Key Risks: Interest, Market, Credit, Currency, Liquidity, Legal, Operational

23/11/2020 0 By indiafreenotes

Market Risk

The risk of investments declining in value because of economic developments or other events that affect the entire market. The main types of market risk are equity risk, interest rate risk and

Currency risk

  • Equity risk: Applies to an investment in shares. The market price of shares varies all the time depending on demand and supply. Equity risk is the risk of loss because of a drop in the market price of shares.
  • Interest rate risk: Applies to debt investments such as bonds. It is the risk of losing money because of a change in the interest rate. For example, if the interest rate goes up, the market value of bonds will drop.
  • Currency risk: Applies when you own foreign investments. It is the risk of losing money because of a movement in the exchange rate. For example, if the U.S. dollar becomes less valuable relative to the Canadian dollar, your U.S. stocks will be worth less in Canadian dollars.

Liquidity Risk

The risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price. In some cases, such as exempt market investments, it may not be possible to sell the investment at all.

Concentration Risk

The risk of loss because your money is concentrated in 1 investment or type of investment. When you diversify your investments, you spread the risk over different types of investments, industries and geographic locations.

Credit Risk

The risk that the government entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit risk applies to debt investments such as bonds. You can evaluate credit risk by looking at the credit rating of the bond. For example, long-term Canadian government bonds have a credit rating of AAA, which indicates the lowest possible credit risk.

Reinvestment Risk

The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a bond paying 5%. Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular interest payments at 4%. Reinvestment risk will also apply if the bond matures and you have to reinvest the principal at less than 5%. Reinvestment risk will not apply if you intend to spend the regular interest payments or the principal at maturity.

Inflation Risk

The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time – the same amount of money will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or debt investments like bonds. Shares offer some protection against inflation because most companies can increase the prices they charge to their customers. Share prices should therefore rise in line with inflation. Real estate also offers some protection because landlords can increase rents over time.

Horizon Risk

The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long term. If you must sell at a time when the markets are down, you may lose money.

Longevity Risk

The risk of outliving your savings. This risk is particularly relevant for people who are retired, or are nearing retirement.

Foreign Investment risk

The risk of loss when investing in foreign countries. When you buy foreign investments, for example, the shares of companies in emerging markets, you face risks that do not exist in India, in your home country, for example, the risk of nationalization. (Bank Nationalization in India)

Manager Risk

The chance that a pooled fund will underperform due to poor investment decisions of the fund manager.

Business Risk

This refers to the risk of a particular business failing and thereby loosing its investment. Poor business performance may be caused by a variety of factors like heightened competition, emergence of new technologies, etc.

Financial Risk

The financial risk is a result of over dependence on borrowed funds. If a company uses a large amount of debt, then it has to pay a relatively large amount of fixed interest. During recession due to lower revenue, risk of non-payment of fixed interest increases and exposes the company to financial risk.

Systematic and Unsystematic Risk

The risk of any individual stock can be separated into two components: non-diversifiable and diversifiable risk. Non-diversifiable risk is that part of the total risk that is in relation to the general economy or the stock market as a whole and hence, cannot be eliminated by diversification.

Non-diversifiable risk is also referred to as market or systematic risk.

  • Diversifiable risk, on the other hand, is margin of the company or industry and hence can be eliminated by diversification. Diversifiable risk is also called as unsystematic risk or specific risk.
  • Example of non-diversifiable or market risk factors: Major change in tax rates, war and other calamities, an increase or decrease in inflation rates, a change in economic/ environmental policy, industrial recession, an increase in international oil prices, etc.
  • Example of diversifiable or specific risk factor: Strike in company, bankruptcy of a major supplier, death/resignation of key company officer, unexpected entry of new competitor into the market, etc.

Legal Risk

Legal risk is the risk arising from failure to comply with statutory or regulatory obligations. Generally, all laws in the host country will apply to an entrepreneur’s local business operations. Examples include filing procedures, employment law, environmental law, tax law, and ownership requirements.