Financial riskFinancial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent. A science has evolved around managing market and financial risk under the general title of modern portfolio theory initiated by Harry Markowitz in 1952 with his article, "Portfolio Selection".
Liquidity riskLiquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price. Market liquidity – An asset cannot be sold due to lack of liquidity in the market – essentially a sub-set of market risk.
Exchange rateIn finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of the euro. The exchange rate is also regarded as the value of one country's currency in relation to another currency. For example, an interbank exchange rate of 131 Japanese yen to the United States dollar means that ¥131 will be exchanged for or that will be exchanged for ¥131.
Risk premiumA risk premium is a measure of excess return that is required by an individual to compensate being subjected to an increased level of risk. It is used widely in finance and economics, the general definition being the expected risky return less the risk-free return, as demonstrated by the formula below. Where is the risky expected rate of return and is the risk-free return. The inputs for each of these variables and the ultimate interpretation of the risk premium value differs depending on the application as explained in the following sections.
Liquidity crisisIn financial economics, a liquidity crisis is an acute shortage of liquidity. Liquidity may refer to market liquidity (the ease with which an asset can be converted into a liquid medium, e.g. cash), funding liquidity (the ease with which borrowers can obtain external funding), or accounting liquidity (the health of an institution's balance sheet measured in terms of its cash-like assets). Additionally, some economists define a market to be liquid if it can absorb "liquidity trades" (sale of securities by investors to meet sudden needs for cash) without large changes in price.
Foreign exchange marketThe foreign exchange market (forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit market. The main participants in this market are the larger international banks.
Covered interest arbitrageCovered interest arbitrage is an arbitrage trading strategy whereby an investor capitalizes on the interest rate differential between two countries by using a forward contract to cover (eliminate exposure to) exchange rate risk. Using forward contracts enables arbitrageurs such as individual investors or banks to make use of the forward premium (or discount) to earn a riskless profit from discrepancies between two countries' interest rates. The opportunity to earn riskless profits arises from the reality that the interest rate parity condition does not constantly hold.
RiskIn simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environment), often focusing on negative, undesirable consequences. Many different definitions have been proposed. The international standard definition of risk for common understanding in different applications is "effect of uncertainty on objectives".
Subprime mortgage crisisThe United States subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the 2007–2008 global financial crisis. The crisis led to a severe economic recession, with millions of people losing their jobs and many businesses going bankrupt. The U.S. government intervened with a series of measures to stabilize the financial system, including the Troubled Asset Relief Program (TARP) and the American Recovery and Reinvestment Act (ARRA).
2007–2008 financial crisisThe 2007–2008 financial crisis, or Global Financial Crisis (GFC), was a severe worldwide economic crisis that occurred in the early 21st century. It was the most serious financial crisis since the Great Depression (1929). Predatory lending targeting low-income homebuyers, excessive risk-taking by global financial institutions, and the bursting of the United States housing bubble culminated in a "perfect storm". Mortgage-backed securities (MBS) tied to American real estate, as well as a vast web of derivatives linked to those MBS, collapsed in value.
Foreign exchange riskForeign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of an unfavourable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed. Foreign exchange risk also exists when the foreign subsidiary of a firm maintains financial statements in a currency other than the domestic currency of the consolidated entity.
Market riskMarket risk is the risk of losses in positions arising from movements in market variables like prices and volatility. There is no unique classification as each classification may refer to different aspects of market risk. Nevertheless, the most commonly used types of market risk are: Equity risk, the risk that stock or stock indices (e.g. Euro Stoxx 50, etc.) prices or their implied volatility will change. Interest rate risk, the risk that interest rates (e.g. Libor, Euribor, etc.) or their implied volatility will change.
Market liquidityIn business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the price at which an asset can be sold, and how quickly it can be sold. In a liquid market, the trade-off is mild: one can sell quickly without having to accept a significantly lower price. In a relatively illiquid market, an asset must be discounted in order to sell quickly.
Capital asset pricing modelIn finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.
Interest rate parityInterest rate parity is a no-arbitrage condition representing an equilibrium state under which investors interest rates available on bank deposits in two countries. The fact that this condition does not always hold allows for potential opportunities to earn riskless profits from covered interest arbitrage. Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic and foreign assets.
Asset pricingIn financial economics, asset pricing refers to a formal treatment and development of two main pricing principles, outlined below, together with the resultant models. There have been many models developed for different situations, but correspondingly, these stem from either general equilibrium asset pricing or rational asset pricing, the latter corresponding to risk neutral pricing.
Carry (investment)The carry of an asset is the return obtained from holding it (if positive), or the cost of holding it (if negative) (see also Cost of carry). For instance, commodities are usually negative carry assets, as they incur storage costs or may suffer from depreciation. (Imagine corn or wheat sitting in a silo somewhere, not being sold or eaten.) But in some circumstances, appropriately hedged commodities can be positive carry assets if the forward/futures market is willing to pay sufficient premium for future delivery.
Credit riskCredit risk is the possibility of losing a lender holds due to a risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs.
Financial crisisA financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults.
Foreign exchange reservesForeign exchange reserves (also called forex reserves or FX reserves) are cash and other reserve assets such as gold held by a central bank or other monetary authority that are primarily available to balance payments of the country, influence the foreign exchange rate of its currency, and to maintain confidence in financial markets. Reserves are held in one or more reserve currencies, nowadays mostly the United States dollar and to a lesser extent the euro.
