What is risk? Definition and Meaning
Risk refers to the probability or threat of loss, liability, injury, damage, or any other negative occurrence resulting from external or internal vulnerabilities, and that may be prevented or avoided through preventive action.
Investors who place their money in high risk investments expect a high return in compensation, while those who invest in safer investments expect a low return.
In finance, the term refers to the probability that an investment’s actual return will be lower than expected. Financial risk is divided into:
– Capital Risk: the probability a business faces that it may lose value on its capital – liquid securities, factories and equipment. Also refers to the risks that investors may face that they lose all or part of the principal amount they invested.
For example, if you invest $25,000 into the stock market, you face a capital risk on the $25,000 you invested. If a firm does not insure the value of its assets, it may face capital risks from theft, flood and fire.
According to New York University’s Leonard N. Stern School of Business: “Risk is part of every human endeavor. From the moment we get up in the morning, drive or take public transportation to get to school or to work until we get back into our beds (and perhaps even afterwards), we are exposed to risks of different degrees.”
Country Risk: the chances of the government of another nation defaulting on its bonds or other financial commitments. The term also refers to the general notion of the degree to which economic, social and political unrest may affect the securities of issuers doing business in a particular nation.
Country risk must be taken into consideration if you are investing abroad. The United States is typically considered the benchmark of low country risk – most country risks are measured against the US.
Default Risk: exposure to loss because a borrower has not met a financial obligation when it becomes payable. Default risk is closely linked to the credit worthiness of the borrower, and is something that is taken into account when determining the terms and interest rates of a loan.
Investors and lenders are exposed to default risk in virtually all types of credit extensions. Default risk can change at any time – the economic climate can improve or deteriorate, an individual’s or company’s financial situation does not always remain the same.
During the financial crisis of 2007-08, also known as the subprime mortgage crisis, mortgage defaults went through the roof. Lenders had badly miscalculated default risk. Hundreds of billions of dollars of taxpayers’ money was used to bail out several banks. (Image: adapted from oaktreelaw.com)
Delivery or settlement Risk: this term refers to any counter-party in an agreement that is unable to fulfill its obligations through failure to pay for or deliver assets as specified in an agreement.
It is a very rare occurrence in investment markets – however, perception is another matter. In business contracts it is much more common.
Overnight delivery risk can occur when the parties are in different time zones and one of the parties to the transaction might not know if a required payment or delivery is made until the following business day.
Economic Risk: the chance that macroeconomic conditions such as political stability, government regulation, or exchange rates will affect an investment, often one in another country.
The Financial Times ft.com/lexicon describes it as “The risk that a company may be disadvantaged by exchange rate movements or regulatory changes in the country in which it is operating.”
Exchange Rate Risk: the chance that a financial risk exists when a transaction is denominated in a foreign currency. Such risk is also possible when a foreign subsidiary of a company maintains financial statements in a currency other than the reporting currency of the whole group.
Businesses exporting and importing goods and services, as well as investors making foreign investments face exchange rate risks which can have significant financial consequences.
Interest Rate Risk: the probability that the market interest rates will increase considerably higher than the interest rate earned on investments such as bonds, resulting in a decline in their *market value. There is a greater risk with long-term bonds.
* Market value refers to how much an asset is really worth – how much people are willing to pay for it, and at a price that is satisfactory for the seller.
The U.S. Securities and Exchange Commission says the following about interest rate risk:
“A fundamental principle of bond investing is that market interest rates and bond prices generally move in opposite directions. When market interest rates rise, prices of fixed-rate bonds fall. this phenomenon is known as interest rate risk.”
Liquidity Risk: the chance that a company is unable to meet its debt obligations without incurring unacceptably large losses.
Funding liquidity risk is the likelihood that a firm won’t be able to meet its current and future cash flow and collateral needs, both unexpected and expected, without materially harming its daily operations or overall financial condition.
Financial firms are particularly sensitive to funding liquidity risk.
Stress testing of financial institutions since the last financial crisis has become compulsory and much stricter. Authorities in the US, Canada, EU, Japan, Australia and other nations need to make sure that banks are prepared for all types of liquidity risks. (Image: osfi-bsif.gc.ca)
Operations Risk: the chances of loss resulting from failed or inadequate internal processes, people and systems from external events.
“The risk of losses stemming from inadequate or failed internal processes, people and systems or from external events. Operational risk includes legal risks but excludes reputational risk and is embedded in all banking products and activities.”
“It has always existed in banking, and non banking, organizations but it has acquired a greater relevance given the increased complexity and globalization of the financial system and the recent materialization of unprecedented extremely large losses. Through the publication of its guidelines and RTS on operational risk, the EBA aims at promoting and enhancing the effectiveness of operational risk management and supervision throughout the banking system.”
Political risk: the exercise of political power is the root cause of political risks in the world of international business. How political power is exercised determines whether actions by a government threaten a company’s value.
For example, a dramatic political event may not affect a multinational corporation much, but a subtle policy change can significantly impact a business’ performance.
While nationwide student-led protests demanding political change may not affect the investment and business climate at all, a change in local tax laws can erode a company’s profits rapidly.
In an article posted on the International Risk Management Institute website, Daniel Wager writes the following regarding political risks:
“The first distinction that must be made is between firm-specific political risks and country-specific political risks. Firm-specific political risks are risks directed at a particular company and are, by nature, discriminatory.”
“For instance, the risk that a government will nullify its contract with a given firm or that a terrorist group will target the firm’s physical operations are firm-specific. By contrast, country-specific political risks are not directed at a firm, but are countrywide, and may affect firm performance.”
“Examples include a government’s decision to forbid currency transfers or the outbreak of a civil war within the host country.”
Political risk exists everywhere. In some parts of the world the chances of a military takeover are high, nationwide demonstrations can emerge anywhere in the world, even in the most seemingly stable advanced economies. Changes in a country’s tax system can sometimes be the kiss of death for some businesses and investments.
Refinancing Risk: in the world of banking and finance, this term refers to the possibility that a borrower is unable to borrow to repay an existing debt. Many lending arrangements include balloon payments at the end of the term.
Usually, the intention or assumption is that the borrower will require a new loan to pay the current lenders.
For borrowers, the risk is that they will not be able to refinance an existing loan, such as a mortgage, at a future date under favorable terms.
Reinvestment Risk: the likelihood that a particular investment might somehow be stopped or cancelled, and that the investor may have to find a new place to invest that money with the risk that there might not be any similarly attractive investment available.
Reinvestment risk occurs primarily if bonds are paid back earlier than expected.
“When interest rates are declining, investors have to reinvest their interest income and any return of principal, whether scheduled or unscheduled, at lower prevailing rates.”
Settlement Risk: the likelihood that a party does not deliver a security or its value in money as agreed when the security was traded after the other party or parties have already delivered cash value or security as per the agreement.
Foreign exchange (FX) settlement risk is the likelihood of a bank in a foreign exchange transaction which has paid for the currency it sold not receiving the currency it bought.
“Settlement risk exists for any traded product but the size of the foreign exchange market makes FX transactions the greatest source of settlement risk for many market participants, involving daily exposures of tens of billions of dollars for the largest banks.”
“Most significantly, for banks of any size, the amount at risk to even a single counterparty could in some cases exceed their capital.”
Sovereign risk: similar to and sometimes the same as Country Risk. The likelihood of a government defaulting on its debt (sovereign debt) or some other financial obligation. It also refers to the risk generally linked to investing in a specific country, or providing money to its government.
Underwriting Risk: the risk relating to the conclusion of insurance contracts and thus the possibility that premium income might not be enough to cover the claims that the insurer or reinsurer is obliged to pay when damage has occurred.
Insurance underwriters must make sure that premiums are adequate to cover expected claims, and also unexpected claims.
When a company goes public for the first time, an investment banker may guarantee to buy all of the new shares that the firm is selling. It faces the threat that the price will fall before they are sold, or that investors will not want to buy them.
The International Risk Management Institute defines underwriting risk as follows:
“Risk of loss borne by insurers and reinsurers. It can take the form of underestimated liabilities from unpaid business written in past years (i.e., applying to expired policies) or underpriced current business (i.e., unexpired policies).”
Risk management involves the forecasting and evaluation of financial and business risks, as well as identifying and implementing procedures and measures to avoid or minimize their potential harms.
Video – What are risks in finance?
In this ESCP Europe video, Prof. Thibierge talks about risks in in the world of finance, and why it is important to understand what they are for business.