Financial Instruments Basic Risks – FAQ | IFRS

Financial instruments Basic risks

Financial instruments Basic risks are risks that apply to any type of financial instrument. However, depending on the relevant financial instrument, one or several of the risks described here below Financial instruments Basic risksmay apply cumulatively, therefore entailing an overall increase in the level of risk incurred by the investor.

1. Economic risk

Changes in the activity of a market economy always influence the prices of financial instruments and exchange rates.

Prices are fluctuating more or less according to the downward or growth trends of the economic activity. The duration and scope of the economic downward or growth trends are variable, as are the repercussions of those variations on the different sectors of the economy. In addition, the economic cycles may vary depending on the different countries.

Failure to take these factors into account as well as a mistaken analysis of the development of the economy when taking an investment decision may lead to losses. In particular, one must take into account the impact of the economic trends on the evolution of investment prices.

Depending, inter alia, of economic trends, good past performance of a financial instrument is no guarantee of good future performance of the same investment. Price losses, entailing losses to the investor, are always possible.

2. Risk of inflation

Losses in value of a currency may cause financial damage to an investor in relation to investments made by the investor. In this context, such a loss in value may have an influence on the actual value of the existing investment portfolio of the investor as well as the actual yield that ought to be realized through this investment portfolio. One should thus take into account actual yields, i.e. the difference between the nominal interest rate and the inflation rate for fixed-rate products.

Therefore, when the inflation rate exceeds the yield generated by the financial instruments (gains in capital and interests), this will lead to a loss in the value of the capital actually invested.

3. Country risk and transfer risk

It may happen that a foreign debtor, although solvent, be unable to pay interest or repay his debts upon maturity or even completely defaults on his debts due to the unavailability of the foreign currency or to currency exchange controls triggered, for instance, by economic, political or social instability in the relevant country.

The ensuing unavailability of the foreign currency or currency exchange controls may indeed lead to defaults on payments for the investors. Concerning financial instruments issued in a foreign currency, the investor risks to receive payments in a currency which turns out not to be convertible anymore because of exchange controls.

Moreover, even in the absence of any crisis, state intervention in some economic sectors (e.g. nationalisation) may have an influence on the value of investors’ assets. In certain extreme cases, investors’ assets can even be confiscated or frozen by local authorities or investors’ rights can be restricted.

As a matter of principle, there is no means to hedge against such risks. However, country ratings published in the financial press can be a useful guide for investors from that point of view. Financial instruments Basic risks

Finally, more generally, instability in the political and/or economic and/or social situation of certain countries may lead to quick price fluctuations. Financial instruments Basic risks

4. Exchange rate risk

Since currency exchange rates fluctuate, there is an exchange rate risk whenever financial instruments are held in a foreign currency (i.e. currency other than the presentation currency of the reporting entity). Depending on exchange rates, the same investment may generate profits or entail losses.

Moreover, since the activities of companies are, to a greater or lesser extent, related to exchange rates, fluctuations in these latter rates are likely to have an impact on the price of the financial instruments they issue. Financial instruments Basic risks

Material elements affecting the exchange rate of currencies are in particular the inflation rate of a country, the gap between domestic interest rates and foreign rates as well as between domestic and foreign productivities, the assessment of economic activity forecasts, the political situation in the world (the political situation in a country is part of country risk) and the safety of investments in general. Additionally, psychological events, such as lack of confidence in political leaders, may weaken the exchange rate of a domestic currency.

5. Liquidity risk

The possibility for an investor to sell financial instruments at any time at market prices is described as liquidity.

Therefore, insufficient liquidity of the market may prevent an investor from selling off financial instruments at market prices. Fundamentally, a distinction has to be made between a lack of liquidity caused by market offer and demand and a lack of liquidity due to the characteristics of the financial instrument or market practices. Financial instruments Basic risks

A lack of liquidity due to market offer and demand arises when the offer or the demand for one financial instrument at a certain price is non-existent or extremely low. Under those circumstances, purchase or sell orders may either not be carried out immediately, and/or only partly (partial execution) and/or at unfavourable conditions.

In addition, higher transaction costs may apply. Financial instruments Basic risks

A lack of liquidity due to the inherent characteristics of the financial instrument or to market practice may occur, for example, because of:

  • a lengthy transcription procedure for a transaction on registered shares,
  • long performance delays because of market practices or other limitations of trade,
  • short-term liquidity needs that cannot be covered quickly enough by the sale of the financial instruments, or
  • long lock-in periods before being entitled to execute a transaction, in particular for alternative investment funds.

6. Psychological riskFinancial instruments Basic risks

Irrational factors may affect the overall evolution of prices, such as for example tendencies, opinions, rumours which may cause important drops in prices, although the financial situation and future perspectives of the relevant companies have not evolved unfavourably.

7. Credit risk Financial instruments Basic risks

Credit-financed purchases of financial instruments contain several additional risks. On the one hand, additional collateral may be required – sometimes at very short notice – in case the credit limit guaranteed is exceeded due to the evolution of the price of the collateral. If the investor turns out to be unable to provide such collateral, the bank may be forced to sell deposited financial instruments at an unfavourable moment. On the other hand, the loss suffered due to an adverse evolution of the price of a financial instrument may exceed the initial investment amount. Fluctuations of prices of the financial instruments constituting the collateral may influence the capacity to repay loans in a negative way.

One needs to be aware that, as a consequence of the leverage effect entailed by the purchase of credit-financed financial instruments, the sensitivity to price fluctuations of those investments will be proportionally more important with the consequence that chances of gains increase, as do the risks of losses. The risks entailed by such investments increase in line with the level of credit-finance leverage.

8. Interest rate risk Financial instruments Basic risks

Generally speaking, fluctuations in interest rates, whether short-term or long-term rates, may have substantial adverse consequences on the prices of financial instruments.

9. Risk of insolvency of the issuer or of the clearing and settlement system

In case of insolvency of the issuer of financial instruments or of the clearing and settlement system on which those instruments are negotiated, an investor may lose part or all the monies invested. Financial instruments Basic risks

10. Additional risks on emerging markets Financial instruments Basic risks

An emerging market is a country that has some characteristics of a developed market but does not satisfy standards to be termed a developed market. This includes countries that may become developed markets in the future. The four largest emerging and developing economies by nominal GDP are/were the BRIC countries (Brazil, Russia, India, and China).

Generally speaking, on these markets, the risks identified above are enhanced. Financial instruments Basic risks

Indeed, political or economic changes (e.g. inflation, exchange rate) will have more influence on investments’ prices in emerging markets than in other countries. Likewise, emerging markets usually react more deeply and durable in case of natural disaster or war.

Moreover, emerging markets often have less elaborated rules for clearance and settlement of transactions with the consequence that processing errors or default in delivery of instruments are more likely to occur. Financial instruments Basic risks

Finally, regulatory supervision over these markets and rules to protect investors are often weak.

11. Other basic risks Financial instruments Basic risks

11.1. Information risk Financial instruments Basic risks

It is the risk of poor investment decisions arising from a lack of information, incomplete information or inaccurate information. This may be due in turn to the use by the investor of unreliable sources, the misinterpretation of originally accurate information by the latter or can be due to communication errors. Financial instruments Basic risks

11.2. Transmission risk Financial instruments Basic risks

When placing an order, the investor must provide certain details necessary for its execution by the bank (financial instrument, type of order, volume, execution date, etc…). The more precise the order placed is, the smaller the risk of transmission error is.

11.3. Risks pertaining to transaction costs Financial instruments Basic risks

The intermediate/bank, as well as other domestic or foreign-based parties, may be involved in the execution of an order (e.g. brokers), in which case the fees and commissions of these persons will be passed on to the investor. Financial instruments Basic risks

An investment becomes profitable only once all these costs have been covered. Financial instruments Basic risks

See also: The IFRS Foundation

Financial instruments Basic risks

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