• Different Risks involved in Trading

    Financial Risk

    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

    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:

    1. Equity risk: Risk that the equity price will change because of different reasons and volatility will increase.
    2. Interest rate risk: Risk that the interest rate will increase which will drive down the share prices. The interest rate risk arises from the increase in inflation, as the central bank always use interest rate hike as the main weapon to control the increasing inflation.
    3. Currency risk: Risk that the adverse movement of currency conversion rate will decrease the value of the investment. If theUSinvestors invest in the Indian market then Rupee depreciation with US dollar will reduce the value of the investment in US dollar terms.
    4. Commodity risk: Risk that the price of different commodities will change over the course of time. Commodities prices can be changed because of different reasons which can reduce the value of portfolio having investment in different types of commodities like Oil, Gold, and Silver etc.

    Liquidity Risk

    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

    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

    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.

    1. Legal Risk: Arises from the in-efficient legal system which leads to illegal operations. Less strict legal practice increases the unfair business practices and increases the risk losing the invested money.
    2. Regulatory Risk: Lack of proper regulatory system leads to unfair trade practices and price manipulation through that. Unfair trading practice can erase the value of a share as well as the value of a portfolio. Proper regulatory system is always necessary to protect the small individual investors from loosing their money through unfair speculative trading.
    3. Transactional Risk: Arises from the lack of proper transactional system which leads to wrong transactions and wrong calculation of money. If the transaction was done incorrectly and not within the proper time duration of placing the trade request, it may lead to incorrect calculation and loosing money through the trade transaction. In a very volatile market, a small lag in time can cause a significant change in trade transaction price, which can make the trader loose the desired money.

    Political Risk

    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

    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

    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

    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 Transfer Risk
    • Political/Sovereign Risk
    • Cross Border Risk
    • Sovereign Risk

    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.

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