Comparison of Financial Risks

1981 words (8 pages) Essay in Finance

08/02/20 Finance Reference this

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Financial Risks

Abstract

 Financial risks are risks that individuals will take when starting a business and will continue to take during the life cycle of the business. There are at least 12 different types of financial risk and I will attempt to discuss and explain at least four of them. The four that I am going to focus on are credit risk, market risk, country risk and interest rate risk. The idea behind this is to be able to determine which risk would work best or which risks will work well together and why they should be used or taken into consideration. Hopefully, by the time the is completed, I will have tried to explain and helped others understand the different types of financial risks there are.

Financial Risks

 Risk is the loss of capital and is evident in all types of investments. If investments are held in different currency, the risk involved would be the movement affecting the value of currency. No matter the type of risk, there will always be the loss of investments, either in part or in whole. There sometimes just isn’t any way around that.

 The next thing would be if looking at financial risks, it almost always goes with the company and their ability to generate the right amount of cash flow and be able to make their interest payments on either their financing bills or their other debt related obligations. If the company has a high debt, they are financing.

Types of Risks

 The four different types of risk that I chose for this week’s assignment are credit risks, currency risks, country risks and foreign risks. All four of these, play important role when trying to invest in capital markets. The risks that are within the capital markets are possibilities of the actual returns being completely different from anticipated returns. This is as most will concur, a risk proposition and can be referred to a gamble.

 When investing in capital markets it is sometimes recommended to go with the lower risk which can mean a lesser return, but it will be minimal on loss. If an investor were to go with a higher risk, then it’s the opposite of the low risk. There is a greater risk of loss; however, there is a much higher return. Is seems the major financial risks can be categorized into four different classes. While I will only be summarizing two of them, the others are interest rate risk and taxes risk.

Credit Risk

 Credit risk is a risk that stems from the financial risks and it is an element of banking. One of the ways that credit risk occurs is the bank taking the change on an individual or company that may be less than stellar. Another way credit risk will be there is if a company fails to pay back their debt and ends up filing bankruptcy, this will then make an individual or company unreliable.

 There are a few different characteristics of credit risk and those are collateral risk, default risk and concentration risk. The credit risk also coincides with currency risk. If the currency drops or rises in value, that too can affect the world of credit. To be able to manage the credit, then there needs to be a lot of attention on the portfolio, do not have a poor portfolio manager and always make sure to do an analysis before investing in anything or anyone.

Market Risk

 Market risk the where there is a possibility of an investor that will experience a loss due to factors that affect the overall performance of the markets. Market risk is al considered a systematic risk, and it cannot be eliminated with diversification; even though it can be hedged. When looking further into market risk you will find interest rate risk, monetary policy, commodity risk and currency risk.

 To looking at the reason that market risk even exists is to look at changing of prices. This would also include the standard deviation of changes within the stock market prices along with currency and commodities. This is referred to as the price volatility. The best way to measure market risk is to use the value-at-risk method. Another way to measure market risk as it also measures that volatility and is used with the beta. This can also be used with the capital asset pricing model.

Country Risk

Country risk will depend on the political, economic and social issues. When looking at going to a foreign country to do business, there should always be an analysis performance on the fundamental premise which can increase the probability of loss materialization and minimize the potential loss. One analysis cannot work for all countries as each country is different and has a different economy. When conducting an analysis of any country, one should look at the economic risk, transfer risk, exchange risk, location, sovereign risk and the major risk that needs to be looked at is the political risk.

Foreign Exchange Risk

 To investigate the foreign exchange risk, one must identify the type of market they will be investing in. They will need to see which way the market is going, whether it is going up or down and if it would be a good choice. To figure this out, the formula for kurtosis, skewness and volatility can be used.

 The one thing that really goes with this would be the currency risks. There seems to be a so-called price-fixing that will and can cause irreputable damage on national economies. This is where the Sherman Act comes in. According to Al Janabi (2006), Although some courts have recognized the probative value of foreign price-fixing conspiracies to the determination of whether defendants agreed to fix prices in the United States,185 most courts have not.

Similarities/Differences

While all the risks are generally the same, they are all quite different and some of them are even or can intertwine with one another. All the risks will correlate with loss, or gains. All these risks can exist in a variety of forms.

If referring to foreign currencies, they are exposed to currency risk and due to these factors, interest rate changes and so forth. Most all the risk all finds themselves going back to the financial markets.

One difference is to look at is whether the risk is either a business risk or a financial risk. You also need to see if the risks are systematic or unsystematic risks. This is where the business owner and/or operator needs to understand exactly what it will take to make the business strive and keep it a float whether a depression or a recession hit.

The other issue that would take on a risk of financial or business would be the mom and pop stores that end up in a bad way due to the large chain stores like Walmart, Amazon

Reduced Risk

 Risk will always be there, no matter the situation. The only real way to keep the risk down and reduced is just by doing the research and figuring out which way to go. Make sure you know what you’re going to be getting into and know how to invest. One of the main things that a financial institution needs to make sure they are lending to upstanding companies and the companies have a good business plan and can be able to forecast their losses and their gains.

 If we look at Toys “R” Us, it is a real-world situation where the company files bankruptcy. As this company was working to restructure and negotiate with the banks and debtholders, to deal with their $5 billion of long-term debt. “Much of this financial risk reportedly stemmed from a $6.6 billion leveraged buyout of Toys “R” Us by mammoth investment firms Bain Capital, KKR & Co. and Vornado Realty Trust in 2005. The purchase, which took the company private, left it with $5.3 billion in debt secured by its assets and it never really recovered, saddled as it was by $400 million worth of interest payments annually.” (Chen, 2019).

 To truly reduce the financial risk, one must figure out which strategy is going to be used. Whether it is a company or an individual, you must look at what has the highest interest rate and start chopping away at it. Once the larger or higher rate has been paid, then look at the smaller ones and start going into those and paying them off.

 As a business, they need to make sure they are balancing and managing their accounts receivables to try and minimize any of the outstanding balances. The company will also need to keep their outstanding loans to a minimum and they will need to control their growth rate.

Conclusion

 In closing, it will always be risk and there will always be losses; however, there will also be gains and/or profit. There is never any way to know exactly how the market will go or how the economy will change to cause a shift in markets.

 If a company has a good business plan, the market it good and the research has been completed on the country of choice, then I don’t really see a problem and I wouldn’t believe there should be any problems and the risk can be kept at a minimum. There are always unforeseen issues that can come up and can cause a few major issues for any company.

 Other items to think about and close on is financial risk always refers to a company’s ability to manage its debt, the higher the debt, will create a larger risk and could cause the company to default on its loans or debt payments.

References

  • Al Janabi, M. A. M. (2006). Foreign-exchange trading risk management with value at risk. Journal of Risk Finance (Emerald Group Publishing Limited), 7(3), 273. Retrieved from https://search-ebsohost-com.libauth.purdueglobal.edu/login.aspx?direct=true&db=edb&AN=21847582&site=eds-live
  • Chen, J. (May 2019). Financial Risk. Retrieved from https://www.investopedia.com/terms/f/financialrisk.asp
  • Folgate, E. (n.d.) Reduce Your Financial Risk During This Recession. Retrieved from https://www.moneycrashers.com/reduce-your-financial-risk-during-this-recession/
  • Gahin F.S. (1967). A Theory of Pure Risk Management in the Business Firm. Journal of Risk & Insurance, 34(1), 121-129. https://doi.org/10.2307/251020
  • Mitchell, V., & Greatorex, M. (n.d.). Risk Perception and Reduction in the Purchase of Consumer Services (4th ed., Vol. 13). doi: https://doi.org/10.1080/02642069300000068
  • Pânzaru, S. (2017). Considerations Regarding the Country Risk Management. Review of General Management, 25(1), 54–64. Retrieved from https://search-ebscohost-com.libauth.purdueglobal.edu/login.aspx?direct=true&db=bth&AN=123767623&site=eds-live
  • Virglerova, A. (2018). Differences in the Concept of Risk Management in V4 Countries. International Journal of Entrepreneurial Knowledge, 6(2), 100-109. https://doi.org/10.2478/IJEK-2018-0017
  • Vitez, Osmond. (n.d.). Five Ways to Manage Financial Risk. Retrieved from https://smallbusiness.chron.com/five-ways-manage-financial-risk-4564.html
  • Wojcicka-Wojtowicz, A. (2018). Credit Risk Management in Finance. A Review of Various Approached. Operations Research & Decisions, 28(4), 99-106. https://doi.org/10.5277/ord180407
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