10:28 pm - Monday December 18, 2017

Risks associated with investments

In any investment, an investor is exposed to several kinds of risks. The risks associated with investments are liquidity risk, market risk, credit risk, operational risk, prepayment risk and extension risk. If the investor decides to go in for commodity investment, besides these risks, s/he is also exposed to basis risks.

Liquidity risk

This is also called as marketability risk. Sometimes, the investments are less frequently traded and the investor may find it difficult to exit the investment. Then the investor is said to be facing liquidity risk. An investment is liquid investment if it can be sold easily without significant price effects. The direct fall out of the liquidity risk could be capital loss.

Market risk

Price risk

The value of the investment may go up or down on account of price fluctuations. This risk is known as price risk.

Interest rate risk

The major risk facing all investors is interest rate risk. The prices of investments move inversely with changes in interest rates (particularly financial investments like bonds)

Exchange rate risk

The investment’s value will change if the underlying currency exchange rate changes. The risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates is called as exchange rate or currency risk.

Credit risk

The possibility of a loss occurring due to the failure to meet contractual debt obligations is called credit risk. When an economy is strong, borrowers are expected to have little difficulty meeting their obligations and the premium required by investors in investments will be small. If the economy is seen to be slowing or in recession, however, investors in investments will demand wider spreads to compensate for the risk that individual borrower will encounter financial distress and default on his/her loans

Operational risk

Operational risk can pose a threat to the performance, reputation and bottom line results. These risks can come in a number of forms such as environment risk, process risk, information for decision-making risk, etc

Prepayment risk

One of the greatest risks faced by the investors in investments is that individual borrowers may pay part or the entire principal of their loans ahead of schedule. This occurs most often at a time of declining interest rates, and can force the owners of the investment to reinvest the prepaid funds at a lower rate of interest than they had expected to receive

Extension risk

This is the reverse of prepayment risk. If the market interest rates rise, the average term of the investment may be higher than expected as borrowers avoid prepayment, causing investors in the investment to be stuck with a comparatively low yielding asset for longer period than they anticipated. Extension risk, like prepayment risk, is difficult to model accurately.

Commodity risks

In practice, there are limited ranges of traded commodities on which derivatives are available. This requires the use of correlation relationships to hedge/trade exposures. This creates exposure to basis risk

Basis risk – Quality/Grade Risk

This refers to the risk involving product specification (quality, grade and size).

Basis risk – Location Risk

The underlying commodity must be physically delivered at a specific location. Significant price differences can exist between locations. This reflects the supply demand condition in the relevant location and the cost of transportation of the commodity between locations. The price differentials between delivery locations can change rapidly

Event risk

This refers to events in individual commodity markets that have significantly affected prices. Examples of event risk affecting commodity prices include the Gulf War, Iraq War, the Hamanaka Copper Scandal and the decision by Central Banks to halt Gold sales.

Thus all these risks may arise due to any factor that influence the potential stream of returns from holding an investment by an investor.

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