Question

1. Determine and evaluate 3 key current risks in the Financial Market today (evaluate the market by data and news and define)
2. Why they critical?
3. EXAMPLES impacting different groups ex. Household, government and financial institution and etc.
4. Consider different securities ex. debt/equity supply/demand and etc
5. Name additional analysis/considiration for this topic

Answer 1

Answer to 1

Market Risk

An investor may experience losses due to factors affecting the overall performance of financial markets. Stock market bubbles and crashes are good examples of heightened market risk. You can’t eliminate market risk, also called systematic risk, through diversification. You can, however, hedge against market risk.

Even though systematic risk affects the entire stock market, the extent to which the market feels the impact can be minimized. Dividend exchange-traded funds (or ETFs), such as the iShares Select Dividend (DVY) or the Vanguard High Dividend Yield ETF (VYM), can be valuable in this regard.

Inflation risk

Inflation risk, also called purchasing power risk, is the chance that the cash flowing from an investment today won’t be worth as much in the future. Changes in purchasing power due to inflation may cause inflation risk. Some ETFs, including the iShares Barclays Treasury Inflation Protected Securities Fund (TIP), invest in U.S. Treasury inflation-protected securities to minimize inflation risk.

Liquidity risk

Liquidity risk arises when an investment can’t be bought or sold quickly enough to prevent or minimize a loss. You can minimize this risk to a good extent by diversifying. A good option is index investing where risk is diversified over the various stocks held in a portfolio tracking a particular index. ETFs such as the SPDR S&P 500 ETF (SPY) and the Vanguard Total Stock Market ETF (VTI) offer this benefit. They invest heavily in stable large-cap U.S. companies like Apple (AAPL) and ExxonMobil (XOM), and so have minimal liquidity risk associated with them.

Inflation risk, also called purchasing power risk, is the chance that the cash flows from an investment won't be worth as much in the future because of changes in purchasing power due to inflation.

How it works (Example):

For example, $1,000,000 in bonds with a 10% coupon might generate enough interest payments for a retiree to live on, but with an annual 3% inflation rate, every $1,000produced by the portfolio will only be worth $970 next yearand about $940 the year after that. The rising inflation means that the interest payments have less and less purchasing power. And the principal, when it is repaid after several years, will buy substantially less than it did when the investor first purchased the bonds.

Some securities attempt to address this risk by adjusting their cash flows for inflation to prevent changes in purchasing power. Treasury Inflation Protected Securities (TIPS) are perhaps the most popular of these securities. They adjust their coupon and principal payments for changes in the consumer price index, thereby giving the investor a guaranteed real return.

Some securities inadvertently provide some load9-risk protection. For example, variable-rate securities provide some protection because their cash flows to the holder (interest payments, dividends, etc.) are based on indices such as the prime rate that are directly or indirectly affected by inflation rates. Convertible bonds also offersome protection because they sometimes trade like bonds and sometimes trade like stocks. Their correlation with stock prices, which are affected by changes in inflation, means convertible bonds provide a little inflation protection.Answer to Part 2,3 and 4

Market risk is the possibility of an investor experiencing losses due to factors that affect the overall performance of the financial markets in which he or she is involved. Market risk, also called "systematic risk," cannot be eliminated through diversification, though it can be hedged against.

Sources of market risk include recessions, political turmoil, changes in interest rates, natural disasters and terrorist attacks.

Market risk and specific risk make up the two major categories of investment risk. The most common types of market risks include interest rate risk, equity risk, currency risk and commodity risk.

Publicly traded companies in the United States are required by the Securities and Exchange Commission (SEC) to disclose how their productivity and results may be linked to the performance of the financial markets. This requirement is meant to detail a company's exposure to financial risk. For example, a company providing derivative investments or foreign exchange futures may be more exposed to financial risk than companies that do not provide these types of investments. This information helps investors and traders make decisions based on their own risk management rules.

In contrast to market risk, specific risk or "unsystematic risk" is tied directly to the performance of a particular security and can be protected against through investment diversification. One example of unsystematic risk is a company declaring bankruptcy, thereby making its stock worthless to investors.

Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade for that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade.

Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other.^[2] This is why liquidity risk is usually found to be higher in emerging markets or low-volume markets.

Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity.

Market and funding liquidity risks compound each other as it is difficult to sell when other investors face funding problems and it is difficult to get funding when the collateral is hard to sell. Liquidity risk also tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk.

A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk example—the two payments are offsetting, so they entail credit risk but not market risk.

Accordingly, liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults.

Why is Inflation risk critical

Although the record inflation of the 1970s is history, inflation risk is still a common worry for income investors. Inflation causes money to lose value, and any investment that involves cashflows over time is exposed to this inflation risk. The ramifications of this can be serious: The investor earns a lower return that he or she originally expected, in some cases causing the investor to withdraw some of a portfolio's principal if he or she is dependent on it for income.

It is important to note that inflation risk isn't the risk that there will be inflation, it is the risk that inflation will be higher than expected. This is one reason investors and analysts speculate considerably about inflation rates and study indicators such as the yield curve to get a feel for where inflation rates are headed. For example, many economists believe that a steep normal yield curve means investors expect higher future inflation and a sharply inverted yield curvemeans investors expect lower inflation.