Let’s talk about financial markets and investments, in the context of trading risk. This is the potential that the choice you’ve made may not bring you any profit. The steps you’ve taken in your investments may fail to deliver your anticipated outcome.
What does that mean? Well, it means that you could get lower returns than expected and lose your original investment. Sometimes, it can even mean a loss that exceeds your deposit. Ouch.
Overall, everyone faces some type of risk every day. Whether it is food, driving, walking, investing, trading, or something else, life is very tricky. You never know what awaits you. Learning the risks that can be applied to different scenarios and some of the ways to manage them holistically will help you out! It does not matter what type of trader you are – you can be a newbie or an expert. All kinds of investors and business managers need to learn how to avoid unnecessary and costly losses.
One of the fundamental ideas in finance is the relationship between action, risk, and return. Each investor has a unique risk profile. It determines his or her willingness and ability to withstand a threat. To sum it all up, as investment risks rise, investors expect higher returns to compensate for taking those risks. Investment chances and risks can come in various ways, and investors need to be paid for taking on additional risk.
The higher the amount of risk an investor is willing to take, the higher the potential return. It is, like gambling, but slightly more sophisticated and calculated.
The Biggest Risk is Not Taking Any Risk
As an example, we can look at the U.S. Treasury bond. It is considered one of the safest investments, and when compared to a corporate bond, it provides a lower rate of return.
Why so? The explanation is quite easy. A corporation or any other type of business is much more likely to go bankrupt than the U.S. government. Thus, the default risk of investing in a corporate bond is higher; investors are offered a higher rate of return.
Academically, there are several theories, metrics, and strategies that have been identified to measure, analyze, and manage risks. Thus, if you are determined enough, you can develop risk management skills and strategies to help achieve them.
As a result, quantifying risk often allows investors, traders, and business managers to hedge some risks away by using various strategies, including diversification and derivative positions.
To sum it all up:
- Risk takes on many forms. However, we can categorize it as an outcome or investment’s actual gain, which in the end differs from the expected outcome or return—kind of like life. You never get what you expect.
- Usually, risk includes the possibility of losing some or all of an investment.
- Risk can be reduced using hedging and diversification strategies.
Types of Financial Risks in Investment
Business Risk – This type of risk refers to the fundamental viability of a business. This risk is concerned with all the expenses a business must cover to remain operational and functioning, during any kind of crisis. The level of a company’s business risk is influenced by factors such as the profit margins, cost of goods, level of demand for the product, and competition.
Political Risk –This type of risk comes from changes in the government or other foreign policymakers, even military control.
Credit or Default Risk – This type of risk mainly concerns investors who hold bonds in their portfolios. This means that a borrower will be unable to pay the contractual interest or principal on its debt obligations.
Interest Rate Risk – The risk that an investment’s value will change due to a change in the absolute level of interest rates. It affects the number of bonds more directly than stocks and is a significant risk to all bondholders.
Foreign-Exchange Risk – When investors invest in foreign countries, it is always essential to remember the currency exchange rate and the change in the price asset pretty quickly. For example, if you live in the U.S. and want to invest in a Canadian stock in Canadian dollars, in case the share value appreciates, you may lose money if the Canadian dollar depreciates to the U.S. dollar.
Liquidity Risk – This risk correlates with an investor’s ability to transact their investment for cash.Counterparty Risk – Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions.