Investment Risk
Based on the name, investment risks are associated with investments and trading. There are several forms of investment risk, but most of them depend on price fluctuations in the market. We can consider the market, liquidity, and credit risks as separate components from the group of investment risks.
Market Risk
Market risk is the risk associated with fluctuations in asset prices. For example, if Alice buys bitcoin, she will be exposed to market risk as the price of the coin could fall because of volatility.
Market risk management begins by considering how much Alice could lose if the price of bitcoin moves against her position. The next step is to create a plan to determine what actions Alice should take in response to such movements.
As a rule, investors face both direct and indirect market risks. Direct market risk is associated with the loss that a trader may incur due to an unfavorable change in the price of an asset.
Liquidity Risk
Liquidity risk is the possibility that investors and traders will not be able to buy or sell a particular asset without a sharp change in its price.
In a liquid market with high volume, Alice can quickly sell her $10,000 cryptocurrency portfolio; more buyers are willing to pay $10 for each unit. But if the market is illiquid, only a few buyers will be ready to buy assets at the required price. For this reason, Alice will have to sell most of her coins for less than she wants.
Credit Risk
Credit risk is the risk of losing a creditor’s funds due to a default by a debtor. For example, if Bob borrows money from Alice, she is exposed to credit risk. In other words, there is an option that Bob will not repay Alice, and it is this possibility that we call credit risk. If Bob refuses to fulfill his obligations for any reason, Alice will lose her money.
Operational Risk
Operational risk is the probability of monetary loss due to errors in the operation of internal processes, systems or during operations. This type of failure is often the result of a human factor or deliberate fraudulent activity.
To mitigate operational risks, every company should conduct periodic security audits and adopt proper procedures for performing operations and ensuring effective internal management of the enterprise.
Operational disruptions can also be caused by external factors that indirectly affect the company’s operations, such as earthquakes, thunderstorms, and other natural disasters.
Compliance Risk
Compliance risk is the loss that can arise when a company or institution does not comply with the rules and regulations of the same jurisdictions. Many companies employ certain practices such as anti-money laundering (AML) and Know Your Customer (KYC) verification to mitigate these risks.
Suppose a service provider or company does not comply with any internal or external requirements and regulations. In that case, the activities of such a legal entity may be suspended or subject to a large fine. For this reason, many investment firms and banks have faced lawsuits and sanctions due to failure to comply with necessary requirements. Insider trading and corruption are also common examples of compliance risks.
Systemic Risk
Systemic risk refers to the possibility that a particular event may have an adverse effect on the business or the market. For example, the collapse of Lehman Brothers in 2008 set off a budgetary crisis in the US that eventually affected many other countries.
The presence of systemic risks is confirmed by a strong correlation between companies representing the same field of activity. If Lehman Brothers had not been so intricately connected to the entire American financial system, its bankruptcy would have been less significant.
An uncomplicated way to understand and remember the concept of systemic risk is to imagine the effect of falling dominoes, where one piece falls and drags all the others with it.
Systemic and Systemic Risk
Systemic risk should not be confused with systemic risk and cumulative risk. The latter is the most difficult to define, as the terminology refers to a wider range of risks beyond economics and finance.
Systematic risks can be associated with a number of economic and socio-political factors such as inflation, interest rates, wars, natural disasters, and significant changes in public policy.
Exchange Rate Risk
When a business goes beyond the national currency market in trading, investing, lending, etc., it runs the risk of losing money due to changes in exchange rates. Let us say a company took out a loan of $1,000,000 for business development, the annual payment was $100,000, and inflation did not reach a standstill.
Do not take loans in foreign currency if the company’s income is not formed from it to a sufficient extent. You can mitigate the risks of currency fluctuations with the help of financial instruments, such as futures and forward contracts.
Discount Rate Risk
If your company is highly dependent on credit resources, an increase in the loan rate will lead to a rise in debt service costs. A large debt or a sharp fluctuation in the size of the rate can then be the thing that drowns the company. To protect yourself, you need to build a portfolio of short-term and long-term financing instruments, which will allow you to adhere to the payment schedule under any circumstances.
About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual bookkeeping, providing service to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud platform where their QuickBooks™️ file, critical financial documents, and back-office tools are hosted in an efficient SSO environment. Complete Controller’s team of certified US-based accounting professionals provide bookkeeping, record storage, performance reporting, and controller services including training, cash-flow management, budgeting and forecasting, process and controls advisement, and bill-pay. With flat-rate service plans, Complete Controller is the most cost-effective expert accounting solution for business, family-office, trusts, and households of any size or complexity.
