The term ‘risk’ is used frequently in finance. You may have heard of concepts like ‘risk-management’ or ‘risk-adjusted returns’. Did you know that there are many types of risks in the financial world? This blog covers some of the common types of risks encountered and their implications.
You may have often heard finance professionals say “risk” when referring to the price of a security. This belongs to one of the largest groups of risk – market risk. Market risk refers to the risk incurred in the trading or holding of securities due to changes in market prices. Let’s break this down into several common sub-categories.
Equity risk: The risk of changes in the value of an equity security or a portfolio of equities. For example, movements in the stock market influences whether the value of your stocks rise or fall.
Interest rate risk: The risk of changes in the value of a fixed income security due to interest rate volatility in the market. Note that this applies to coupon payments, and does not affect the principal amount.
Exchange rate risk: The risk of changes in the value of cash flows denominated in foreign currencies due to changes in exchange rates. For example, if you hold USD but your portfolio is reported in AUD terms, then the appreciation of AUD against the USD would imply that the value of your investment falls.
Note that all market risk can be either systematic (affecting whole markets, such as a trade war or the lowering of official interest rates) or idiosyncratic (pertaining only to individual securities, such as managerial issues or the announcement of an acquisition). Further, not all risk is bad news, as risk can be both upside and downside. While high risk is usually undesirable, especially during financial crises, high risk during boom periods could imply strong returns.
Another form of risk that commonly features in finance, especially in the fixed income space, is credit risk. This refers to the potential loss in the value of an asset due to debtor(s) defaulting on their commitments. For example, if you’ve purchased bonds from a company, but it goes bankrupt and is unable to repay its debts even after liquidating its assets, you will have suffered a loss of money. As a precaution against credit risk, creditors commonly charge a margin above the risk-free rate to compensate for the potential loss in money, creating what is called a credit spread. The larger this spread, the higher the credit risk.
In addition, a very short-term form of financial risk is liquidity risk. This refers to the risk that is incurred when an institution cannot meet its short-term financing obligations. For example, if a company has insufficient cash flows to repay its suppliers, then it suffers from liquidity risk. This could develop into a serious problem if not addressed timely, as liquidity risk could accumulate into solvency risk in the longer-term, leading to potential bankruptcy. As such, liquidity risk is a common metric used to measure the financial health of an institution.
Hopefully you have gained a better understanding of the common types of risks encountered in finance! Financial markets are fast-moving and volatile, and the implications of these risks need to be considered whilst keeping an eye on potential returns!
Disclaimer: The intent of this blog is to provide careers advice, not financial advice. It does not take into account individual circumstances. For financial advice, please see a financial adviser.
