09
  9. 1 2 "What is Currency Risk?" . Retrieved 2023-08-09.
  10. ↑ DEUTSCH, H., & Beinker, M. (2016). DERIVATIVES AND INTERNAL MODELS (5th ed., pp. 7-53). [Place of publication not identified]: PALGRAVE MACMILLAN.
  11. 1 2 "Access EIS - Co-Invest With Super Angels". SyndicateRoom. Retrieved 2023-08-09.
  12. ↑ "Systemic Risk | Definition and Meaning". capital.com. Retrieved 2023-08-09.
  13. ↑ Atkinson, T., Luttrell, D., & Rosenblum, H. (2013). How bad was it? The costs and consequences of the 2007–09 financial crisis. Staff Papers, (Jul).
  14. ↑ "COVID-19 is a stark reminder that our assault on the natural world has consequences". World Economic Forum. 2020-05-01. Retrieved 2023-08-09.
  15. ↑ Ambrose, Jillian (2020-04-20). "Over a barrel: how oil prices dropped below zero". The Guardian. ISSN   0261-3077 . Retrieved 2023-08-09.
  16. 1 2 "specific risk". TheFreeDictionary.com. Retrieved 2023-08-09.
  17. ↑ "Unsystematic Risk | Definition and Meaning". capital.com. Retrieved 2023-08-09.
  18. ↑ Reed, R., & Luffman, G. (1986). Diversification: The Growing Confusion. Strategic Management Journal, 7(1), 29-35. Retrieved May 18, 2020, from www.jstor.org/stable/2485965
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  20. 1 2 3 4 "Business Case Studies" . Retrieved 2023-08-09.
  21. ↑ Monetary policy and inflation. (n.d.). Retrieved May 23, 2020, from https://www.rbnz.govt.nz/challenge/team-resources/monetary-policy-and-inflation
  22. 1 2 "Financial Stability". Reserve Bank of Australia. Retrieved 2023-08-09.
  23. ↑ "5 The Influences of Government Investments and Regulatory Policies on Corporate Time Horizons." National Academy of Engineering. 1992. Time Horizons and Technology Investments. Washington, DC: The National Academies Press. doi : 10.17226/1943
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  25. ↑ Abarbanell, J., & Bushee, B. (1997). Fundamental Analysis, Future Earnings, and Stock Prices. Journal of Accounting Research, 35(1), 1-24. doi : 10.2307/2491464
  26. ↑ "The Top Tools for Fundamental Analysis". The Balance. Retrieved 2023-08-09.
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  29. ↑ Mitchell, W. (1925). Quantitative Analysis in Economic Theory. The American Economic Review, 15(1), 1-12. Retrieved May 3, 2020, from www.jstor.org/stable/1808475
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