Financial Risk Management

7 Types of Financial Risks with Real-World Examples

Financial risks are becoming more pronounced in this volatile world economy. It’s keeping economists & companies on their toes as they upgrade their risk management techniques and practices. In this article, we look at seven different types of financial risks And how each risk affects different parts of the economy & it’s constituents.

Types of Financial Risks

The seven types of financial risk are –

  1. Asset-backed risk
  2. Credit risk
  3. Foreign Investment risk
  4. Currency risk
  5. Liquidity
  6. Stock Market risk
  7. Interest Rate risk

Asset-Backed Risk

Consumers borrow money for purchasing a car (auto loan), a house or running a balance on a credit card. These loans are treated as assets in the financial books of the financing entity. Bank, non-banking financial institution or a housing finance company are the financing entities.

The key value in this asset is captured by the steady stream of receivables that these assets are expected to receive. These are car loan EMIs, mortgage instalments, student loans EMI or credit card outstanding payments.

Financing institutions package these assets as asset-backed securities which are sold to institutional investors like pension funds and mutual funds.

Depending on the type of asset, profile of consumers, past record of repayment and the general nature of the economy, financial institutions offer different spreads and interest rates on these asset-backed securities. These instruments are generally treated as fixed-income securities. And hence lapped up by pension funds & insurance companies which look for risk-averse options.

OK. Got it.

Asset-backed securities face challenges with pricing risks. This happens when investors pay more than what the bundle of assets is worth. We saw this during the 2008 financial crisis well-chronicled in Michael Lewis’s book The Big Short: Inside the Doomsday Machine

Watch the video below to know more about asset-backed securities and the financial risks it faces

Credit Risk

A credit risk happens when there is a chance that the loan borrower might skip, delay or default on his/her obligation to the bank or financial institution that has lent the money.

Let’s understand this with an example.

Say you were to borrow from a bank. And they offer you the loan at a much higher interest rate of say, 13%.

This 13% interest rate consists of three parts –

  1. Money that needs to be paid to the individual or institution from whom the bank borrowed the money,
  2. Account for the cost of acquiring and servicing the borrower and,
  3. Provision for potential delay or default in the repayment of the loan.

Management of the credit risk is the primary function of the financing institution. Underwriting the loan is a core responsibility of the lending institution. Offering a lower-than-required interest rate or offering the loan to a low-capacity-to-repay individual or firm can lead to tremendous losses and even bankruptcy.

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Risk management at financial institutions

Although the loans are fixed-income in nature, financing institutions face numerous financial risks such as –

  • Interest rate risk. An increase in interest rates will reduce the marketable value of these securities. This will tempt borrowers to refinance their loans at more favourable rates
  • Term modification risk. Not all borrowers are able to pay per the agreed schedule. However, they are not wilful defaulters and have the intention of paying back. To ease the borrower’s path to loan repayment, financiers agree to mid-term reduction in the loan’s interest rate, an alternative loan type, extension in the maturity of loan or a combination of all three.
  • Pre-payment risk. This is when borrowers pre-pay their loan. This might sound good for the financing institution but this puts them up with two problems:
    • 1. they need to find another person to loan money to and
    • 2. they have to find another investing option that earns them the same return on investment
  • Bankruptcy risk. Borrowers may file of bankruptcy which means the loan too could be lost in its entirety to bankruptcy

Risk management practices against credit risk

Institutions employ sound credit risk management practices by –

  1. Obtaining accurate and detailed customer data including income, financial statements, manner in which loan will be utilized etc.
  2. Building the right underwriting and pricing models
  3. Being choosy of the customer profile who shall be extended the loan
  4. Develop a strong loan collection infrastructure
  5. Reviewing, repricing and restrategizing on the basis of external factors like interest rate, general economy, competition etc.

Foreign Investment Risk

Foreign investment risk is the financial risk of swift and acute changes in the value of investments due to external factors like –

  • Changes in accounting, reporting and auditing standards
  • Nationalization. It refers to the transfer of private assets to the government often with no compensation e.g. Cuba expropriated all foreign-owned private companies after the Cuban Revolution in 1959 and Japan nationalized the Tokyo Electric Power Company after the Fukushima Daiichi nuclear disaster
  • Changes in taxation rules. The Indian government raised a tax demand of ₹11,000 crores from Vodafone. This was related to Vodafone’s USD 11 billion acquisition of Hutchison Telecom in 2009. While the Supreme Court subsequently quashed the demand in 2012, the government amended its Income Tax Act retrospectively, putting the liability back on Vodafone Group. The issue is still under arbitration.
  • Economic conflict. These can be trade wars like the one we see between the United States and China
  • Political or diplomatic changes. Certain political parties in West Bengal have been resisting foreign investment in the state. This puts even existing investments at risk if they were to come in power.
  • Regulatory issues
External factors have had massive impact on the equity markets

Currency Risk

Currency risk or foreign exchange risk can happen when a company is having a transaction with a foreign company where one currency is stronger than the other.

The two types of currency risks are –

  1. Transaction risk. These are losses that are likely to occur when dealing in different currency. Like the ones international food chains like Dominos and KFC face where they sell locally but report in US dollars.
  2. Economic risk. This refers to risk associated with different political policies, varied regulations and general state of the economy in the country where business is being conducted

Currency risk can be upwards or downwards.

Let’s say you are running a KFC outlet out of India where 1 US dollar fetches 70 Indian Rupees. The outlet retails ₹14,000,000 of products every month which translates to $200,000 in monthly revenue from that New Delhi outlet.

Due to worsening domestic macroeconomic variables and rise in crude oil prices, the INR/USD exchange rate has moved from ₹70 per dollar to ₹73 per dollar.

Unless the local KFC pushes up the price of the products, it will continue to sell ₹14,000,000 of products for the month. When converted to US dollars, the local sales will now fetch $191,780 to the US multinational corporation. That’s a loss of 4.1% due to currency devaluation. However had the rupee become stronger against the dollar, the local KFC outlet would have increased the dollar-denominated revenue for the multinational.

Liquidity risk

Liquidity risks are financial risks that a given asset cannot be traded quickly enough to prevent a loss or expected profit.

There are two kinds of liquidity risks –

  1. Asset liquidity. This is where an asset cannot be sold in the market when you want to sell it. This is most common with houses where depressed conditions puts a stop on demand and pushes away buyers.
  2. Funding liquidity. This is where one does not have enough money to pay off a loan when it comes due. This may be because the borrower’s money is stuck somewhere else. A scenario where this occurs if when you, as a merchant, is expecting your goods to hit the port in Mumbai this Friday but due to adverse weather conditions, the goods will be delivered only the week next.

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Stock Market Risk

Stock market risk is the chance that equities (stock prices) in general and the assumed volatility will change more than expected. These financial risks is not for any one particular company or industry but for the entire market as a whole.

There are three primary stock market risks –

  1. Volatility
  2. Timing
  3. Overconfidence

Volatility

Volatility refers to the fluctuations in price of the equity markets. This may happen due to a number of external factors ranging from geopolitical events, economic events, inflation etc.

This volatility is measured using different statistical measures like alpha, beta, R-squared, Standard deviation and Sharpe Ratio

While volatility does not indicate the direction of a price move (up or down), it is limited to the range of price fluctuations over the period. Some suggested strategies for reducing the impact of volatility are –

  1. Add bonds to your portfolio. It is claimed that a 60-40 stock-bond mix will produce average annual gains equal to 75% of a stock portfolio with half the volatility.
  2. Reduce exposure to high volatility securities. There are mutual funds available for such scenarios like the Vanguard Global Minimum Volatility (VMVFX) fund
  3. Hedging. Hedging means taking a counter or offsetting position in a related index or security

Timing

Timing is high heaven for market pundits who claim to be able to predict which way particular stocks will move through the day. In common parlance, these are known as stock tips where experts sell the “buy low – sell high and profit” dream.

However good the advice, it is pretty tough to implement since prices are constantly shifting. Katherine Roy, chief retirement strategist at J.P. Morgan Asset Management, pointed out, “You have to guess right twice. You have to guess in advance when the peak will be – or was. And then you have to know when the market is about to turn back up, before the market does that.” Some suggested strategies to thwart financial risks on timing include –

  1. Dollar-Cost Averaging or Systematic Investment Plans (SIP). This is a system which helps users ignore the good timing v bad timing issue and sets up a systematic, disciplined investment plan.
  2. Index Fund Investing. This system helps you avoid the specific timing risks of owning individual stocks. Further it gives you broad market access in a systemic format. A recent news on The Economic Times points out that less than only 20% of actively managed large-cap mutual funds have outperformed the Nifty50 index over the last 3 years.

Overconfidence

Overconfidence in one’s decisions, carelessness, and assumption of unnecessary financial risks is what makes investing more challenging than what it should be. Investing requires homework on your part and the perils of not doing that or overconfidence are many. Here are some –

  1. Failure to recognize biases which makes you give preference to information based on your viewpoint. Even a great investor like Warren Buffett has been biased when he shunned technology stocks. Now Mr. Buffett claims that he didn’t invest because he did not understand the tech business. But my submission is that it might have been that he didn’t do his homework. Even he might have biases like “if you can’t see it, you can’t value it
  2. Too much concentration in a single stock or industry
  3. Excessive leverage is the mother of all sins. I see this with all new investors who have a misplaced sense of supreme confidence after just a month of investing. That’s when they see their stock pick has gone up by 6% and end up emptying their bank savings account to pour money into stocks. Financial prudence is always appreciated.
  4. When you hear a person say “I can time the market”, you know who to keep away from. Again, this comes from overconfidence because all data shows that the average investor – moving in and out of the market – has earned just 55% in the last 15 years of what they would have made if they had simply matched the performance of the stock index. An analyst has noted for the S&P 500 – “If an investor had been out of the market for the ten best days over the past 20 years, his returns would be slashed in half
Confidence is knowing you can make it through the day without screwing up. Overconfidence is when you believe you can do it again the next day.
Reducing Overconfidence

Some suggestions for you to reduce the impact of overconfidence –

  1. Spread your financial risks using diversification strategies
  2. Buy and hold. Own good companies over a long period. There has been some recent data to suggest that this is not working as well as before due to the fast changing nature of industries and the economy
  3. Avoid borrowing (Dave Ramsey puts it well – “Debt is dumb. Cash is king.”)

Interest Rate Risk

Interest rate risk is the chance that an unexpected change in interest rates will affect the value of an investment.

Here’s how it works.

You purchase a bond of a housing finance company, say HDFC Limited. You bought one unit at a par-price of ₹1,000.

Because bond prices typically fall when interest rate rise, the downside interest rate risk is a drop in the value of the bond from ₹1,000 to ₹950. The reverse is true when the interest rate falls, you get a good appreciation in the value of the bond.

Why do bond prices rise when interest rates fall?

Let’s understand why bond prices rise when interest rates fall with our earlier example. The HDFC Limited bond, which is available at ₹1,000, has a maturity of 5 years. It comes at a coupon rate of 5%.

This means, as long as you hold the bond, you will continue to receive an annual interest payout of ₹50 for the next five year. And at the end of five years, you will be paid the principal back i.e. ₹1,000. However, since bonds are marketable securities (i.e. anyone can buy and sell a bond before maturity), the market value of your bond will fluctuate depending on interest rates, economy, valuation of HDFC Limited etc.

Now, we happen to have a situation where the interest rate falls to 4%. So, if I want to buy a new bond, I will be able to make only 4% interest on my investment. This means, the 5% coupon bond of HDFC Limited I hold becomes more precious as there will be a higher demand for bonds which can give a higher interest rate.

And hence the bonds you hold will command a higher premium. This is why bond prices rise when interest rates fall. Conversely, when interest rates rise the bond prices drop.

Generally, short-term bonds carry less interest rate risk because it is easier to predict the movement of the interest rates when compared to long-term bonds. This supports the case for long-term bond yields to have a premium on account of a higher interest rate risk.

Interest rates in India

Here is a snapshot of the interest rates set by The Reserve Bank of India over a 20-year period.

source: tradingeconomics.com

Investors who intend to hold their bonds (most corporates and all mutual fund houses will not fall in this category) are less exposed to interest rate risk as they are not bothered with interim movements. Thus, the principal the investor receives at maturity remains the same as contracted. This is the preferred approach for pension funds and insurance companies.

However these pension funds and insurance companies have two financial risks –

  1. credit risk i.e. default by the company that issued the bonds and
  2. opportunity risk i.e. it is possible that the maturity proceeds may not find suitable interest rates because the economy was in a low-interest rate regime.

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