The concept of ‘risk’ when dealing with finance is not that easily understood and for the layman can be something that’s hard to comprehend. There are various kinds of risk which are identified as being connected to certain investments, savings and other means of dealing with finances, all of which are considered as taking more of a risk or to be less risky.
However, this all depends on situations as well as the applications connected to any financial deals that are set in place. With this said, some financial risks people may be more familiar with are as follows:
Chart showing fluctuations in interest rates from Dow Jones
Chart showing fluctuations in interest rates
Interest Rates – Risk Factors Involved
Risks involving interest rates are connected to the uncertainty associated with changes in market interest rates, one example being any fluctuations on the London’s stock exchange. The two risks factors identified are risk and reinvestment rate risk.
People are always advised to check interest rates before committing to loans or any other financial agreements that involve interest rates. By tying into a set interest rate, there is a risk of losing out should interest rates go down at some future point in time. However, should interest rates go up, then a person would be saving them money.
Price Risk – Risk Factors Involved
Prices change due to the uncertainty that’s associated with any potential changes in the price of assets. These changes are caused when interest rates go up or down. They are also affected by rates of return in an economy.
The risk happens due to fluctuations in interest rates which then affect changes in any discounts rates in place. These in turn affect current values of future cash flow. Should interest rates rise then automatically prices fall, if on the other hand interest rates rise, then prices will go up. Interest rates affect discount rates as well as current values where future cash flows are concerned, and as such represent underlying economic values.
Price risk is more usually referred to as ‘maturity risk’ for the simple reason the greater the maturity in an investment then the greater the risk of a price change in interest rates. Investments, corporate financial as well as banking have price risk and reinvestment risk connected with them.
Obviously, if there is an item or deal on offer at any given time, it is advisable to grab the offer because a week later, the same item may cost a lot more due to a rise in price as a direct result if a rise in interest rates.
Different currencies on view
Different currencies on view (Image source: http://farm7.staticflickr.com/6004/5902557577_0cceab6259.jpg)
Foreign Exchange Risks – Risk Factors Involved
Changes in foreign exchange rate values of currencies create two types of risks which are known as transaction risks and translation risks.
Translation risks involve the uncertainty connected to how a foreign currency reacts to what is determined to be a home currency. These are affected by many different factors. When talking about companies, risks could be associated with the fact the organisation deals in foreign currencies or they that the company lists foreign assets to balance sheets, as such the greater the proportion of liability, assets and equity tied up in this way, the bigger the translation risk.
Transactions risks are the reverse as it involves home currency values of transactions which could be affected by any changes in the value of other foreign currencies. Individuals as well as corporations who deal in various currencies risk difficulties due to significant fluctuations in exchange rates that may occur very quickly in a short period of time. However, volatility can usually be hedged (reduced) by swapping currencies. The longer the time between buying a currency and selling it, the greater the transaction risk simply because more time allows any two exchange rates to fluctuate.
When dealing with risk factors connected to finances, the rule of thumb is the higher the return on an investment the bigger the risk factor involved. The reverse is true of lower gains on an investment which normally involves much safer ways of investing money.