Magoosh GRE

Financial Risk – Study Notes

| May 20, 2012 | 0 Comments

General Definition:

The risk associated with financing projects where there may not be enough cash flow to meet the financial obligations.

Categories of Financial Risk:

  1. Credit Risk:

Also called default risk, is the risk associated with a borrower going into default (not making payments as promised). Investor losses include lost principal and interest, decreased cash flow, and increased collection costs.

 

  1. Asset Backed Security:

An asset-backed security is a security whose value and income payments are derived from and collateralized (or “backed”) by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually. Pooling the assets into financial instruments allows them to be sold to general investors, a process called securitization, and allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the diverse pool of underlying assets. The pools of underlying assets can include common payments from credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments and movie revenues.

 

  1. Foreign Investment Risk:

Risk of rapid and extreme changes in value due to: smaller markets; differing accounting, reporting, or auditing standards; nationalization, expropriation or confiscatory taxation; economic conflict; or political or diplomatic changes.

See: Commercial and Political investment risk

 

  1. Liquidity Risk:

The risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).

 

  1. Market Risk:

The risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices (equity risk), interest rates (interest rate risk), foreign exchange rates (currency risk), and commodity prices (commodity risk).

 

  1. Operational Risk:

Risk arising from execution of a company’s business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such as fraud risks, legal risks, physical or environmental risks.

 

  1. Model Risks:

MANAGING RISK:

Risk involved in using models to value financial securities.

 

Diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents.

Hedging is a method for reducing risk where a combination of assets are selected to offset the movements of each other. For instance when investing in a stock it is possible to buy an option to sell that stock at a defined price at some point in the future. The combined portfolio of stock and option is now much less likely to move below a given value. As in diversification there is a cost, this time in buying the option for which there is a premium.

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Category: Essay & Dissertation Samples, Finance Essay Examples

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