Financial Transactions & Risk Exposures

FIN/366

Financial Transactions & Risk Exposures

Just as there are many different types of financial transactions there are also a variety of risk exposures. Financial transactions can be influenced by interest rates, interest income, and sometimes both. In this paper I will discuss the different types of risk and the type of transactions that are exposed to. Also the features used to measure interest risks.

Interest Rate Risk

Interest rate risk is the danger lenders and borrowers face when dealing with bonds or commercial loans. These type of investments are affected as interest rates change so if there is drop in interest rates yields decrease in said bonds or loans. This means the cost of the bond could potentially decrease in order for it to compete with newly issued bonds. But in effect, if interest rates rise the return on such investments also increase.

Credit Risk

Credit risk is refers to the potential failure of repayment by the borrower. Commercial loans, mortgage loans, and corporate bonds are some examples of financial transactions that face credit risk exposure. When creditors loan funds there is the possibility that the borrower will default on the loans. Borrowers are rated to help investors ensure that they will be paid. If borrowers are considered high risk of default then lenders will expect to charge more based on the higher risk. Higher risk means higher interest rates.

Technology Risk

This risk arises when there are business acquisitions or two companies, banks, or organizations merge together. When a company buys another company there is a chance that their technologies will not align. This is likely to happen when companies conduct business internationally, especially if it is with a less developed country. The technologies and systems would not merge with each other simply which could result in more expenses.

Foreign Exchange Risk

Foreign exchange risk is the possibility that the value of an investment may decrease because of changes in the value of the currencies held. Companies are exposed to this type or risk when conducting business in countries other than the one they are based out of. Increase or decrease of the value of the currencies involved would have a direct impact on cashflow. Investors who buy and trade internationally are also exposed to foreign exchange risk. This affects both the cost and interest income for investors.

Country Risk

This type of risk refers to the unpredictability of investing in another country. The risk of investing in another country is based on many different reasons. Some reasons are political, economic, foreign exchange rate, and even technological matters. All of these factors can stand in the way of investors receiving payment. Investors or companies should carefully consider country risk when thinking about investing in a less developed country. The political stability of a nation is of high importance for investors to be less at risk of loss. High country risk can have reduce the expected return on securities being issues or business being conducted in that country. Which is why investors would demand a higher return or higher interest rate to compensate for the high level of risk they are exposed to.

Measuring Interest Risk

Interest rate risk can be measured by assessing how the value of a security or bond is affected by the changes in interest rates. Investors in short term money market securities is not really affected when interest rates rise because their securities will mature soon and can quickly reinvest them into the higher-rate securities. And investor with a longer term maturity, say 10 years, is stuck in the lower rate until their maturity date. The expected return on long-term securities is much higher than short-term securities due to the higher risk of interest rate risk.

Conclusion

Financial transactions conducted either domestically or internationally have to be carefully made due to the many different risks that they can potentially be exposed to. Investors and businesses can be exposed to interest rate risk, credit risk, technology risk, foreign exchange risk, and country risk. Some can even be exposed to every single risk that was just listed. Interest rate risk is the possibility of being exposed to changing interest rates. Credit risk is the possibility of not being paid the borrower or buyer. Technology risk refers to the chance of not being able to merge the technologies of your current organization with the one being acquired. Foreign exchange risk is that faced when the value of the currencies involved fluctuate which can result in a loss depending on the scenario. Country risk is a risk that involves political, economic, and technological risk all in one. If an investor decides to conduct business in a less developed country the possibility of them being exposed to every risk listed is quite likely. This would mean they are high risk and the return expected by investors would be just as high. Being informed of all of these risk factors is very important for investors and businesses alike.