Read this chapter and learn more about risk and return. When and how are risk and return used in business?
Types of Risk
There are many types of financial risk, including asset-backed, prepayment, interest rate, credit, liquidity, market, operational, foreign, and model risk.
Classify different securities by the types of financial risk associated with the investment opportunity
- 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
- 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.
The term "financial risk" is broad, but can be broken different categories to understand it better.
Types of Financial Risk
Asset-backed risk affects investments in asset-backed securities such as home loans. In order to finance home sales, banks issue bonds that serve as a debt obligation to its buyer. The buyer of the debt is essentially receiving the interest from the bank that the home-buyer is paying to it.
Prepayment risk is the risk that the buyer goes ahead and pays off the mortgage. Therefore, the buyer of the bond loses the right to the buyer's interest payments over time.
Interest rate risk refers an asset whose terms can change over time, such as a VariableRate 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 (i.e. stocks) can be sold immediately at the current market rate and others (i.e. houses) are subject to a much higher degree of liquidity risk.
Market risk is the term 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.
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 which they really couldn't afford. The mortgages often featured variable rate annuities, meaning that the interest rate terms of the mortgage started low and increased over time. Over the past 20 year period, house prices had risen constantly and investors assumed the trendwould continue. Buyers worried about an adjustment to their interest rate, and all of a sudden a 1500 monthly payment became 2000. When interest rates climbed 2 percentage points and the mortgage climbed to $2000, some owners had to default (stop making payments) . They were promised that their investment would appreciate in value and they would be able to refinance it. The home loans were packaged and shipped off to investors all over the world in the form of complex investment vehicles. They seemed rewarding and highly safe at first, 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 there were no mechanics 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.
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