Risk

Types of Risk

Read this chapter on risk and return. When and how do businesses consider and use risk and return? Make sure you can classify securities by the types of financial risk associated with the investment opportunity. You should also be able to calculate the risk of a portfolio using computational methods.

There are many types of financial risk, including asset-backed, prepayment, interest rate, credit, liquidity, market, operational, foreign, and model risk.

The term "financial risk" is broad but can be broken into different categories to understand it better.

Types of Financial Risk

Asset-backed risk affects investments in asset-backed securities such as home loans. To finance home sales, banks issue bonds that serve as a debt obligation to their buyers. The buyer of the debt essentially receives the interest from the bank that the home-buyer is paying to it.

Prepayment risk is the risk that the buyer will pay off the mortgage. Therefore, the bond buyer loses the right to the buyer's interest payments over time.

Interest rate risk refers to an asset whose terms can change over time, such as a Variable-Rate Mortgage payment.

Credit risk, or default risk, is the risk that a borrower will default (or stop making payments).

Liquidity risk is the risk that an asset or security cannot be converted into cash in a timely manner. Some investments (e.g., stocks) can be sold immediately at the current market rate, while others (e.g., houses) are subject to a much higher degree of liquidity risk.

Market risk is associated with the risk of losing value in an investment will lose value because of a decline in the market.

Operational risk is another type of risk that deals with the operations of a particular business. If you are invested in the Boston Red Sox, your operational risk might include the chance that starting pitchers and recent acquisitions won't perform, that your manager will turn the clubhouse into a mess, or that ownership will not be able to execute a long-term strategy. Any of these risks might result in decreased revenues from ticket sales.

Foreign investment risk involves the risk associated with investments in foreign markets.

Model risk involves the chances that past models, which have been used to diversify away risk, will not accurately predict future models.

Example

A recent phenomenon that applies the concepts of these risks and how they interact with each other happened in 2008 when the housing market crashed. Can you find an example of each form of risk here?

Leading up to the crisis, many people received loans to buy houses they could not afford. The mortgages often featured variable-rate annuities, meaning that the interest rate terms started low and increased over time.

Over the past 20 years, house prices have risen constantly, and investors assumed the trend would continue. Buyers worried about an adjustment to their interest rate, and all of a sudden, a $1,500 monthly payment became $2,000. When interest rates climbed two percentage points, and the mortgage climbed to $2,000, some owners had to default (stop making payments).

They were promised that their investment would appreciate in value and that they would be able to refinance it. The home loans were packaged and shipped off to investors all over the world as complex investment vehicles. They seemed rewarding and highly safe initially, but then a few started breaking down. By now, these vehicles had made their way all the way around the world.

When some investors defaulted, the world realized no mechanics were around to fix these vehicles. After a few vehicles broke down, no one wanted to buy them, leading to the worst crash across world markets since 1929.

Key Points

Financial risk is associated to the chances that an investor might lose value in an investment. It is separated into different sources of decline.
Often the risks interact with each other and ultimately shock causes panic. Many of the worst market crashes have been a result of widespread speculation and not the devaluation of that asset itself.
In the market crash of 2008, investors feared that some home owners would default. It triggered a chain of events that shocked the whole world and left many people in bad financial situations.

Term

Variable Rate Mortgage – a variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets.

Source: Boundless Finance, https://ftp.worldpossible.org/endless/eos-rachel/RACHEL/RACHEL/modules/en-boundless-static/www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-risk-and-return-8/risk-79/index.html
This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 License.