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What does it mean to Accept Risk?

The notion of who bears risk for various sorts of failures, circumstances, or losses is a prevalent one in the financial world, and many institutions make all of their money accepting risks. To accept a risk is to bear the burden of loss or replacement if an event occurs that causes an asset to lose value or disappear. There is a bright side to this, however. There is a real and theoretical “risk premium” due to those who accept a risk. Continue reading...

What is Risk?

Risk can be defined as exposure to the possibility of loss of an asset. Risk might be used to denote the cause of the potential loss, or the probability of the loss. In finance, it is common to hear about the correlation between risk and return; more risk may yield a higher return, but it also has the potential for more loss. The situation requires that an investor willing to take such a risk must provide the capital to fund the investment which may grow or may fail. Continue reading...

What is currency risk?

Countries, investors, and international businesses have to frequently assess currency risk, which is the chance that exchange rates will change unfavorably at inopportune times. An investment in a foreign security or company, or income payments coming from foreign sources, can be at risk for exchange rate changes. If an investor or company has financial interests which are based in another currency, or if the investor engages in Forex trading, currency risk looms over the future value of the holdings, on top of any typical market risk. Continue reading...

What is Systematic Risk?

Systematic risk is the broad risk of fluctuations and downturns in the market as a whole, which it is said cannot be eliminated through diversification. Systematic risk is also known as market risk, which is the exposure of all investors to the broad movements and downturns of the market as a whole. Theoretically it cannot be controlled for through simple diversification, since that would only bring a portfolio closer to the broad market performance, with a Beta closer to 1. Continue reading...

What is Unsystematic Risk?

Unsystematic risk is idiosyncratic or unique risk that does not reflect a direct correlation with the risk present in the market, or systematic risk. Most securities and portfolios experience risk and variations which are not attributable to the market as a whole, and this is known as unsystematic risk. Systematic risk, on the other hand, is the risk borne by all investors in the market, where broad changes in the market cannot be avoided through diversification of a portfolio. Continue reading...

What is market risk?

Market risk is the chance that an investment will not maintain its value when it is dependent on the many factors that influence the health of the economy and the stock market. Investors must be aware that investing money in a stock or mutual fund is to tie the fate of that money to the fate of the company or companies that they have invested in. The other side of the coin, of course, is the potential for gains. The potential gains of an investment are the premium that is paid to an investor in exchange for allowing a company or mutual fund to take risks with the investor’s money. Continue reading...

What is the Equity Risk Premium?

The Equity Risk Premium (aka, Equity Premium) is the expected return of the stock market over the risk-free rate (U.S. Treasuries). This number basically refers to the amount an investor should expect in exchange for accepting the risk inherent in the stock market. The size of the equity risk premium varies depending on the amount of risk of a portfolio, the market, or a specific holding investment, against the risk-free rate. Continue reading...

What is Counter-Party Risk?

Counter-party risk is the risk that the person on the other side of the trade will not meet his or her contractual obligations. In other words, it’s essentially the risk of doing business with someone. In financial contracts, counter-party risk is also known as “default risk.” Continue reading...

What are the Risks Associated With Stocks?

Stocks are inherently risky, and an investor has risk of capital loss. As with most things in life, no risk yields no return. Theoretically, the greater the risk, the greater the potential return. A new company which has not established itself yet will have a decent chance of crashing and an investor can lose all invested capital. But — what if it takes off? Your potential gains in such a situation are potentially vast. There is a point when the rate of increased return per degree of risk begins to slow down. Continue reading...

What Does Market Risk Premium mean?

Market Risk Premium refers to the expected return on a risk asset, minus the risk-free rate. A good barometer for the risk-free rate is using a U.S. Treasury bond, which is largely considered a risk-less asset if held to maturity. To give an example, let’s say the annual expected return on Stock ABC is 11%, and a 1-year U.S. Treasury pays 2%. In this case, the market risk premium is the difference between the two, or 9%. Continue reading...

What is the Risk/Return Trade-Off

There are investments which have the potential for very high returns, but they will always be that much riskier than the lower-yielding alternatives, and this is part of the risk/return trade-off. The relationship between risk and return is a positive linear relationship in most theoretical depictions, and if an investor seeks greater returns, he or she will have to take on greater risk. This is called the risk/return trade-off. For more stability and less risk, an investor will have to sacrifice some potential returns. Continue reading...

What are Risk-Weighted Assets?

International banking regulations set forth in the Basel Accords require that institutions maintain a certain amount of capital relative to the amount of risk-weighted assets (RWA) they have. Conservative investments such a treasury notes have a risk weighting of zero, while corporate bonds have a weighting of .20, and so forth. The exact weighting system is laid out in Basel agreements. The system is designed to reveal a bank’s level of exposure to potential losses, and the capital requirements are there to balance out the risks and to protect the global economy from a meltdown in the financial system. Continue reading...

What is the ‘Risk-Free Rate of Return’?

The risk-free rate of return is the rate an investor can get on a risk-free asset at a given time. It is usually the current yield on a 10-year treasury, which is backed by the full faith and credit of the US Government and is considered risk-free. The risk-free rate is used in several calculations and considerations in finance, to show what return can be earned in the current market environment without being exposed to any risk. Continue reading...

How Do I Measure My Risk Tolerance?

Your risk tolerance should be a measure of how willing you are to absorb losses in your portfolio. Studies in behavioral science show that investors loathe losses about two and a half times more then they enjoy gains. Everyone can likely relate to this stat. But, to be a successful investor that achieves long-term equity like returns, one has accept some level of risk inherent in the stock market. Continue reading...

What is the “Riskless” (or Risk-Free) Rate of Return?

For comparisons of the risk/return ratio of an investment, one must start with a benchmark of a risk-free rate of return in the current market. Since U.S. Treasury bills are backed by the full faith, credit, and taxing power of the U.S. Government, they are considered “riskless,” or as close to riskless as we can get. The current yield on a 10-year Treasury note is generally considered the risk-free rate of return. Continue reading...

Should I buy other currencies?

The U.S. dollar is the world’s reserve currency, so generally speaking, if you are not planning to travel to foreign countries or do not have the need for foreign currencies in your business, you might as well stay with U.S. dollars. If you are using foreign currencies in your investment portfolio, you must be prepared for volatility and continue to educate yourself on the Forex market as well as international trade. The famous example of George Soros, who almost destroyed the Bank of England, and made a couple of billion dollars along the way, might not necessarily be applicable to you. Continue reading...

What is a Bank Guarantee?

When a lending institution offers a Bank Guarantee, they are reducing the risk involved in a transaction by guaranteeing payment to the seller. Bank Guarantees often come into play with deals made internationally, where the participants in the deal prefer to have some assurances before they do business. The guarantee acts as insurance to protect the parties involved in transactions where they are not fully able to assess the strength and reliability of the other, such as when small companies bid for projects or when bids for a job come-in from around the world. Continue reading...

What is an Accounting Standard?

Accounting standards are the practices which make financial information uniform and normalized between various businesses and accounting firms. Accounting standards constitute what is known as GAAP: Generally Accepted Accounting Principles. These may apply to how revenue is recognized, how assets are classified, acceptable methods of depreciating assets, and so on. Some of these are based on IRS opinions and the jurisprudence of the law, some are just industry best-practices that are widely used. Continue reading...

What are Debt Ratios?

Debt ratios give a relative picture of a company’s ability to repay debts, make interest payments, and meet other financial obligations. They generally compare the level of debt in a company to the level of assets. Debt ratios are key for investors and particularly creditors, to determine the overall level of financial risk faced by a company. Debt ratios that increasingly turn unattractive can serve as “canaries in a coal mine” that a company is in danger of bankruptcy or default. There are several types of debt ratios, such as debt-to-equity, debt-to-capital, cash flow to debt, and so on. Continue reading...

What is the Capital Market Line?

The Capital Market Line is a complex concept, but put simply, it is a calculation meant to give the investor/analyst a range of potential returns for a portfolio, based on the risk free rate and the standard deviation of the portfolio. The Capital Market Line is a part of the capital asset pricing model (CAPM) that solves for expected return at various levels of risk. It takes into consideration a portfolio’s risk assets and the risk-free rate. Continue reading...