Six Critical Risks in Financial Instruments

A good working definition of financial risk can be found on http://www.investopedia.com: “…the chance that an investment’s actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is usually measured using the historical returns or average returns for a specific investment.”

With that definition as a starting point, let’s look at the key components of financial risk. It’s important to take all of them into account when deciding on investing your hard-earned money.

Volatility

Volatility risk measures how much the value of an asset will deviate from the principal committed to that asset. This volatility is measured using a statistical concept known as standard deviation. Standard deviation predicts how much the value of an asset will deviate from its current value, based on historical data, within a certain degree of confidence.

Example: If over the last 10 years a financial asset has a standard deviation of 20 percent, we can assume there is a 67 percent possibility that it will fluctuate plus or minus 20 percent in the future. The big “if,” of course, is that the asset will follow its established historical pattern.

The more volatile an asset, the riskier it should be considered. When there is a high probability of fluctuation, it’s appropriate to demand a higher return to compensate for that risk.

Inflation risk

There is the risk that the dollar you receive in the future will be worth much less than it is today. You measure inflation risk through the real rate of return. If inflation is running at a 5 percent annual rate and you have your money sitting in the bank earning 3 percent, then your real return is a minus 2 percent. Inflation is eating away two cents for each dollar you’ve “saved.”

Now, here is a teaser: If you don’t know where the inflation rate is heading, would you call a savings account deposit an investment or a speculation? Is the interest rate you get on checking deposits a bargain? And what about the rate they promise on Certificates of Deposit? Are you investing or speculating, given what you now know about inflation-rate risk?

Interest-rate risk

Interest-rate risk most often applies to fixed-rate instruments such as bonds, but keep in mind that interest rates affect the cost of money. Since companies’ earnings can be affected by high costs of financing, up-or-down movement in interest rates will also impact share prices, or any other financial asset with a value that hinges on current interest rates.

All else being equal, if interest rates increase the price of bonds will fall, and if rates decrease the price will increase. Thus, if you buy a bond, you can expect its price to fluctuate until the maturity date, as would a stock until you sell it.

If interest rates rise after you buy one, a bond issued later will become more appealing, since it will offer coupon rates more in line with the higher rate. Since markets cannot change the coupon rate, adjusting the price of the bond can adjust the yield expected—bringing the expected return more in line with the higher rates.

Here is where interest risk comes into play. The bond you bought that pays a lower coupon rate will decrease in price, and as a result will show a principal loss on paper. In contrast, if interest rates decrease, your bond will increase in price, so you will show a gain on paper.

Credit or default risk

When you buy a corporate bond you are also exposed to what is known as credit or default risk. A bond is a debt instrument that amounts to a contractual agreement between the bond holder and the company that issued it. The company promises to pay interest and return the principal at a certain date in the future (called the maturity date).

What if a company can no longer fulfill its obligations to debt holders or creditors? In that case, the company will likely file for bankruptcy protection and the bond’s contractual agreement to pay interest and return the principal will no longer apply. Thus, credit or default risk means you will no longer receive the cash flow you expected and there is a high probability that you will not get 100 percent of your committed principal back.

Market or systemic risk

Then there is market risk. This risk, also known as systemic risk, is the risk that exposes your holdings to the daily up-and-down uncertainties of the markets. When there is a significant break in the positive trend of a market, your positions will be affected just because the market in general is being affected.

Examples include the aftermath of the tragic events of 9/11 and the current economic crisis, as the financial sector reacts to federal intervention in the bailout of investment banks caught in the fallout from the sub-prime mortgage collapse.

Market risk is not limited to stocks. It applies to all sorts of financial assets, including real estate, bonds from corporate or government issuers and commodities. Note however that market risk is not always negative. As shares move along the market — as measured by an index — they can move to the upside, too.

Liquidity risk

When you try to sell a financial asset and cannot find a buyer who will pay an acceptable price, you have just bumped up against liquidity risk. It is defined as the risk to which you are exposed when trying to sell a financial asset. The lack of buyers or interested parties may prevent you from selling the asset at a favorable price. In fact, if you must sell at any price, you most likely will realize a loss.

To allow for the possibility that you will not have immediate access to funds if you decide to “cash in your chips” when buying illiquid assets, you should adjust the expected return on these assets upwards to compensate for the lack of liquidity. Rule of thumb: The return expected should be significantly higher than a U. S. Treasury note.

Country and other risk

Country risk takes into account that an investor, speculator or corporate entity may lose all or part of its principal or capital expenditure when expanding operations outside its home country. This loss could be attributable to the economic environment or political actions such as nationalization of the company, forced confiscation of assets, or repudiation of debt. One example: The attorneys for Exxon, are now dealing with a $12 billion lawsuit against Venezuela for freezing the company’s assets.

There are of course, many other risks to which we are exposed. Unexpected and rare events that result from exposure to blind risks are called “Black Swan” events. A Black Swan event gets its name from the long and firmly held belief that swans came in only one color — white — and any other color variation was genetically impossible — until black swans were discovered in Australia.

Risk is a fascinating concept that is intrinsically related to what separates investment from speculation and speculation from outright gambling. The fact is that if you want to make money or, for that matter, succeed in life, you need to take chances. The important thing is to understand those risks and enter into any sort of investment with your eyes open.