FD Module-2

Financial Risk
Financial Risk

What Is Financial Risk?

Financial risk is the possibility of losing money on an investment or business

venture. Some more common and distinct financial risks include credit risk,
liquidity risk, and operational risk.

Financial risk is a type of danger that can result in the loss of capital to interested
parties. For governments, this can mean they are unable to control monetary policy
and default on bonds or other debt issues. Corporations also face the possibility of
default on debt they undertake but may also experience failure in an undertaking
the causes a financial burden on the business.

Financial risk is the risk that a business will not be able to meet its debt repayment
obligations, which in turn could mean that the potential investors will lose the
money invested in the company. The more debt a firm has, the higher the potential
financial risk.

This type of risk typically arises due to instabilities, losses in the financial market
or movements in stock prices, currencies, interest rates, etc.

Difference between business risk and financial risk

Business risk relates to the basic viability of a business. It refers to your ability to
turn a profit and cover your operating expenses, such as salaries, rent, production
costs and office expenses. Financial risk, on the other hand, is concerned with the
costs of financing and the amount of debt you incur to finance your operations.

Finally,

● Financial risk can also apply to a government that defaults on its bonds.
 ● Credit risk, liquidity risk, asset-backed risk, foreign investment risk, equity
risk, and currency risk are all common forms of financial risk.

● Investors can use a number of financial risk ratios to assess a company's

prospects.

Understanding Financial Risks

Sources of Financial risk (Types of Financial risk)

Financial markets face financial risk due to various macroeconomic forces,

changes to the market interest rate, and the possibility of default by sectors or large
corporations. Individuals face financial risk when they make decisions that may
jeopardize their income or ability to pay a debt they have assumed.

1. Credit risk

In financial risk management, credit risk is of paramount importance. This risk

refers to the possibility that a creditor will not receive a loan payment or will
receive it late.

It is also known as Default risk—is the danger associated with borrowing money.
Should the borrower become unable to repay the loan, they will default. Investors
affected by credit risk suffer from decreased income from loan repayments, as
well as lost principal and interest. Creditors may also experience a rise in costs
for collection of the debt.

Credit risk is therefore a way of determining a debtor's capacity to fulfill its

payment obligations.

● Excess cash flows may be written to provide additional cover for credit risk.
When a lender faces heightened credit risk, it can be mitigated via a higher
coupon rate, which provides for greater cash flows.

● Although it's impossible to know exactly who will default on obligations,

properly assessing and managing credit risk can lessen the severity of a loss.

● Interest payments from the borrower or issuer of a debt obligation are a

lender's or investor's reward for assuming credit risk.
 ● Consumer credit risk can be measured by the five Cs: credit history,
capacity to repay, capital, the loan's conditions, and associated collateral.

● Consumers posing higher credit risks usually end up paying higher interest
rates on loans.

Importance of Credit Risk

● When lenders offer mortgages, credit cards, or other types of loans, there is a
risk that the borrower may not repay the loan. Similarly, if a company offers
credit to a customer, there is a risk that the customer may not pay their
invoices. Credit risk also describes the risk that a bond issuer may fail to
make payment when requested or that an insurance company will be unable
to pay a claim.

● If there is a higher level of perceived credit risk, investors and lenders

usually demand a higher rate of interest for their capital.

● If an investor considers buying a bond, they will often review the credit
rating of the bond. If it has a low rating (< BBB), the issuer has a relatively
high risk of default. Conversely, if it has a stronger rating (BBB, A, AA, or
AAA), the risk of default is progressively diminished.

● Bond credit-rating agencies, such as Moody's Investors Services and Fitch

Ratings, evaluate the credit risks of thousands of corporate bond issuers and
governments on an ongoing basis.

● For example, a risk-averse investor may opt to buy an AAA-rated

government bond. In contrast, a risk-seeking investor may buy a bond with a
lower rating in exchange for potentially higher returns.

2. Market risk

Market risk involves the risk of changing conditions in the specific marketplace in
which a company competes for business.

It is the possibility that an individual or other entity will experience losses due to
factors that affect the overall performance of investments in the financial markets.

Example
One example of market risk is the increasing tendency of consumers to shop
online. This aspect of market risk has presented significant challenges to traditional
retail businesses.

Companies that have been able to make the necessary adaptations to serve an
online shopping public have thrived and seen substantial revenue growth, while
companies that have been slow to adapt or made bad choices in their reaction to the
changing marketplace have fallen by the wayside.

This example also relates to another element of market risk—the risk of being
outmaneuvered by competitors. In an increasingly competitive global marketplace,
often with narrowing profit margins, the most financially successful companies are
most successful in offering a unique value proposition that makes them stand out
from the crowd and gives them a solid marketplace identity.

● Market risk, or systematic risk, affects the performance of the entire market
simultaneously.

● Market risk cannot be eliminated through diversification.

● Market risk may arise due to changes to interest rates, exchange rates,
geopolitical events, or recessions.

Understanding Market Risk

Market risk, also called "systematic risk," cannot be eliminated through

diversification, though it can be hedged in other ways. Sources of market risk
include recessions, political turmoil, changes in interest rates, natural disasters, and
terrorist attacks. Systematic, or market risk, tends to influence the entire market at
the same time.

Market risk exists because of price changes. The standard deviation of changes in
the prices of stocks, currencies, or commodities is referred to as price volatility.
Volatility is rated in annualized terms and may be expressed as an absolute
number, such as Rs100, or a percentage of the initial value, such as 10%.

The most common types of market risks include interest rate risk, equity risk,
currency risk, and commodity risk.
 ● Interest rate risk covers the volatility that may accompany interest rate
fluctuations due to fundamental factors, such as central bank announcements
related to changes in monetary policy. This risk is most relevant to
investments in fixed-income securities, such as bonds.

● Equity risk is the risk involved in the changing prices of stock investments,

● Commodity risk covers the changing prices of commodities such as crude oil
and corn.

● Currency risk, or exchange-rate risk, arises from the change in the price of
one currency in relation to another. Investors or firms holding assets in
another country are subject to currency risk.

Investors can utilize hedging strategies to protect against volatility and market risk.
Targeting specific securities, investors can buy put options to protect against a
downside move, and investors who want to hedge a large portfolio of stocks can
utilize index options.

Credit Risk V/s Market Risk

Credit risk refers to the probability of a borrower not repaying the loan and other
contractual obligations. Delays in the payment of the loan also comes under credit
risk.

Market risk refers the probability of occurrence of losses on financial investments

caused by adverse price movements. Decline in the price of shares bought is an
example for market risk. Poor returns from the securities invested is another
example for market risk.

Default Risk

The probability that a borrower fails to make full and timely payments of principal
and interest

Default risk, also called default probability, is the probability that a borrower fails
to make full and timely payments of principal and interest, according to the terms
of the debt security involved. Together with loss severity, default risk is one of the
component of credit risk.
The assessment of default risk is a necessary step in the valuation of government
and corporate bonds or credit derivatives, such as credit default swaps (CDS).
Since high-quality bonds generally come with low default rates, the assessment of
default risk for such instruments is generally more important than the estimate of
the loss severity in case of default.

Therefore, default risk is key in determining the price and yield of financial
instruments. A higher default risk generally corresponds with higher interest rates,
and issuers of bonds that carry higher default risk will often find it difficult to
access to capital markets.

Borrowing Capacity

The level of default risk mainly depends on the borrower’s capacity; that is, the
ability of the borrower to make its debt payments on time. A borrower’s capacity is
influenced by many factors, which are discussed below.

1. Debtor’s financial health

● Other conditions being equal, companies with high levels of debt relative to
their cash flows, cash reserves, or assets will generally be less creditworthy
than those with debt-free or debt-light balance sheets, liquid assets, or high
cash-flows relative to debt.

● A debtor’s financial health is generally assessed through an in-depth look at

the fundamentals, including the analysis of profitability, cash flows,
coverage ratios, liquidity, and leverage.

2. Economic cycle and industry conditions

● A company’s performance may be negatively affected by external economic

conditions or by issues that its customers or suppliers are facing.

● In times of macroeconomic downturn or industry-specific weakness, even

relatively healthy companies can face a deterioration in their
creditworthiness and an increase in default risk for their bonds.

● Conversely, during an economic boom or a very good period for a specific

industry, even companies with a relatively poor financial health and a weak
 competitive position may experience an improvement in creditworthiness
and a decrease in default risk.

3. Currency risk

● If a company owes debt in one currency but generates cash flows in another,
it will be exposed to the effects of currency fluctuations.

● High volatility in the currency markets, if not properly hedged, can exert a
significant impact on a company’s financial stability and creditworthiness.

4. Political factors and rule of law

● Geopolitical issues, such as war, regime changes, or a corrupted

environment can make it more difficult for a debtholder to effectively and
efficiently collect payments or enforce its rights as a creditor.

● Other conditions held equal, bonds issued by companies in countries with a

troubled or uncertain socio-political environment will carry higher default
risk than bonds issued by companies in more stable and more predictable
environments.

5. Other risks

● Some risks may be more difficult, and sometimes impossible, to measure.

● Examples include litigation risk, environmental risk, and exposure to natural

disasters.

Understanding Default Risk

● Whenever a lender extends credit to a borrower, there is a chance that the

loan amount will not be paid back. The measurement that looks at this
probability is the default risk. Default risk does not only apply to
individuals who borrow money, but also to companies that issue bonds and
due to financial constraints, are not able to make interest payments on
those bonds.

● Whenever a lender extends credit, calculating the default risk of a

borrower is crucial as part of its risk management strategy. Whenever an
 investor is evaluating an investment, determining the financial health of a
company is crucial in gauging investment risk.

● Default risk can change as a result of broader economic changes or

changes in a company's financial situation. Economic recession can
impact the revenues and earnings of many companies, influencing their
ability to make interest payments on debt and, ultimately, repay the debt
itself.

● Companies may face factors such as increased competition and lower

pricing power, resulting in a similar financial impact. Entities need to
generate sufficient net income and cash flow to mitigate default risk. Default
risk can be gauged using standard measurement tools, including Credit
scores for consumer credit, and credit ratings for corporate and
government debt issues. Credit ratings for debt issues are provided by
nationally recognized statistical rating organizations (NRSROs), such as
Standard & Poor's (S&P), Moody's, and Fitch Ratings.

Determining Default Risk

Lenders generally examine a company's financial statements and employ several

financial ratios to determine the likelihood of debt repayment.

● Free cash flow is the cash that is generated after the company reinvests in
itself and is calculated by subtracting capital expenditures from operating
cash flow. Free cash flow is used for things such as debt and dividend
payments. A free cash flow figure that is near zero or negative indicates
that the company may be having trouble generating the cash necessary
to deliver on promised payments. This could indicate a higher default
risk.

● The interest coverage ratio is one ratio that can help determine the default
risk. The interest coverage ratio is calculated by dividing a company's
Earnings before interest and taxes (EBIT) by its periodic debt interest
payments. A higher ratio suggests that there is enough income generated to
cover interest payments. This could indicate a lower default risk.

Types of Default Risk

Rating agencies rate corporations and investments to help gauge default risk. The
credit scores established by the rating agencies can be grouped into two categories:

Investment grade and non-investment grade (or junk).

Investment-grade debt is considered to have low default risk and is generally

more sought-after by investors. Conversely, non-investment grade debt offers
higher yields than safer bonds, but it also comes with a significantly higher
chance of default.

While the grading scales used by the rating agencies are slightly different, most
debt is graded similarly. Any bond issue given a AAA, AA, A, or BBB rating by
S&P is considered investment grade. Anything rated BB and below is considered
non-investment grade.

AAA Highest creditworthiness supported by many excellent factors.

AA Very high creditworthiness supported by some excellent factors.

A High creditworthiness supported by a few excellent factors.

BBB Creditworthiness is sufficient, though some factors require attention in

times of major environmental changes.

BB Creditworthiness is sufficient for the time being, though some

factors

require due attention in times of environmental changes.

B Creditworthiness is questionable and some factors require

constant

attention.

CCC Creditworthiness is highly questionable and a financial obligation of an

issuer is likely to default.

CC All of the financial obligations of an issuer are likely to default.

D All of the financial obligations of an issuer are in default.

A plus (+) or minus (-) sign may be appended to the categories from AA to
CCC to indicate relative standing within each rating category. The plus and
minus signs are part of the rating symbols.

Foreign Exchange Risk

The risk that a business' financial performance or financial position will be affected
by changes in the exchange rates between currencies.

What is Foreign Exchange Risk?

Foreign exchange risk, also known as exchange rate risk, is the risk of financial
impact due to exchange rate fluctuations. In simpler terms, foreign exchange risk is
the risk that a business’ financial performance or financial position will be
impacted by changes in the exchange rates between currencies.

Also known as currency risk, FX risk and exchange-rate risk, it describes the
possibility that an investment’s value may decrease due to changes in the relative
value of the involved currencies.

Foreign exchange risk is a major risk to consider for exporters/importers and

businesses that trade in international markets.

The three types of foreign exchange risk include transaction risk, economic
risk, and translation risk.

Factors causing Foreign Exchange Risk

● Foreign exchange risk arises when a company engages in financial

transactions denominated in a currency other than the currency where
that company is based. Any appreciation/depreciation of the base currency
or the depreciation/appreciation of the denominated currency will affect the
cash flows emanating from that transaction. Foreign exchange risk can
also affect investors, who trade in international markets, and businesses
engaged in the import/export of products or services to multiple
countries.

● The proceeds of a closed trade, whether its a profit or loss, will be

denominated in the foreign currency and will need to be converted back to
 the investor's base currency. Fluctuations in the exchange rate could
adversely affect this conversion resulting in a lower than expected amount.

● An import/export business exposes itself to foreign exchange risk by

having account payables and receivables affected by currency exchange
rates. This risk originates when a contract between two parties specifies
exact prices for goods or services, as well as delivery dates. If a currency’s
value fluctuates between when the contract is signed and the delivery
date, it could cause a loss for one of the parties.

Important Points to Ponder

● Foreign exchange risk refers to the risk that a business’ financial

performance or financial position will be affected by changes in the
exchange rates between currencies.

● The three types of foreign exchange risk include transaction risk, economic
risk, and translation risk.

● Foreign exchange risk is a major risk to consider for exporters/importers

and businesses that trade in international markets.

Example of Foreign Exchange Risk

A company based in Canada that does business in China – i.e., receives financial
transactions in Chinese yuan – reports its financial statements in Canadian dollars,
is exposed to foreign exchange risk.

The financial transactions, which are received in Chinese yuan, must be converted
to Canadian dollars to be reported on the company’s financial statements. Changes
in the exchange rate between the Chinese yuan (foreign currency) and Canadian
dollar (domestic currency) would be the risk, hence the term foreign exchange risk.

Foreign exchange risk can be caused by appreciation/depreciation of the base

currency, appreciation/depreciation of the foreign currency, or a combination
of the two. It is a major risk to consider for exporters/importers and
businesses that trade in international markets.

Types of Foreign Exchange Risk

 ● Transaction risk

It is the risk faced by a company when making financial transactions between

jurisdictions. The risk is the change in the exchange rate before transaction
settlement. Essentially, the time delay between transaction and settlement is the
source of transaction risk. Transaction risk can be mitigated using forward
contracts and options.

● This is the risk that a company faces when it's buying a product from a
company located in another country. The price of the product will be
denominated in the selling company's currency. If the selling company's
currency were to appreciate versus the buying company's currency then the
company doing the buying will have to make a larger payment in its base
currency to meet the contracted price.

● For example, a Canadian company with operations in China is looking to

transfer CNY600 in earnings to its Canadian account. If the exchange rate at
the time of the transaction was 1 CAD for 6 CNY, and the rate subsequently
falls to 1 CAD for 7 CNY before settlement, an expected receipt of CAD100
(CNY 600/6) would instead of CAD86 (CNY 600/7).

2. Economic risk

Economic risk, also known as forecast risk, is the risk that a company’s market
value is impacted by unavoidable exposure to exchange rate fluctuations. Such a
type of risk is usually created by macroeconomic conditions such as geopolitical
instability and/or government regulations.

For example, a Canadian furniture company that sells locally will face economic
risk from furniture importers, especially if the Canadian currency unexpectedly
strengthens.

3. Translation risk

● Translation risk, also known as translation exposure, refers to the risk

faced by a company headquartered domestically but conducting
business in a foreign jurisdiction, and of which the company’s financial
performance is denoted in its domestic currency. Translation risk is
 higher when a company holds a greater portion of its assets, liabilities,
or equities in a foreign currency.

● A parent company owning a subsidiary in another country could face losses

when the subsidiary's financial statements, which will be denominated in
that country's currency, have to be translated back to the parent
company's currency.

For example, a parent company that reports in Canadian dollars but oversees a
subsidiary based in China faces translation risk, as the subsidiary’s financial
performance – which is in Chinese yuan – is translated into Canadian dollar for
reporting purposes.

● Companies that are subject to FX risk can implement hedging strategies to

mitigate that risk. This usually involves forward contracts & options that
can protect the company from unwanted foreign exchange moves.

Problems on Foreign Exchange Risk

Question 1:

Company A, based in Canada, recently entered into an agreement to purchase 10

advanced pieces of machinery from Company B, which is based in Europe. The
price per machinery is €10,000, and the exchange rate between the euro (€) and the
Canadian dollar ($) is 1:1. A week later, when Company A commits to purchasing
the 10 pieces of machinery, the exchange rate between the euro and Canadian
dollar changes to 1:1.2. Is it an example of transaction risk, economic risk, or
translation risk?

Answer: The above is an example of transaction risk, as the time delay between
transaction and settlement caused Company A to need to pay more, in Canadian
dollars, for the pieces of machinery.

Question 2:

Company A, based in Canada, reports its financial statements in Canadian dollars

but conducts business in U.S. dollars. In other words, the company makes financial
transactions in United States dollars but reports in Canadian dollars. The exchange
rate between the Canadian dollar and the US dollar was 1:1 when the company
reported its Q1 financial results. However, it is now 1:1.2 when the company
reported its Q2 financial results. Is it an example of transaction risk, economic risk,
or translation risk?

Answer: The above is an example of translation risk. The company’s financial

performance from Q1 to Q2 is negatively impacted due to the translation from the
U.S. dollar to the Canadian dollar.

Question 3

An American liquor company signs a contract to buy 100 cases of wine from a
French retailer for €50 per case, or €5,000 total, with payment due at the time of
delivery. The American company agrees to this contract at a time when the Euro
and the US Dollar are of equal value, so €1 = $1. Thus, the American company
expects that when they accept delivery of the wine, they will be obligated to pay
the agreed upon amount of €5,000, which at the time of the sale was $5,000.

However, it will take a few months for delivery of the wine. In the meantime, due
to unforeseen circumstances, the value of the US Dollar depreciates versus the
Euro to where at the time of delivery €1 = $1.10. The contracted price is still
€5,000 but now the US Dollar amount is $5,500, which is the amount that the
American liquor company will have to pay.

The FX risk faced by the American Liquor Company is a case of Transaction

Risk

Interest Rate Risk

What is Interest Rate Risk?

Interest rate risk is defined as the risk of change in the value of an asset as a result
of volatility in interest rates. It either renders the security in question non-
competitive or increases its value. Though the risk is said to arise due to an
unexpected move, generally, investors are concerned with downside risk

Interest rate risk is the potential for investment losses that result from a change in
interest rates. If interest rates rise, for instance, the value of a bond or other fixed-
income investment will decline..
This risk directly affects the fixed-rate security holder. Whenever the interest rate
rises, the price of the fixed-income bearing security falls and vice-a-versa.

There are various ways of combating the interest rate risk. One can buy

● interest rate swaps,

● call or put options for the securities or

● invest in the negatively correlated securities to hedge the risk.

Causes for Interest Rate Risk

Interest rate risk is the decline in the interest rate of an asset, which would return
less to an investor and is primarily a concern with fixed-income products.
Declining interest rates cause interest rate risk and are a larger concern for products
with longer maturities.

Is Interest Rate Risk a Market Risk?

Yes, interest rate risk is a market risk. Interest rates in an economy can change and
thereby impact the interest rate on fixed-income securities. The risk is that the
interest paid on a fixed-income security will decrease and the payout to the
investor will be smaller.

What Happens When Interest Rates Rise?

When interest rates rise, the cost of borrowing money becomes more expensive.
This causes consumers to buy less as the cost of goods, such as a home or car,
becomes more costly. When consumers buy less, demand has decreased, when
demand decreases, companies eventually decrease the supply of goods and
services, which means producing less, which means hiring fewer people or even
letting go of some employees, which causes consumers to spend even less, further
strengthening the cycle. The overall increase of interest rates results in a slow
down of the economy.

Purchasing power risk

What Is Purchasing Power?

Purchasing power is the value of a currency expressed in terms of the number
of goods or services that one unit of money can buy. It can weaken over time
due to inflation. That's because rising prices effectively decrease the number of
goods or services you can buy. Purchasing power is also known as a currency's
buying power.

● Inflation erodes the purchasing power of a currency over time.

● Central banks adjust interest rates to try to keep prices stable and
maintain purchasing power.

So finally, Purchasing power risk is the possibility that you will not be able to
buy as much with your savings in the future. It represents a loss of value due
to inflation.

Purchasing power risk

Inflation risk or Purchasing power risk is the risk that the purchasing power of
your investment returns will be reduced by increasing inflation. Rising inflation
that causes an increase in prices effectively lowers the real return of a given
investment.

What is inflation?

Inflation is the increase in the prices of goods and services over time. The
Consumer Price Index (CPI) is a commonly used tracker of inflation. It uses
quarterly survey data to gather the average prices for a market basket of consumer
goods and services in urban areas. The basket includes common household
purchases, such as cereal, milk, coffee, clothing, and medical care and
transportation, and other basic services.

Explanation of Inflation Risk

An increasing trend in the inflation rate can significantly stress the purchasing
power in an economy. The investment portfolio has to generate much higher
returns to help beat the inflation rate and maintain the same level of purchasing
power.

Example of Inflation Risk

Let us take the example of a 1-year $1,000 bond that pays 5% as an annual coupon.

So, the investor or holder of the bond will receive a $50 coupon and $1,000
principal at the end of one year, which results in an aggregate bond value of
$1,050.

But now the real question is – has the purchasing power also increased by 5%?

So, first, let us look at what the bondholder can purchase today with the $1,000.
Today, the bondholder can buy a wooden table representing the purchasing power
of $1,000 at present.

Now, let us imagine that the inflation rate is 8%, and hence after one year, the
same wooden table will be priced at $1,100. So, it means that the bondholder won’t
be able to purchase the wooden table with the proceeds from the bond a year later.
The purchasing power will deteriorate due to the inflation rate being greater
than the bond’s return. Therefore, although the bond will generate nominal
return of 5%, the real return will be -3% (= 5% – 8%).

Purchasing Power and CPI

Governments institute policies and regulations to protect a currency’s purchasing

power and keep an economy healthy. They also monitor economic data to stay on
top of changing conditions.

CPI is one of the measures of inflation and purchasing power. It calculates the
change in the weighted average of prices of consumer goods and services, and in
particular, transportation, food, and medical care, at a given time. CPI can point to
changes in the cost of living as well as deflation.

The Reserve Bank of India (RBI) has mandated using CPI as the sole indicator of
inflation for its monetary policy.

CPI in India is one of the most widely used (Around 187 countries in the
world) economic indicator for identifying Inflation or Deflation. This is also
known as the barometer of Inflation in India.

Consumer Price Index or CPI

It is the measure of changes in the price level of a basket of consumer goods and
services bought by households. CPI is a numerical estimation calculated using the
rates of a sample of representative objects the prices of which are gathered
periodically.

The Consumer Price Index or CPI assesses the changes in the price of a common
basket of goods and services by comparing with the prices that are prevalent during
the same period in a previous year.

The formula for calculating CPI is:

CPI = (Cost of market basket in a given year / Cost of market basket in base
year) x 100

Long-time investors know that loss of purchasing power can greatly impact
their investments. Rising inflation affects purchasing power by decreasing the
number of goods or services you can purchase with your money.