Financial Risk refers to the risk associated with any kind of financial investment be it equity shares, bonds, derivatives or any other financial instruments. Risk arises from the uncertainty of the return of the investment and loosing the whole or part investment value because of different reasons. Main types of financial risks are as follows
Market risk arises from different market related factors which decreases the value of the investment or portfolio. These market risks are caused because of different market variables.
The Main market risks are as follows:
Liquidity risk arises mainly from low trading volume where the asset can not traded quickly enough to reduce the loss or make the desired profit. This is a situation where number of buyers does not match with the number of sellers in the market and trading volume stays very low which makes it very difficult to liquidate the holding assets at the desired price. Wide bid-ask spread can be a example for the same.
Credit risk arises from the non-credibility of the borrower to pay the principal or interest as promised. When the borrowers are not able to pay the promised payment or become default on the payment, the investor or the lender losses the money. For default cases, sometimes it becomes very difficult to recover even the principal amount.
To handle this risk the credit rating agencies provide rating on the borrowers which denotes the credibility of paying the promised payment (or not becoming default) at the scheduled time. Higher rating denotes the higher credibility of paying the principal as well as interest.
Operational risk arises from different types of operational or transactional failures. That can happen because of in-efficient operational system or platform. The different types of operational risks are specified below.
Political risk arises from the adverse political situation or government related risk of a country. If the government is not stable or political uncertainty is present or foreign policies are not investment friendly, then it increases the political risk of a country. To have minimum political risk, the government has to be stable, efficient and investment friendly.
Business risk arises from the uncertainty that the business may not be able to generate the desired cash flow. There is always some uncertainty regarding the cash inflow from the business if the business process is not very much robust. We have to consider the business risk while considering a company for investment.
Geographical risk arises from the specific geographic related conditions like prone to natural calamity, terrorism and adverse weather.Japandue to more earthquakes prone and middle-east countries due to terrorism have more geographic risk.
Country risk is caused due political uncertainties and adverse conditions to do business in the foreign countries. Because of these uncertainties, investors call it as a risk of doing business or investing money in that particular country.
Country risk can be because of
Country risk premium is a premium return that has to be added to the total expected return because of additional country specific risks associated with investment in the particular country. Macroeconomic factors such as political instability, adverse exchange rate changes, adverse foreign policies and high interest rate cause investors reluctant to invest in foreign countries. It makes them require a premium for investing in terms of more expected return. The extra premium is decided based on the extra risk they are taking. Country risk premium is much more for developing countries than developed countries.