Answer to Question #209358 in Management for Adam Ahmed Fouad

Question

Financial risks arise from changing market conditions and involve which four factors?

Answer 1

Financial risk refers to the organization's ability to manage debt and fulfil the financial obligations. Financial risk involves four factors which are;

1) EQUITY RISK- This is the risk that stock prices in general will change. In long-term investments, equities provide a return that might exceed the risk free rate of return. Equity risk premium is the difference between return and the risk free rate. It is assumed that higher risk leads higher returns in equity risk. An investor will be compensated for bearing more risk and therefore, more incentive to invest in riskier stock. A significant portion of high risk/ high return investments comes from emerging markets that are perceived as volatile.

2) INTEREST RATE RISK- This is the risk that interest rates change. Change in market rates and their impact on the probability of a bank will lead to interest rate risk. Therefore, this risk can affect the financial position of a bank and may create unfavorable financial results. The potential for the interest rate to change at any given time can have either positive or negative effects for the bank and the consumer. For instance, if a bank gives out a 30-year mortgage at a rate of 4% and the interest rate rises to 6%, the bank loses and the consumer wins. This is an opportunity cost for the bank and a reason why the bank could be affected financially.

3) CURRENCY RISK- This is the risk that foreign exchange rates will change which affects the value of an asset held in that currency. Currency fluctuations in the marketplace can have a drastic impact on an international firm's value because of the price effect on domestic and foreign goods, as well as the value of foreign currency denominate assets and liabilities. When a currency appreciates or depreciates, a firm can be at risk depending on where they are operating and what currency denominations they are holding.

4) COMMODITY RISK- This is the risk that commodity prices will change. There is too much variation between the amount of risks producers and consumers of commodities face in order to have a helpful framework or guide. Commodity price changes will cause financial losses for either commodity buyers or producers. Buyers face the risk that commodity prices will be higher than expected. For example, many furniture manufacturers must buy wood, so higher wood prices increase the cost of making furniture and negatively impact furniture maker profit margins.

Lower commodity prices are a risk for commodity producers. If crop prices are high this year, a farmer may plant more of that crop on less productive land. If prices fall next year, the farmer may lose money on the additional harvest planted on less fertile soil.