ACCO 20083 

  FINANCIAL MARKETS 

TOPIC 2      PART 2 

  

Risk in the Financial Market 

  
RISKS IN THE FINANCIAL MARKETS 
  
Market risk is the possibility of an investor experiencing losses due to factors that
affect the overall performance of the financial markets in which he or she is
involved. ... 
  
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 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 – listed companies. 
  
 Individuals face financial risk when they make decisions that may jeopardize their
income or ability to pay a debt they have assumed. 
  
  
 Sources of market risk include recessions, political turmoil, changes in interest
rates, natural disasters and terrorist attacks. 
  
Four primary sources of risk affect the overall market:  
1.     interest rate risk,  
2.     equity price risk,  
3.     foreign exchange risk, and  
4.     commodity risk 
  
  
  
  
  
  
TYPES OF RISKS 
There are different types of risks that a firm might face and needs to overcome.
Widely, risks can be classified into three types:  
1.      Business Risk,  
2.     Non-Business Risk, and 
3.      Financial 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 
  
Financial risk is the possibility of losing money on an investment or business
venture.  
  
Financial Risks for Governments 
Financial risk also refers to the possibility of a government losing control of its
monetary policy and being unable or unwilling to control inflation and defaulting
on its bonds or other debt issues. 
  
Some more common and distinct financial risks include 
·        credit risk,  
·        liquidity risk, and  
·        operational risk. 
  
  
Financial risks are everywhere and come in many sizes, affecting everyone.  
You should be aware of all financial risks. Knowing the dangers and how to
protect yourself will not eliminate the risk, but it can mitigate their harm. 
  
Understanding Financial Risks for Businesses 
·        It is expensive to build a business from the ground up.  
·        At some point in any company's life the business may need to seek outside
capital to grow. This need for funding creates a financial risk to both the business
and to any investors or stakeholders invested in the company. 
  
  
THUS, HAVING THE FOLLOWING 
  
  
1.       Credit risk—also known as default risk—is the danger associated with
borrowing money. OR LENDING 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.   
  
  
  
When only one or a handful of companies are struggling it is known as a specific
risk.  
This danger, related to a company or small group of companies, includes issues
related to capital structure, financial transactions, and exposure to default. The
term , specific risk, is typically used to reflect an investor's uncertainty of
collecting returns and the accompanying potential for monetary loss. 
  
  
  
 EXAMPLE OF FINANCIAL RISKS 
Financial Risks for the Market 
Several types of financial risk are tied to financial markets.  
During the 2007 to 2008 global financial crisis, when a critical sector of the market
struggles it can impact the monetary wellbeing of the entire marketplace. During
this time, businesses closed, investors lost fortunes, and governments were
forced to rethink their monetary policy.  
However, many other events also impact the market. 
  
Volatility brings uncertainty about the fair value of market assets. Seen as a
statistical measure, volatility reflects the confidence of the stakeholders that
market returns match the actual valuation of individual assets and the
marketplace as a whole. Measured as implied volatility (IV) and represented by a
percentage, this statistical value indicates the bullish or bearish—market on the
rise versus the market in decline—view of investments. Volatility or equity risk
can cause abrupt price swings in shares of stock.  
Default and changes in the market interest rate can also pose a financial risk.
Defaults happen mainly in the debt or bond market as companies or other issuers
fail to pay their debt obligations, harming investors. Changes in the market
interest rate can push individual securities into being unprofitable for investors,
forcing them into lower-paying debt securities or facing negative returns. 
Asset-backed risk is the chance that asset-backed securities—pools of various
types of loans—may become volatile if the underlying securities also change in
value. Sub-categories of asset-backed risk involve the borrower paying off a debt
early, thus ending the income stream from repayments and significant changes in
interest rates. 
  
Financial Risks for Individuals 
Individuals can face financial risk when they make poor decisions. This hazard can
have wide-ranging causes from taking an unnecessary day off of work to investing
in highly speculative investments. Every undertaking has exposure to pure risk—
dangers that cannot be controlled, but some are done without fully realizing the
consequences. 
  
  
2.       Liquidity risk comes in two scenarios or flavors for investors to fear.  
1.     The first involves securities and assets that cannot be purchased or
sold quickly enough to cut losses in a volatile market. This is known as market
liquidity risk this is a situation where there are few buyers but many sellers.  
2.     The second risk is funding or cash flow liquidity risk. Funding liquidity risk is
the possibility that a corporation will not have the capital to pay its debt, forcing it
to default, and harming stakeholders. 
  
3.      operational risk  --Businesses can experience operational risk when they
have poor management or flawed financial reasoning. Based on internal
factors, this is the risk of failing to succeed in its undertakings. 
  
  
  
  
  
Speculative Risk  -  is one where a profit or gain has an uncertain chance of
success. Perhaps the investor did not conduct proper research before investing, 
·        reached too far for gains, or  
·        invested too large of a portion of their net worth into a single investment        
DO NOT PUT ALL YOUR EGGS IN ONE BASKET … 
·        investment portfolio… invest in different companies in different industries 
Currency risk   -  Investors holding foreign currencies are exposed to currency
risk because different factors,  
·        such as interest rate changes and 
·         monetary policy changes, can alter the calculated worth or the value of their
money. 
 Meanwhile, changes in prices because of market differences, 
·        political changes,  
·        natural calamities, 
·         diplomatic changes,  
·        or economic conflicts may cause volatile foreign investment conditions that
may expose businesses and individuals to foreign investment risk. 
  
Things to understand on the good and bad of Financial Risk 
Ø Financial risk, in itself, is not inherently good or bad but only exists to different
degrees. 
Ø "Risk" by its very nature has a negative connotation, and financial risk is no
exception. A risk can spread from one business to affect an entire sector, market,
or even the world.  
Ø Risk can stem from uncontrollable outside sources or forces, and it is often
difficult to overcome. 
Ø Understanding the possibility of financial risk can lead to better, more informed
business or investment decisions. Assessing the degree of financial risk associated
with a security or asset helps determine or set that investment's value.  
Ø Risk is the flip side of the reward. RISK RETURN TRADEOFF 
Ø No progress or growth can occur, be it in a business or a portfolio, without
assuming some risk.  
Ø Financial risk usually cannot be controlled, exposure (IMPACT) to it can be
limited or managed. 
  
Further discussions on some economic theories 
  
Liquidity Preference Theory is a model that suggests that an investor should demand a higher interest rate
or premium on securities with long-term maturities that carry greater risk because, all other factors being
equal, investors prefer cash or other highly liquid holdings 
  
Liquidity Preference Hypothesis. A theory stating that, all other things being equal, investors prefer
liquid investments to illiquid ones.... 
  
Expectations theory attempts to predict what short-term interest rates will be in the future based on
current long-term interest rates. The theory suggests that an investor earns the same interest by investing
in two consecutive one-year bond investments versus investing in one two-year bond today.Nov 13, 2020 
  
Expectations theory attempts to explain the term structure of interest rates. ... Expectations theories are
predicated upon the idea that investors believe forward rates, as reflected (and some would say predicted)
by future contracts are indicative of future short-term interest rates.Aug 5, 2020 
  
Unbiased Expectations Theory states that current long-term interest rates contain an implicit prediction
of future short term interest rates. ... If we assume the theory to be true, we can use it to make practical
predictions about the future of bond yields for our own investing.Dec 20, 2015 
  
Pure expectation Theory 
A theory that asserts that forward rates exclusively represent the expected future rates. In other words, the
entire term structure reflects the market's expectations of future short-term rates.  
  
  
What Is Market Segmentation Theory? 
Market segmentation theory is a theory that long and short-term interest rates are not
related to each other. It also states that the prevailing interest rates for short,
intermediate, and long-term bonds should be viewed separately like items in different
markets for debt securities. 
 Market segmentation theory states that long- and short-term interest rates are
not related to each other because they have different investors. 
 Related to the market segmentation theory is the preferred habitat theory,
which states that investors prefer to remain in their own bond maturity range
due to guaranteed yields. Any shift to a different maturity range is perceived as
risky. 
  
Market segmentation theory further asserts that the buyers and sellers who make up
the market for short-term securities have different characteristics and motivations than
buyers and sellers of intermediate and long-term maturity securities. The theory is
partially based on the investment habits of different types of institutional investors,
such as banks and insurance companies. Banks generally favor short-term securities,
while insurance companies generally favor long-term securities. 
  
  Preferred habitat theory says that investors prefer certain maturity lengths over others when it
comes to the term structure of bonds. ... Meanwhile, market segmentation theory suggests that
investors only care about yield, willing to buy bonds of any maturity. 
What is a swap rate? 
A forex swap rate, also known as a rollover rate or a swap, is a fee that is paid or charged to an open
trade at the end of each trading session. It’s the interest fee, which is charged or earned, for keeping
positions open overnight. A swap rate allows positions to be extended into the next interbank session
without closing or settling. 
Swap rates can be calculated using the following formula: Rollover rate = (Base currency
interest rate – Quote currency interest rate) / (365 x Exchange Rate).Sep 19, 2019 
Types of swaps 
There are several types of swaps in financial trading. 
Interest rate swaps 
An interest rate swap (IRS) is a derivative contract where two parties exchange interest payments on
underlying debt. The most common type of IRS involves the exchange of fixed-rate payments for
variable-rate payments. An IRS allows companies and/or banks to hedge their exposure to interest rate
changes. 
Currency swaps 
A currency swap is a contract where two parties trade principal and interest in one currency for the
same in another currency. A currency swap is usually executed by a bank or financial institution to hedge
exposure to exchange rates. Unlike an IRS, a currency swap involves the exchange of principal. 
Commodity swaps 
A commodity swap is a derivative contract where two parties agree to exchange cash flows based on the
price of an underlying commodity, such as oil. The agreement involves a fixed-leg component and a
variable-leg component, allowing traders to fix the price of an agreed quantity of the commodity, at a
future date. 
Credit default swaps 
Also known as a CDS, a credit default swap is similar to an insurance policy. It is a contract that allows
traders to swap or offset their credit risk with another trader or investor. For example, a trader may
decide to invest in company bonds, in exchange for a fixed rate of interest, known as a bond dividend.
To protect their investment against company default, the trader may engage in a CDF, usually issued by
a bank or an insurance provider. The CFD seller then charges the trader a fee in exchange for taking on
the risk. 
Zero coupon swaps 
In financial trading, a zero-coupon swap is a linear interest rate derivative (IRD). It’s an exchange of cash
flows where the variable-leg interest payments are made periodically, whereas the fixed-leg component
is made as a lump sum at maturity. 
Total return swaps 
Also known as a TRS, a total return swap is a contract between two parties where one party makes
payments based on a set rate, being fixed or variable. Whereas the second party makes repayments
based on the return of an underlying asset. 
Libor swap rate 
LIBOR is an acronym for London Inter-Bank Offered Rate, which is the benchmark for variable short-term
interest rates used by high-credit banks. The rate is set daily and has seven different maturity dates,
including one day, one week. 1, 2, 3, 6 and 12 months. 
What is the value of a swap? 
At the initiation or start date of a swap, the value is zero to both parties involved. The value of the swap
then changes over time as the value of the underlying asset or interest rate changes. Because one leg of
the swap is fixed and the other leg is variable, any positive change for one party will result in an adverse
change to the other party. 
At the initiation date, the two parties involved in a swap will agree to exchange cash flows to the same
value. Therefore, fixed value = variable value. The party making payments on a variable rate will typically
use the benchmark rate set by LIBOR while the party making payments based on a fixed rate uses a
benchmark to U.S. Treasury Bonds. 
A forward rate is the settlement price of a transaction that will not take place until a predetermined date;
it is forward-looking. In bond markets, the forward rate refers to the effective yield on a bond,
commonly U.S. Treasury bills, and is calculated based on the relationship between
interest rates and maturities.Aug 10, 2020 
  
Forward Rate vs. Spot Rate: An Overview 
The precise meanings of the terms "forward rate" and "spot rate" are somewhat
different in different markets. But what they have in common is that they refer, for
example, to the current price or bond yield—the spot rate—versus the price or yield for
the same product or instrument at some point in the future—the forward rate. 
In commodities futures markets, a spot rate is the price for a commodity being traded
immediately, or "on the spot". A forward rate is the settlement price of a transaction
that will not take place until a predetermined date; it is forward-looking. 
In bond markets, the forward rate refers to the effective yield on a bond, commonly U.S.
Treasury bills, and is calculated based on the relationship between interest rates and
maturities. 
 In commodities markets, the spot rate is the price for a product that will be
traded immediately, or "on the spot." 
 A forward rate is a contracted price for a transaction that will be completed at
an agreed upon date in the future. 
 In bond markets, forward rate refers to the future yield based on interest rates
and maturities. 
The Spot and Forward Rates in Commodities Markets 
A spot rate, or spot price, represents a contracted price for the purchase or sale of a commodity,
security, or currency for immediate delivery and payment on the spot date, which is normally one or
two business days after the trade date. The spot rate is the current price quoted for immediate
settlement of the contract. 
For example, if during the month of August a wholesale company wants immediate delivery of orange
juice, it will pay the spot price to the seller and have orange juice delivered within two days. 
On the other hand, if the company needs orange juice to be available in late December, but believes the
commodity will be more expensive during the winter period due to lower supply, it wouldn't want to
make a spot purchase since the risk of spoilage is high. A forward contract would a better fit for the
investment. Unlike a spot transaction, a forward contract, involves an agreement of terms on the
current date with the delivery and payment at a specified future date. 
  
  
 In summary 
·         . Liquidity preference theory -This economic theory accordingly drives the interest rate assumes
that the interest rates are dependent on the preference of the household whether they hold or use it for
investment. Liquidity premium increases as the maturity lengthens 
  
·         The risk-free rate should be the rate that assumes zero default in the market where this is more or
less equivalent to the rates offered by the sovereign. 
 In finance, interest can be determined by the function of the risk and the compensation of the investor
on the difference between the risk-free rate and the market fluctuations 
  
·         Market Segmentation Theory assumes that the driver of the interest rates are the savings and
investment flows. 
·         Default risk arise on the inability to make payment consistently 
·         Liquidity Risk is identified by ensuring the business to be capable of meeting all its currently
maturing obligation. 
·         Legal risk is dependent on the covenants set and agreed in between the lenders and the
borrowers. 
·         Market risk is the impact of the market drivers to the ability of the borrowers to settle the
obligation. 
·         When the agreement is a spot rate the applicable interest rate is based on the prevailing market
rate at. the particular time 
·         Forward rates are normally contracted rates that fixed the rates and allow a party to assume such
risk on the difference between the contracted rate and the spot rate. 
·         Swap rate is another contract rate where a fixed rate exchange for a certain market rate at a
certain maturity. 
.                  
·          In order to mitigate the risk, most businesses hedge forward rates or enter into a swap rate
agreement. It is important for the borrowers and lenders to know what the spot rate in the prevailing
market is and employ certain expectations in the future. 
  
·         Expectation theory This economic theory accordingly affects the term structure of interest rate.
Interest rates are driven by the expectation of the lender or borrowers in the risks of the market in the
future. 
·         Market segmentation theory This economic theory accordingly affects the terms structure of
interest rate. This theory assumes that the driver of the interest rates are the savings and investment
flows. 
·         Pure Expectation theory This theory is based on the current data and statistical analysis to project
the behavior of the market in the future 
·         Biased expectation theory - This theory includes that there are other factors that affect the term
structure of the loans as well as the interest to be perceived moving forward. The forward rates will be
affected or will be adjusted if the liquidity of the borrower will be weaker or stronger in the future