A financial risk is the risk of losing money as a result of a financial transaction (on a financial asset) or an economic transaction with a financial impact (eg a sale on credit or in foreign currency).
There are many risks, some are specific others not, but the vast majority ranks in the risks below.
Market risk or volatility
It is the risk of loss that can result from fluctuations in the prices of the financial instruments that make up a portfolio.
The risk may relate to stock prices, interest rates, foreign exchange rates, commodity prices, etc.
By extension, it is the risk of economic activities directly or indirectly related to such a market (for example an exporter is subject to exchange rates, a car manufacturer at the price of steel …). It is due to the evolution of the whole economy, taxation, interest rates, inflation, and also investor sentiment vis-à-vis future developments … It affects more or minus all financial securities.
In modern portfolio theory, this risk is usually measured by market volatility, a statistical datum.
This is the risk of non-repayment of debt by a borrower (this also applies to debt securities such as sovereign bonds or bonds of the public treasury).
This is the risk for a creditor to permanently lose his claim to the extent that the borrower can not, even by liquidating all of its assets, repay all of its commitments. Traders talk about “counterparty risk”. Counterparty risk is a similar notion.
The list of risks in finance
This is a risk that can occur in the current business. These risks are so numerous that it is impossible to quote them all.
Example of the bank as a computer problem, a trading error or a dispute. For this purpose, banking institutions set up verification procedures for each transaction.
the technology is outdated or replaced
The risk of strike, turnover, death with the company killed me, bad reputation etc.
For example, the inadequacy of the commercial network
The threat of new entrants
If the sector is particularly lucrative.
Can not buy at a good price or have access to a resource
Risk that customers put pressure
It reflects the risk related to a political situation or a decision of the political power: nationalization without sufficient compensation, revolution, exclusion of certain markets, discriminatory taxation, impossibility to repatriate capital …
The change of law or regulation can directly affect the profitability of an economic sector (pharmaceuticals, banking, insurance, energy …).
This is a risk that occurs when investing abroad (loan in Dollar for example) and for financial products in foreign currency.
A rise in the currency against its currency is a cost for the institution, it can nevertheless hedge risk by hedging instruments.
Interest rate risk
This is the risk that credit rates are unfavorably changing. Thus, a variable rate borrower experiences a rate risk when rates rise because he has to pay more. Conversely, a lender is at risk when rates fall because he loses income.
This is the risk on the ability to buy or sell an asset. If a market is not liquid, you may not find a buyer when you want it or find a seller when you absolutely need it. This is a risk related to the nature of the underlying (of the commodity) but also to the credibility of the buyer-seller. Indeed, it is easy to buy or sell a current product to a trusted counterpart, but more difficult with a very specialized product. It is the liquidity of this product. In addition, if the buyer / seller is not credible, the counterparty risk for potential suppliers / customers dissuades them from processing.
For a bank, this is the risk of being unable to cope with a massive withdrawal of deposits by customers. If this risk is likely to spread gradually between banks ( domino effect ), particularly because of the drying up of interbank financing, or psychological contagion between depositors, we talk about systemic risk, because the system as a whole collapses.
Basic or intrinsic risk
Linked to the evolution of an underlying price and it can bring together many risks. Weather risk for commodity prices such as wheat, country risk, home risk if you buy in stone etc.
There are other types of risks, but most can be similar to the definitions presented here.
The risk of inflation. This is the risk of being repaid in a depreciated currency, to obtain a rate of return lower than the rate of inflation. It has, among other things, caused the ruin of the grandchildren of the pensioners of Balzac.
The risk of fraud.
It can be internal or external to the company.
These are for example those of a storm, an earthquake, a volcanic eruption, a cyclone, a tidal wave that destroys assets (buildings, machinery …). The recent period has shown us that these could not be neglected.
The cyclical risk
Enthusiasm or “depression” on the stock market, anticipation of a fall or rise in activity.
It is very difficult to rank the risks, but some have tried and classified the risks into two categories
- economic risks (risks linked to the company’s activity, political, natural, inflation and fraud risks, etc.): these are the risks that threaten the flows linked to the financial title and which belong to the economic world or the real world ;
- financial risks (liquidity risk, currency risk, interest rate risk, etc.) that do not relate directly to cash flows and are specific to the financial sphere. These risks are not attributable to the company but to external financial events
Specific case study
Real estate (rental)
This is a risk that is often ignored because there have been big price rises and we forget to say that real estate is a particularly cyclical market which poses the problem of bubbles and the bursting of the latter. The risk is not fictitious and the fluctuations of the real estate market have nothing to envy the stock markets.
The risk of a vacancy
Known risk and feared by all owners. The rental holidays greatly undermine the profitability of the property. A month less rent, it is all lower income. The fixed costs (property tax, charges) that are payable regardless of the level of occupation of the property, as long as it is rented as long as possible.
The conflict with the tenant
Conflict with a tenant can be a big source of financial problems as well as wasted time. It is quite possible for a tenant to invoke a defect rightly or wrongly (leak, crack or any other reason) for not paying his rent. This can go very far: reports of bailiffs, courts. For a faulty owner, it can go very far too (vetusteté). For example, excessive savings from the end of a candle or the opposite can undermine the profitability of a good.
The risk of unpaid
Tenant who lost work, conflict can cause a risk of major unpaid.
The risk of degradation of the property
Undecided tenants are always possible, despite paying attention and selecting tenants.
Defects and work
More traditional, work that is late, extra costs etc are commonplace. But big workmanship rarely happens (see farmer curve) but can really be a problem.
Business going bankrupt
How many times do construction companies go bankrupt? Sometimes with forget to pay the insurance to finish the good the owner finds the beak in the water.
Crowdfunding real estate
Risks of loss of capital and illiquidity
First, there are risks inherent in investing in securities of unlisted companies. There is a risk of loss of capital, in whole or in part, and liquidity risk (funds are frozen). These risks de facto position real estate crowdfunding as a diversification investment like estate guru.
Real estate risks
A real estate transaction is not without risk. Risks of delay of construction site, risks of failure of a subcontractor, prices too high causing a difficult commercialization, recourse of a third.
Frequency of risks
To say that there is no risk is to show a blindness, a very serious fault for a financier.
I present you the Farmer curve, I just think that it represents the risks very well and that it does not need comment.
the frequencies/the gravity of the risk
Influence of risk
But simply knowing that a company is subject to significant risks will lead some investors to be reluctant to acquire securities. Investors’ perception that a company’s future cash flows are uncertain (ie, volatile) will reduce the value of a security in the eyes of investors, so the materialisation of the risk is not even effective.
Finance is based on the assumption that investors seek to reduce the uncertainness of their future flows. it’s just that a normal person is risky, she does not like risk.
By nature, a risk will make uncertain future flows that must generate an asset: this element will therefore be taken into account in the assessment of value.