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Financial risk
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Financial risk
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.
Modern portfolio theory initiated by Harry Markowitz in 1952 under his thesis titled "Portfolio Selection" is the discipline and study which pertains to managing market and financial risk. In modern portfolio theory, the variance (or standard deviation) of a portfolio is used as the definition of risk.
According to Bender and Panz (2021), financial risks can be sorted into five different categories. In their study, they apply an algorithm-based framework and identify 193 single financial risk types, which are sorted into the five categories market risk, liquidity risk, credit risk, business risk and investment risk.
The four standard market risk factors are equity risk, interest rate risk, currency risk, and commodity risk:
Equity risk is the risk that stock prices in general (not related to a particular company or industry) or the implied volatility will change. When it comes to long-term investing, equities provide a return that will hopefully exceed the risk free rate of return The difference between return and the risk free rate is known as the equity risk premium. When investing in equity, investors invest on the basis that higher risk is only advantageous if it is accompanied by potentially higher returns. Hypothetically, an investor will be compensated for bearing more risk and thus will have more incentive to invest in riskier stock. A significant portion of high risk/ high return investments come from emerging markets that are perceived as volatile.
Interest rate risk is the risk that interest rates or the implied volatility will change. The change in market rates and their impact on the profitability of a bank, lead to interest rate risk. Interest rate risk can affect the financial position of a bank and may create unfavorable financial results. The potential for the interest rate to change at any given time can have either positive or negative effects for the bank and the consumer. If a bank gives out a 30-year mortgage at a rate of 4% and the interest rate rises to 6%, the bank loses and the consumer wins. This is an opportunity cost for the bank and a reason why the bank could be affected financially.
Currency risk is the risk that foreign exchange rates or the implied volatility will change, which affects, for example, the value of an asset held in that currency. Currency fluctuations in the marketplace can have a drastic impact on an international firm's value because of the price effect on domestic and foreign goods, as well as the value of foreign currency denominate assets and liabilities. When a currency appreciates or depreciates, a firm can be at risk depending on where they are operating and what currency denominations they are holding. The fluctuation in currency markets can have effects on both the imports and exports of an international firm. For example, if the euro depreciates against the dollar, the U.S. exporters take a loss while the U.S. importers gain. This is because it takes fewer dollars to buy a euro and vice versa, meaning the U.S. wants to buy goods and the EU is willing to sell them; it is too expensive for the EU to import from U.S. at this time.
Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) or implied volatility will change. There is too much variation between the amount of risks producers and consumers of commodities face in order to have a helpful framework or guide.
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Financial risk
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.
Modern portfolio theory initiated by Harry Markowitz in 1952 under his thesis titled "Portfolio Selection" is the discipline and study which pertains to managing market and financial risk. In modern portfolio theory, the variance (or standard deviation) of a portfolio is used as the definition of risk.
According to Bender and Panz (2021), financial risks can be sorted into five different categories. In their study, they apply an algorithm-based framework and identify 193 single financial risk types, which are sorted into the five categories market risk, liquidity risk, credit risk, business risk and investment risk.
The four standard market risk factors are equity risk, interest rate risk, currency risk, and commodity risk:
Equity risk is the risk that stock prices in general (not related to a particular company or industry) or the implied volatility will change. When it comes to long-term investing, equities provide a return that will hopefully exceed the risk free rate of return The difference between return and the risk free rate is known as the equity risk premium. When investing in equity, investors invest on the basis that higher risk is only advantageous if it is accompanied by potentially higher returns. Hypothetically, an investor will be compensated for bearing more risk and thus will have more incentive to invest in riskier stock. A significant portion of high risk/ high return investments come from emerging markets that are perceived as volatile.
Interest rate risk is the risk that interest rates or the implied volatility will change. The change in market rates and their impact on the profitability of a bank, lead to interest rate risk. Interest rate risk can affect the financial position of a bank and may create unfavorable financial results. The potential for the interest rate to change at any given time can have either positive or negative effects for the bank and the consumer. If a bank gives out a 30-year mortgage at a rate of 4% and the interest rate rises to 6%, the bank loses and the consumer wins. This is an opportunity cost for the bank and a reason why the bank could be affected financially.
Currency risk is the risk that foreign exchange rates or the implied volatility will change, which affects, for example, the value of an asset held in that currency. Currency fluctuations in the marketplace can have a drastic impact on an international firm's value because of the price effect on domestic and foreign goods, as well as the value of foreign currency denominate assets and liabilities. When a currency appreciates or depreciates, a firm can be at risk depending on where they are operating and what currency denominations they are holding. The fluctuation in currency markets can have effects on both the imports and exports of an international firm. For example, if the euro depreciates against the dollar, the U.S. exporters take a loss while the U.S. importers gain. This is because it takes fewer dollars to buy a euro and vice versa, meaning the U.S. wants to buy goods and the EU is willing to sell them; it is too expensive for the EU to import from U.S. at this time.
Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) or implied volatility will change. There is too much variation between the amount of risks producers and consumers of commodities face in order to have a helpful framework or guide.