Financial risk is a term that can apply to businesses, government units, the financial marketplace as a whole, and the individual. This risk is the risk or likelihood that shareholders, stakeholders, or other fiscal stakeholders will lose money.
There are numerous specific risk factors that can be considered as a fiscal risk. Any risk is a threat that produces damaging or unwanted results. Some more shared and diverse financial risks include credit risk, liquidity risk, and operational risk.
The Basics of Financial Risk
Financial risk is a type of risk that can affect the loss of capital to interested parties.
- For governments, this can mean they are incapable to regulate economic policy and default on bonds or additional debt issues.
- Corporations also face the likelihood of default on debt they undertake but may also experience failure in an undertaking the causes a financial weight on the business.
- Individuals face financial risk when they make conclusions that may endanger their income or capacity to pay a debt they have assumed.
- Financial markets face financial risk due to numerous macroeconomic forces, changes to the market interest rate, and the possibility of default by sectors or large corporations.
Financial risks are ubiquitous and come in many different sizes, affecting everyone. You should be aware of all financial risks. Knowing the risks and how to guard yourself will not remove the risk, but it will mitigate their harm.
Financial Risks for the Market
Several types of financial risk are tied to financial markets. As mentioned earlier, many circumstances can impact the financial market. As demonstrated during the 2007–2008 global financial crisis, when a critical sector of the market struggles it can impact the monetary wellbeing of the entire marketplace. During this time, businesses closed, investors lost fortunes, and governments were forced to rethink their monetary policy. However, many other events also impact the market.
Volatility brings uncertainty about the fair value of market assets. Seen as a statistical measure, volatility reflects the confidence of the stakeholders that market returns match the actual valuation of individual assets and the marketplace as a whole. Measured as implied volatility (IV) and represented by a percentage, this statistical value indicates the bullish or bearish — market on the rise versus the market in decline — view of investments. Volatility or equity risk can cause abrupt price swings in shares of stock.
Default and changes in the market interest rate can also pose a financial risk. Defaults happen mainly in the debt or bond market as companies or other issuers fail to pay their debt obligations, harming investors. Changes in the market interest rate can push individual securities into being unprofitable for investors, forcing them into lower paying debt securities or facing negative returns.
Asset-backed risk is the chance that asset-backed securities — pools of various types of loans — may become volatile if the underlying securities also change in value. Sub-categories of asset-backed risk involve prepayment — the borrower paying off a debt early, thus ending the income stream from repayments — and significant changes in interest rates.
Financial Risks for Individuals
Individuals can face financial risk when they make poor decisions. This hazard can have wide-ranging causes from taking an unnecessary day off of work to invest in highly speculative investments. Every undertaking has exposure to pure risk — dangers that cannot be controlled, but some are done without fully realizing the consequences.
Liquidity risk comes in two flavours for investors to fear. The first involves securities and assets that cannot be purchased or sold quickly enough to cut losses in a volatile market. Known as market liquidity risk this is a situation where there are few buyers but many sellers. The second risk is funding or cash flow liquidity risk. Funding liquidity risk is the possibility that a corporation will not have the capital to pay its debt, forcing it to default, and harming stakeholders.
Speculative risk is one where a profit or gain has an uncertain chance of success. Perhaps the investor did not conduct proper research before investing, reached too far for gains, or invested too large of a portion of their net worth into a single investment.
Investors holding foreign currencies are exposed to currency risk because different factors, such as interest rate changes and monetary policy changes, can alter the calculated worth or the value of their money. Meanwhile, changes in prices because of market differences, political changes, natural calamities, diplomatic changes, or economic conflicts may cause volatile foreign investment conditions that may expose businesses and individuals to foreign investment risk.
What is Risk Management?
Risk management occurs everywhere in the realm of finance. It occurs when an investor buys U.S. Treasury bonds over corporate bonds, when a fund manager hedges his currency exposure with currency derivatives, and when a bank performs a credit check on an individual before issuing a personal line of credit. Stockbrokers use financial instruments like options and futures, and money managers use strategies like portfolio and investment diversification to mitigate or effectively manage risk.
Inadequate risk management can result in severe consequences for companies, individuals, and the economy. For example, the subprime mortgage meltdown in 2007 that helped trigger the Great Recession stemmed from bad risk-management decisions, such as lenders who extended mortgages to individuals with poor credit; investment firms who bought, packaged, and resold these mortgages; and funds that invested excessively in the repackaged, but still risky, mortgage-backed securities (MBS).
- Risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions.
- Risk is inseparable from return in the investment world.
- A variety of tactics exist to ascertain risk; one of the most common is standard deviation, a statistical measure of dispersion around a central tendency.
- Beta, also known as market risk, is a measure of the volatility, or systematic risk, of an individual stock in comparison to the entire market.
- Alpha is a measure of excess return; money managers who employ active strategies to beat the market are subject to alpha risk.
Risk Management and Psychology
While that information may be helpful, it does not fully address an investor’s risk concerns. The field of behavioural finance has contributed an important element to the risk equation, demonstrating asymmetry between how people view gains and losses. In the language of prospect theory, an area of behavioural finance introduced by Amos Tversky and Daniel Kahneman in 1979, investors exhibit loss aversion: They put more weight on the pain associated with a loss than the good feeling associated with a profit.
Often, what investors really want to know is not just how much an asset deviates from its expected outcome, but how bad things look way down on the left-hand tail of the distribution curve. Value at risk (VAR) attempts to provide an answer to this question. The idea behind VAR is to quantify how large a loss on investment could be with a given level of confidence over a defined period. For example, the following statement would be an example of VAR: “With about a 95% level of confidence, the most you stand to lose on this $1,000 investment over a two-year time horizon is $200.” The confidence level is a probability statement based on the statistical characteristics of the investment and the shape of its distribution curve.
Of course, even a measure like VAR doesn’t guarantee that 5% of the time will be much worse. Spectacular debacles like the one that hit the hedge fund Long-Term Capital Management in 1998 remind us that so-called “outlier events” may occur. In the case of LTCM, the outlier event was the Russian government’s default on its outstanding sovereign debt obligations, an event that threatened to bankrupt the hedge fund, which had highly leveraged positions worth over $1 trillion; if it had gone under, it could have collapsed the global financial system. The U.S. government created a $3.65-billion loan fund to cover LTCM’s losses, which enabled the firm to survive the market volatility and liquidate in an orderly manner in early 2000.
Risk Management In The Cryptocurrency Space
Risk Management, as with all organisations, plays a vital role in meeting and exceeding objectives whilst providing resilience and stakeholder confidence. Exchanges and companies that are raising/have raised ICO’s should ensure that Risk Management is part of their business. Identifying risks and opportunities, assessing them and implementing response plans should be standard. Cyber risks, reputational risks, operational risks, system risks and strategic risks should all be considered and prepared for, which would minimise market disruption and reduce the likelihood of financial ruin. At the very least they owe it to the investors who have funded them.
For investors, with volatility so high, the rewards are great but so are the risks. Investors should ensure that they only invest what they can afford to lose, do their due diligence on their investments which includes understanding the technology, the team and look for a prototype rather than a wild concept. Additionally, investors should always be on the lookout for phishing scams and suspicious emails.
Finally, even the most optimistic investor should at least consider that cryptocurrencies are a speculative bubble that could burst.