Risk with Financial Instruments
Investopedia writes at the https://www.investopedia.com/terms/r/risk.asp adress:
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Risk
Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment.1
Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In finance, standard deviation is a common metric associated with risk. Standard deviation provides a measure of the volatility of asset prices in comparison to their historical averages in a given time frame.
Overall, it is possible and prudent to manage investing risks by understanding the basics of risk and how it is measured. Learning the risks that can apply to different scenarios and some of the ways to manage them holistically will help all types of investors and business managers to avoid unnecessary and costly losses. " ...
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Speculative Risk
Speculative risk is a category of risk that, when undertaken, results in an uncertain degree of gain or loss. In particular, speculative risk is the possibility that an investment will not appreciate in value. Speculative risks are made as conscious choices and are not just a result of uncontrollable circumstances. Since there is the chance of a large gain despite the high level of risk, speculative risk is not a pure risk, which entails the possibility of only a loss and no potential for gains.
Almost all investment activities involve some degree of speculative risk, as an investor has no idea whether an investment will be a blazing success or an utter failure. Some assets—such as an options contract—carry a combination of risks, including speculative risk, that can be hedged or limited. "
The credit-suisse publication: Risks Involved in Trading Financial Instruments (2023) - risks-involved-in-trading-financial-instruments-125343.pdf , explains the Risk factor in the financial economy more deeply.
1.3 General risks in trading financial instruments
This section explains the general risks involved in trading financial instruments.
Country risk
The value of a financial instrument and thus the possibility of accessing it depend on various political, legal and economic factors relating to the country in which it is issued, held in custody or traded.
Country risks concern the political and economic stability of a given country. Examples of political risks
include the potential confiscation of assets and state intervention in certain industries.
Economic risks typically include fluctuations in interest and inflation rates. Other country risks concern the quality of
infrastructure (particularly as regards clearing houses and exchanges) and the legislative framework: market transparency, supervisory authorities, investor protection, insolvency regimes and taxation.
All of these can change over time, sometimes in unpredictable ways. In the past, for example, some states have imposed restrictions on trading in financial instruments via economic sanctions or controls on the
exporting and free movement of capital. These can make it difficult or even impossible to retain control of or sell the financial instruments affected, even if they are held with a Swiss bank.
Countries with special risks: emerging markets
There is no standard definition of the term “emerging market” (alternatively “developing country”). Common criteria for defining emerging markets are income per capita, the level of development of the financial sector and the proportion of the total economy made up by the service sector. Emerging
markets can be at very different stages of economic development, but one thing most of them have in common is that their political, legal and economic systems are either comparatively new (e.g. democracy)
or not very firmly established. As a result, emerging markets’ financial systems and institutions tend to enjoy less stability and legal certainty than their counterparts in developed countries.
Investments in emerging markets entail risks that are less pronounced or entirely absent in developed countries, including settlement (see Settlement risk) and liquidity risks (see Liquidity risk). Higher risks
associated with investments in financial instruments relating to emerging markets also apply when the issuer (see section 1.1) or offeror only has its head office or the focus of its activity in such a market.
Issuer risk
Most investments involve a risk that the issuer (see Glossary) will become insolvent. This is called the issuer risk. A financial instrument’s value depends not only on product-specific aspects – e.g. business results for equities or the performance of the underlying financial instrument for structured products –
but also on the issuer’s creditworthiness. This can change at any time during the term of an investment. It is therefore important to know who issued the instrument in question and who is responsible for meeting the obligations. This is essential for correctly assessing the issuer’s creditworthiness and thus the issuer risk. With debt instruments (see Glossary) such as bonds, this risk is known as the credit risk
because the borrower normally acts as the issuer.
Settlement risk
A settlement risk arises when a financial instrument must be bought at a specific price before delivery. In this case, the investor risks paying the purchase price without receiving the instrument on time or even at
all. Conversely, an investor who sells a financial instrument and must deliver it without receiving the purchase price also incurs a settlement risk. Settlement risks are especially high in emerging markets and
for some offshore funds, private equity investments and derivatives (see Glossary).
Currency risk
If a financial instrument is denominated in a currency other than the investor’s reference currency (see Glossary), the risk of exchange rate fluctuations must be taken into account. Some financial service providers recommend using hedging instruments to minimise this risk or offer currency-hedged products.
Currency risk can thus be mitigated, but – depending on the asset class and hedging technique in question – it cannot always be completely eliminated.
Liquidity risk
Liquidity risk is the risk that an investor will not always be able to sell an investment at an appropriate price. When specific financial instruments or derivatives are difficult or impossible to sell or can only be sold at a greatly reduced price, this is termed an illiquid market. The risk of illiquidity occurs in particular with unlisted and small-capitalisation companies, investments in emerging markets (see Glossary), investments with sales restrictions, some structured products and alternative investments (see Glossary).
In addition, liquidity risks cannot be ruled out with bonds if they are merely held after issue (see Glossary) and hardly traded at all.
Legal risk
To evaluate the legal risk attached to an investment, its legal framework must be taken into account. This includes legal provisions on investor protection, for example investment guidelines and obligations regarding transparency, information and disclosure as well as bans on insider trading and duties of management. Attention must also be paid to the mechanisms and institutions that enforce the law, such as supervisory authorities, courts and ombudsmen.
The legal framework can affect the value of an investment (e.g. in cases of fraud) and limit the scope for investors to assert their rights. This can be important if an issuer (see Glossary) fails to meet its obligations.
Economic risk
Changes in a country’s economic activity tend to have an impact on the prices of financial instruments. This is referred to as economic risk.
Interest rate risk
Interest rate risk affects investors buying bonds, particularly when interest rates rise as this means that new bonds will be issued with higher rates, making existing bonds with lower rates less attractive and
causing their prices to fall.
Inflation risk
Inflation risk is the risk that investors will suffer financial losses as the value of money declines. It is most pronounced for long-term investments in foreign currencies. The central banks of countries with less
developed financial markets and low reserves of hard currency (see Glossary) are sometimes unable to meet their inflation targets. As a result, inflation and exchange rates in such countries can fluctuate more
severely than those in developed countries.
Soft factor risks
Prices of financial instruments do not just depend on “hard” facts like a company’s business performance and forecasts, they are also influenced by subjective “soft” factors such as expectations, fears and
rumours. There is thus always a risk that the price of a financial instrument might fall in the short term due to soft factors, even though its value objectively remains intact.
Volatility risk
The prices of financial instruments go up and down over time. Financial experts use the term “volatility” to describe the range of these movements over a specific period. Volatility is a measure of market risk.
The higher a financial instrument’s volatility, the more risky an investment it is, as its value could fall sharply.
Cluster risk
Cluster risks are caused by the way an investment portfolio is constructed. They arise when a single financial instrument, a small number of instruments or a single asset class makes up a large share of the
portfolio. Portfolios with cluster risks can suffer greater losses than more diversified portfolios in a market downturn. Diversified portfolios spread their investments among different financial instruments
and asset classes in order to reduce the overall risk of price fluctuations. When buying and selling financial instruments, it is important to take account of portfolio structure and in particular to ensure sufficient diversification.
Cluster risks at issuer (see Glossary) country and sector level must be taken into consideration. A cluster risk at issuer level exists, for example, in a portfolio containing a bond issued by Company X, shares in
Company X, a structured product with Company X as its underlying asset (see Glossary) and an equity fund with 20 % of its assets invested in that same Company X.
Publisher: Swiss Bankers Association (SBA).
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