FINANCIAL RISK FACTORS

By Priyadarshini. K

Financial Risk
Financial risk refers to the chance that a business's cash flows are insufficient to pay off debt and other financial responsibilities. Or Any event or possibility of an event which can adversely affect corporate earnings or cash flows overtime. Corporate earnings or cash flows would influence the shareholders.

Factors influencing financial risks:

I.

Economic policies of government. Economic policy refers to the actions that government take in the economic field. It covers the systems for setting interest rates and government budget as well as the labor market, national ownership, and many other areas of government interventions into the economy. It results in -Changes in taxation -Changes in regulatory policies - Budget deficits or surpluses - Changes in money supply by Central bank - Levels of inflation, interest rates etc

II. Individual consumer preferences resulting in certain patterns of international trade surplus in some economies and deficit in others. III. Technological factors that bring in new products making redundant other products in the process impacting fortunes of corporate manufacturing and marketing. IV. Political, social, ethnic and racial issues influencing the availability or demand for a particular commodity which results in price volatility.

V. Corporate governance practices, financial performance of corporations which is the result of competitive factors in various markets. VI. Other factors influencing financial risk:
Market risk Liquidity risk

Interest rate risk

Exchange rate risk Commodity price risk Credit risk/Counter party risk

 Market risk

Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. For example: Option A is an investment of $100 in a risk free, FDIC-insured Certificate of Deposit. Option B is an investment of $100 in SPY, the ETF that charts the S&P 500 Index. If the expected return on Option A is 1%, and the expected return on Option B is 10%, investors are demanding 9% to move their money from a risk-free investment to a risky equity investment.

 Liquidity risk

Liquidity risk is the risk involved in selling the asset or security quickly at a fair price or without making a substantial price concession. It is also referred to as marketability risk.

For example: Consider a $1,000,000 home with no buyers. The home obviously has value, but due to market conditions at the time, there may be no interested buyers. In better economic times when Market Conditions improve and demand increases, the house may sell for well above that price.

Liquidity risk (contd..)

However, due to the home owners need of cash to meet near term financial demands, the owner may be unable to wait and have no other choice but to sell the house in an illiquid market at a significant loss. Hence, the liquidity risk of holding this asset.

 Interest rate risk Interest rate risk is the risk (variability in value) borne by an interest-bearing asset, such as a loan or a bond, due to Variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond's duration.
For example: Let's assume you purchase a bond from Company XYZ. Because bond prices typically fall when interest rates rise, an unexpected increase in interest rates means that your investment could suddenly lose value. If you expect to sell the bond before it matures, this could mean you end up selling the bond for less than you paid for it(a capital loss). Of course, the magnitude of change in the bond price is also affected by the maturity, coupon rate, its ability to be called, and other characteristics of the bond.

 Exchange rate risk

Exchange rate risk is a form of financial risk that arises from the potential change in the exchange rate of one currency against another. Investors or businesses face an exchange rate risk when they have assets or operations across national borders or if they have loans or borrowings in a foreign currency. It is also called as Currency risk. For example: If money must be converted into a different currency to make a certain investment, changes in the value of the currency relativeAmerican dollar will affect the total loss or gain on the investment when the money is converted back. This risk usually affects businesses, but it can also affect individual investors who make international investments.

 Commodity price risk

Commodity price risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities.

For example: Transport companies are exposed to the risk of rising fuel prices.

 Credit risk/Counter party risk

Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised.

For example: A consumer does not make a payment due on a mortgage loan, credit card, line of credit, or other loan. A business or consumer does not pay a trade invoice when due. A business does not pay an employee's earned wages when due. A business or government bond issuer does not make a payment on a coupon or principal payment when due An insolvent insurance company does not pay a policy obligation etc.

Thank You