Types of Risk

Inflation Risk

Inflation Risk is the chance that the cash flows from an investment won’t be worth as much in the future because of the changes in purchasing power due to inflation. Inflation causes money to decrease in value at some rate, and does so whether the money is invested or not.

Inflation in the United Kingdom has hit a four year low, in which The Bank of England will now be under less pressure to raise interest rates. Inflation is now subdued we don’t need to think about it. The only real danger of this is that Britain could contract a nasty dose of deflation – in which the Japanese faced. This would include falling prices, stalled demand in expectation of a further price slide and curtailed investment.

Credit Risk

The risk of loss of principal or loss of a financial reward steaming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation they have. Credit risk arises whenever a borrower is expected to use future cash flows to pay current debts they have. Investors are compensated for assuming credit risk by the way of interest payments from the borrower or issuer of a debt obligation.

Credit is closely linked to the potential return of an investment, most notably being that the yields on bonds correlate strong to their perceived credit risk.

An example of this would be to say if higher the perceived risk, the higher the rate of interest that investors will demand for lending their capital. Credit risks are calculated based on the borrowers’ overall ability to repay. The calculation for this includes the borrowers collateral assets, revenue generating ability and taxing authority (such as for government and municipal bonds.)

Currency

A risk arises in currency from a change in price of one currency against another. Whenever investors or companies have assets or business across different countries, they face currency risk if their positions are not hedged.  Any business that operates across different territories that use different currencies will face currency risk. Businesses will be hurt and helped in different ways from exchange rate movement.

Examples of this are:

  • If you’re a British manufacturer and your main market is Europe, you will benefit when the pound weakens. The euro you receive in return for you goods will be worth more pounds therefore your profit increases. And vice versa if the Euro is weaker than the pound you will lose money.

Risk in Stock Markets

The Market risk is the possibility for the investor to experience losses due to the factors that affect the overall performance of the financial market. Market risk, also known as ‘systematic risk’ cannot be eliminated through diversification, thought it can be hedged against it. The major Market Risk is natural disaster as this will cause a decline in the market as a while as an example of market risk. Other sources of market risk are:

  • Recession
  • Political turmoil
  • Changes in interest rates
  • Terrorist attacks