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Investment - Investment Risk
Risk is a significant factor of financial decisions. Investors, for instance, buy equities securities, commodities, or real estate. When they do, they are subject to investment risk – that is, the risk connected with investing. For example, investors may experience losses if the company in which they bought common shares loses value or goes bankrupt, or if commodity or real estate values collapse.
Investment risk can take numerous forms based on the company’s investments and operations. Companies in the investment industry often suffer three primary forms of investment risk.
Market risk is risk generated by changes in market conditions affecting prices.
Credit risk is the risk for a lender that a borrower fails to honour a contract and make timely payments of interest and principal.
Liquidity risk is the risk that an asset or security cannot be acquired or sold rapidly without a major sacrifice in price.
A common feature for success in all sorts of investment risk management is the requirement to recognize the risks and price them appropriately.
Market Risk
Market risk, which originates from price movements in financial markets, can be categorized into the risks associated with the underlying market instruments:
Equity price risk
Interest rate risk (for debt securities)
Foreign exchange rate risk
Commodity price risk
Many investment firms are in the business of assuming investment risks, and they tend to tolerate market hazards. But like any other organization, they must align their risk profiles with their risk tolerance. They commonly adopt an approach called risk budgeting to establish how risk should be shared across different business units, portfolios, or individuals.
For example, an asset management business may apply the following risk budgeting steps:
Quantify the level of risk that can be carried by the firm
Set risk budgets and restrictions for each asset class and/or investment manager
Allocate assets in line with the risk budgets
Monitor to verify that risk budgets are respected
Market risks that cannot be tolerated must be managed, and companies have different solutions available. One of them is to hedge undesirable risks by employing derivative products.
Credit Risk
When analyzing the creditworthiness of borrowers, it is crucial to examine both their ability and willingness to repay their obligations.
For example, after the decrease in real estate prices in 2008, many homeowners in the United States were left with mortgage loan obligations that surpassed the market worth of the property. Some of those borrowers still had the means to keep paying their mortgage payments but elected to fail and let the bank take possession of the property.
This potentially unethical option is rational from a purely financial perspective, except from the lower credit profile for future borrowing.
The predicted loss from credit exposure is a function of three elements:
Amount of money lent to a given borrower
Probability that the borrower defaults
Loss that would be incurred if the borrower defaults
The amount that is at risk may be decreased if collateral or assurances from third parties are added. Enforcing contract restrictions to acquire possession of collateral, however, can be a time-consuming legal process. The value of collateral assets for a lender depends on their liquidity and marketability – that is, how easy it is to sell the assets to a third party and at how big of a discount if sold on short notice. Assets for which a consistent market demand exists and that can be moved and easily transferred are more valuable than assets that are exchanged less frequently and are less mobile.
Various sources of independent information exist on borrower creditworthiness, such as credit rating organizations, which should be used in conjunction with internal risk analysis. Any analysis, whether internal or external, should incorporate a degree of critical judgement and scepticism.
There are numerous techniques to managing credit risk:
EXPOSURE LIMITS
Credit risk can be managed by placing restrictions on the amount of exposure to a given counterparty or level of credit rating allowed. For example, a maximum limit of 5% exposure could be specified for a certain counterparty.
COLLATERAL AND COVENANTS
Credit risk can also be addressed by requesting more collateral and enforcing covenants. Covenants are terms for loans that describe both what a borrower must do (positive covenants) and what a borrower is not allowed to do (negative covenants).
For example, a bank may prevent borrowers from issuing more debt, paying dividends, or getting into very risky business projects. When one of the restrictive criteria is broken, the lender may recall the loan or require some action, such as the assignment of extra collateral.
DERIVATIVE INSTRUMENTS
Credit risk can also be addressed through the use of derivative products. For example, credit default swaps are typically employed when corporations seek to protect themselves against the risk of a drop in value of a debt security or index of debt securities.
Lending to governments or state-owned firms raises another sort of credit risk. Sovereign risk is the risk that a government will not return its debt because it does not have either the ability or the motivation to do so. The distinctive characteristic of sovereign risk is that lenders have limited legal remedies available to compel the borrower to repay or to be able to retrieve the assets themselves. A government can also restrict borrowers in its country from repaying their loans to foreign investors — for example, by instituting currency controls to make it difficult or impossible for money to leave the country.
Liquidity Risk
As noted previously, liquidity refers to the capacity to purchase and sell fast without incurring a loss. It is a basic worry for organizations and is often disregarded when sources of financing, such as bank loans, are plentiful.
But during the global financial crisis of 2008, an acute shortage of liquidity in the banking institutions in several nations led to failures. These failures happened because some companies were unable to maintain access to sufficient money to fund their working capital (inventories and receivables from customers net of payables from suppliers) and, thus, to keep their companies functioning.
Firms in the investing industry suffer a greater level of liquidity risk than, for example, manufacturers. To function profitably, they need marketplaces that can handle their trades without large unfavorable effects on prices.
When markets are illiquid — either temporarily, such as during financial crises, or more structurally, such as in some emerging markets — the capacity to trade assets is severely limited, which has a detrimental effect for these firms.
Risk is a significant factor of financial decisions. Investors, for instance, buy equities securities, commodities, or real estate. When they do, they are subject to investment risk – that is, the risk connected with investing. For example, investors may experience losses if the company in which they bought common shares loses value or goes bankrupt, or if commodity or real estate values collapse.
Investment risk can take numerous forms based on the company’s investments and operations. Companies in the investment industry often suffer three primary forms of investment risk.
Market risk is risk generated by changes in market conditions affecting prices.
Credit risk is the risk for a lender that a borrower fails to honour a contract and make timely payments of interest and principal.
Liquidity risk is the risk that an asset or security cannot be acquired or sold rapidly without a major sacrifice in price.
A common feature for success in all sorts of investment risk management is the requirement to recognize the risks and price them appropriately.
Market Risk
Market risk, which originates from price movements in financial markets, can be categorized into the risks associated with the underlying market instruments:
Equity price risk
Interest rate risk (for debt securities)
Foreign exchange rate risk
Commodity price risk
Many investment firms are in the business of assuming investment risks, and they tend to tolerate market hazards. But like any other organization, they must align their risk profiles with their risk tolerance. They commonly adopt an approach called risk budgeting to establish how risk should be shared across different business units, portfolios, or individuals.
For example, an asset management business may apply the following risk budgeting steps:
Quantify the level of risk that can be carried by the firm
Set risk budgets and restrictions for each asset class and/or investment manager
Allocate assets in line with the risk budgets
Monitor to verify that risk budgets are respected
Market risks that cannot be tolerated must be managed, and companies have different solutions available. One of them is to hedge undesirable risks by employing derivative products.
Credit Risk
When analyzing the creditworthiness of borrowers, it is crucial to examine both their ability and willingness to repay their obligations.
For example, after the decrease in real estate prices in 2008, many homeowners in the United States were left with mortgage loan obligations that surpassed the market worth of the property. Some of those borrowers still had the means to keep paying their mortgage payments but elected to fail and let the bank take possession of the property.
This potentially unethical option is rational from a purely financial perspective, except from the lower credit profile for future borrowing.
The predicted loss from credit exposure is a function of three elements:
Amount of money lent to a given borrower
Probability that the borrower defaults
Loss that would be incurred if the borrower defaults
The amount that is at risk may be decreased if collateral or assurances from third parties are added. Enforcing contract restrictions to acquire possession of collateral, however, can be a time-consuming legal process. The value of collateral assets for a lender depends on their liquidity and marketability – that is, how easy it is to sell the assets to a third party and at how big of a discount if sold on short notice. Assets for which a consistent market demand exists and that can be moved and easily transferred are more valuable than assets that are exchanged less frequently and are less mobile.
Various sources of independent information exist on borrower creditworthiness, such as credit rating organizations, which should be used in conjunction with internal risk analysis. Any analysis, whether internal or external, should incorporate a degree of critical judgement and scepticism.
There are numerous techniques to managing credit risk:
EXPOSURE LIMITS
Credit risk can be managed by placing restrictions on the amount of exposure to a given counterparty or level of credit rating allowed. For example, a maximum limit of 5% exposure could be specified for a certain counterparty.
COLLATERAL AND COVENANTS
Credit risk can also be addressed by requesting more collateral and enforcing covenants. Covenants are terms for loans that describe both what a borrower must do (positive covenants) and what a borrower is not allowed to do (negative covenants).
For example, a bank may prevent borrowers from issuing more debt, paying dividends, or getting into very risky business projects. When one of the restrictive criteria is broken, the lender may recall the loan or require some action, such as the assignment of extra collateral.
DERIVATIVE INSTRUMENTS
Credit risk can also be addressed through the use of derivative products. For example, credit default swaps are typically employed when corporations seek to protect themselves against the risk of a drop in value of a debt security or index of debt securities.
Lending to governments or state-owned firms raises another sort of credit risk. Sovereign risk is the risk that a government will not return its debt because it does not have either the ability or the motivation to do so. The distinctive characteristic of sovereign risk is that lenders have limited legal remedies available to compel the borrower to repay or to be able to retrieve the assets themselves. A government can also restrict borrowers in its country from repaying their loans to foreign investors — for example, by instituting currency controls to make it difficult or impossible for money to leave the country.
Liquidity Risk
As noted previously, liquidity refers to the capacity to purchase and sell fast without incurring a loss. It is a basic worry for organizations and is often disregarded when sources of financing, such as bank loans, are plentiful.
But during the global financial crisis of 2008, an acute shortage of liquidity in the banking institutions in several nations led to failures. These failures happened because some companies were unable to maintain access to sufficient money to fund their working capital (inventories and receivables from customers net of payables from suppliers) and, thus, to keep their companies functioning.
Firms in the investing industry suffer a greater level of liquidity risk than, for example, manufacturers. To function profitably, they need marketplaces that can handle their trades without large unfavorable effects on prices.
When markets are illiquid — either temporarily, such as during financial crises, or more structurally, such as in some emerging markets — the capacity to trade assets is severely limited, which has a detrimental effect for these firms.
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