Asset-liability Risk: Risk to a firm from having assets and liabilities whose risk exposures do not offset one another. Business risk: The chance that the firm will be unable to cover its operating cost. Level is driven by the firm’s revenue stability and the structure of its operating cost. Corporate risk: reflects uncertainty of the future bottom line of corporate activities. Principal causes of corporate risk are business risk and market risk. Credit Risk: The risk arising from the possibility that the borrower will default.
Currency risk: is a risk associated with fluctuations in one national currency’s exchange rate towards that of another country. This type of risk occurs when investing in foreign financial assets and then converting foreign currency into the national currency of the investor. Record bankruptcies and correlated risks have increased institutions’ focus on credit risk aggregation and management. Default Risk: the chance that customers will fail to repay their loans. As mentioned earlier, many consumer finance companies lend to borrowers who are unable to obtain credit from other sources.
Naturally, these borrowers tend to default more frequently. Finance company delinquency rates are usually higher than those for banks or thrifts. Event risk: the chance that a totally unexpected event will have a significant effect on the value of the firm or a specific investment. Exchange rate risk: the danger that an unexpected change in the exchange rate between the dollar and the currency in which a project’s cash flows are denominated will reduce the market value of that project’s cash flow; the risk caused by varying exchange rates between two currencies.
Financial Risk: The chance that the firm will be unable to cover its financial obligations. Level is driven by the predictability of the firm’s operating cash flows and its fixed- cost financial obligation. 10. Inflation risk: is a risk associated with the macroeconomic situation in a country. There is always a risk that rising inflation could decrease real income of an institutional investor, regardless of what gross profit could be received because of the investor’s activities.
However part of it, and sometimes all of it, could be written off to coveran inflationary spiral. This risk type is influencing all institutional investors operating in the countries with high inflation rates. Interest-rate Risk: is a major problem for banks and thrifts but not of great concern to finance companies. Recall that interest-rate risk refers to a decline in value of fixed-rate loans when market interest rates rise. Liquidity Risk: Liquidity risk refers to problems that arise when a firm runs short of cash.
For example, a bank may have a liquidity problem if many depositors withdraw their funds at once. Finance companies run the risk of liquidity problems because their assets, consumer and business loans, are not easily sold in the secondary financial markets. Market risk: The chance that the value of an investment will decline because of markets factors that are independent of the investment (such as economic, political, and social event). In general, the more a given investment value responds to the market, the greater its risk; the less it responds, the smaller the risk.
Political risk: risk that arises from the possibility that a host government will take actions harmful to foreign investors or that political turmoil in a country will endanger investments there. Price risk: is a risk associated with volatility in the price of any financial asset. Many financial institutions – mutual funds, banks, insurance companies, pension funds – carry out their activities using primarily borrowed money (bank and pension deposits, insurance contributions).
The funds received are invested by institutional investors in various markets – stock markets, government securities markets, commodity markets and real estate markets. Purchasing power risk: the chance that changing price levels caused by inflation or deflation in the economy will adversely affect the firm’s or investment’s cash flows and value. Reinvestment Risk: the interest-rate risk associated with the fact that the proceeds of short-term investments must be reinvested at a future interest rate that is uncertain. Stock Market Risk: the risk associated with fluctuations in stock prices.
Systematic Risk (Nondiversifiable Risk): the component of an asset’s risk that cannot be eliminated by diversification. Tax risk: the chance that unfavorable changes in tax laws will occur. Firms and investments with values that are sensitive to tax law changes are more risky. Total risk: the combination of a security’s nondiversifiable risk and diversifiable risk. Unsystematic Risk (Diversifiable Risk): the portion of an asset’s risk that is attributable to firm specific, random causes; can be eliminated through diversification.