Investment Risk & Its Types.

Smart investing includes risk management. For each stock, bond, mutual fund or other investment you purchase, there are three distinct risks you must guard against; they are business risk, valuation risk, and force of sale risk. In this article, we are going to examine each type and discover ways you can protect yourself from financial disaster. Investment Risk #1: Business Risk:
Business risk is, perhaps, the most familiar and easily understood. It is the potential for loss of value through competition, mismanagement, and financial insolvency. There are a number of industries that are predisposed to higher levels of business risk (think airlines, railroads, steel, etc).
The biggest defense against business risk is the presence of franchise value. Companies that possess franchise value are able to raise prices to adjust for increased labor, taxes or material costs. The stocks and bonds of commodity-type businesses do not have this luxury and normally decline significantly when the economic environment turns south.
Investment Risk #2: Valuation Risk:
Recently, I found a company I absolutely love (said company will remain nameless). The margins are excellent, growth is stellar, there is little or no debt on the balance sheet and the brand is expanding into a number of new markets. However, the business is trading at a price that is so far in excess of it’s current and average earnings, I cannot possibly justify purchasing the stock.
Why? I’m not concerned about business risk. Instead, I am concerned about valuation risk. In order to justify the purchase of the stock at this sky-high price, I have to be absolutely certain that the future growth prospects will increase my earnings yield to a more attractive level than all of the other investments at my disposal.
The danger of investing in companies that appear overvalued is that there is normally little room for error. The business may indeed be wonderful, but if it experiences a significant sales decline in one quarter or does not open new locations as rapidly as it originally projected, the stock will decline significantly. This is a throw-back to our basic principle that an investor should never ask "Is company ABC a good investment"; instead, he should ask, "Is company ABC a good investment at this price."
Investment Risk #3: Force of Sale Risk:
You’ve done everything right and found an excellent company that is selling far below what it is really worth, buying a good number of shares. It’s January, and you plan on using the stock to pay your April tax bill.
By putting yourself in this position, you have bet on when your stock is going to appreciate. This is a financially fatal mistake. In the stock market, you can be relatively certain of what will happen, but not when. You have turned your basic advantage (the luxury of holding permanently and ignoring market quotations), into a disadvantage.
Consider the following: If you had purchased shares of great companies such as Coca-Cola, Berkshire Hathaway, Gillette and Washington Post at a decent price in 1987 yet had to sell the stock sometime later in the year, you would have been devastated by the crash that occurred in October. Your investment analysis may have been absolutely correct but because you imposed a time limit, you opened yourself up to a tremendous amount of risk.

Types of Investments

The term "investment" is used differently in economics and in finance. Economists refer to a real investment (such as a machine or a house), while financial economists refer to a financial asset, such as money that is put into a bank or the market, which may then be used to buy a real asset.

Business management:
The investment decision (also known as capital budgeting) is one of the fundamental decisions of business management: Managers determine the investment value of the assets that a business enterprise has within its control or possession. These assets may be physical (such as buildings or machinery), intangible (such as patents, software, goodwill), or financial (see below). Assets are used to produce streams of revenue that often are associated with particular costs or outflows. All together, the manager must determine whether the net present value of the investment to the enterprise is positive using the marginal cost of capital that is associated with the particular area of business.
In terms of financial assets, these are often marketable securities such as a company stock (an equity investment) or bonds (a debt investment). At times the goal of the investment is for producing future cash flows, while at others it may be for purposes of gaining access to more assets by establishing control or influence over the operation of a second company (the investee). Economics:
In economics, investment is the production per unit time of goods which are not consumed but are to be used for future production. Examples include tangibles (such as building a railroad or factory) and intangibles (such as a year of schooling or on-the-job training). In measures of national income and output, gross investment (represented by the variable I) is also a component of Gross domestic product (GDP), given in the formula GDP = C + I + G + NX, where C is consumption, G is government spending, and NX is net exports. Thus investment is everything that remains of production after consumption, government spending, and exports are subtracted.
Both non-residential investment (such as factories) and residential investment (new houses) combine to make up I. Net investment deducts depreciation from gross investment. It is the value of the net increase in the capital stock per year.
Investment, as production over a period of time ("per year"), is not capital. The time dimension of investment makes it a flow. By contrast, capital is a stock, that is, an accumulation measurable at a point in time (say December 31).
Investment is often modeled as a function of Income and Interest rates, given by the relation I = f(Y, r). An increase in income encourages higher investment, whereas a higher interest rate may discourage investment as it becomes more costly to borrow money. Even if a firm chooses to use its own funds in an investment, the interest rate represents an opportunity cost of investing those funds rather than lending out that amount of money for interest.
Finance:
In finance, investment is the commitment of funds by buying securities or other monetary or paper (financial) assets in the money markets or capital markets, or in fairly liquid real assets, such as gold, real estate, or collectibles. Valuation is the method for assessing whether a potential investment is worth its price. Returns on investments will follow the risk-return spectrum.
Types of financial investments include shares, other equity investment, and bonds (including bonds denominated in foreign currencies). These financial assets are then expected to provide income or positive future cash flows, and may increase or decrease in value giving the investor capital gains or losses.
Trades in contingent claims or derivative securities do not necessarily have future positive expected cash flows, and so are not considered assets, or strictly speaking, securities or investments. Nevertheless, since their cash flows are closely related to (or derived from) those of specific securities, they are often studied as or treated as investments.
Investments are often made indirectly through intermediaries, such as banks, mutual funds, pension funds, insurance companies, collective investment schemes, and investment clubs. Though their legal and procedural details differ, an intermediary generally makes an investment using money from many individuals, each of whom receives a claim on the intermediary.
Personal finance:
Within personal finance, money used to purchase shares, put in a collective investment scheme or used to buy any asset where there is an element of capital risk is deemed an investment. Saving within personal finance refers to money put aside, normally on a regular basis. This distinction is important, as investment risk can cause a capital loss when an investment is realized, unlike saving(s) where the more limited risk is cash devaluing due to inflation.
In many instances the terms saving and investment are used interchangeably, which confuses this distinction. For example many deposit accounts are labeled as investment accounts by banks for marketing purposes. Whether an asset is a saving(s) or an investment depends on where the money is invested: if it is cash then it is savings, if its value can fluctuate then it is investment.
Real estate:
In real estate, investment money is used to purchase property for the purpose of holding or leasing for income and there is an element of capital risk.
Residential real estate:
The most common form of real estate investment as it includes property purchased as a primary residence. In many cases the buyer does not have the full purchase price for a property and must engage a lender such as a bank, finance company or private lender. Different countries have their individual normal lending levels, but usually they will fall into the range of 70-90% of the purchase price. Against other types of real estate, residential real estate is the least risky.
Commercial real estate:
Commercial real estate consists of multifamily apartments, office buildings, retail space, hotels and motels, warehouses, and other commercial properties. Due to the higher risk of commercial real estate, loan-to-value ratios allowed by banks and other lenders are lower and often fall in the range of 50-70%..

Investment

Investment or investing is a term with several closely-related meanings in busines management, finance and economics, related to saving or deferring consumption. Investing is the active redirecting resources from being consumed today so that they may create benefits in the future; the use of assets to earn income or profit.
An investment is the choice by the individual to risk his savings with the hope of gain. Rather than store the good produced, or its money equivalent, the investor chooses to use that good either to create a durable consumer or producer good, or to lend the original saved good to another in exchange for either interest or a share of the profits.
In the first case, the individual creates durable consumer goods, hoping the services from the good will make his life better. In the second, the individual becomes an entrepreneur using the resource to produce goods and services for others in the hope of a profitable sale. The third case describes a lender, and the fourth describes an investor in a share of the business.
In each case, the consumer obtains a durable asset or investment, and accounts for that asset by recording an equivalent liability. As time passes, and both prices and interest rates change, the value of the asset and liability also change.
An asset is usually purchased, or equivalently a deposit is made in a bank, in hopes of getting a future return or interest from it. The word originates in the Latin "vestis", meaning garment, and refers to the act of putting things (money or other claims to resources) into others' pockets. See Invest. The basic meaning of the term being an asset held to have some recurring or capital gains. It is an asset that is expected to give returns without any work on the asset per se.

Islamic Finance news.

Islamic finance has come a long way since its active re-introduction about 25 years ago. Presently, it is estimated that Islamic banks and financial institutions manage some US$200 billion of funds all over the world. Although small in terms of the total global assets managed by financial intermediaries, the growth rate is impressive by any standards.
Over the last few years the whole Islamic finance movement has been given a major boost by the rise of Bahrain as a key intermediation centre in this market and by Malaysia’s decision to adopt Shari’a compliant financial instruments as an integral component of its growing market.
As a result of these developments Islamic financial institutions have developed a vast range of products designed to serve the growing market. These cater for housing and consumer finance, business loans and project funding. Lately, Malaysia and Bahrain have been instrumental in launching tradeable securities. These should create much needed liquidity and a secondary market for institutional investors in the Islamic finance market. Several “Islamic equity” investment funds have also been launched, with both FTSE and Dow Jones providing indices to monitor this growing market.
Bodies have already sprung up to address issues of accounting and auditing standards, Shari’a compliance, and central bank regulation. In the beginning of November the Islamic Financial Services Board (IFSB) will be launched in Malaysia. This initiative of D-8 countries will lay the foundation of the regulation of the Islamic Finance market on a consistent basis.
As was to be expected the major instruments utilised by the Islamic banks are those which approximate closely to those in the conventional banking market. In particular, there is still a dearth of pure risk sharing instruments where gains and losses are shared equitably between investors and operators. With the emergence of quoted tradeable instruments this anomaly is expected to be addressed in the next generation of products.
Finally, in countries like the United Kingdom, much progress has been made towards launching mainstream housing and other consumer finance products compliant with the Sha’ria. Following a long period of consultation and advocacy, agreement is close to allow such products to be launched on a competitive basis. It is expected that within the next six months one will see many such products being marketed from high street financial institutions in the UK. This is expected to be followed by similar initiatives amongst the twenty million Muslims in Europe and the United States.
As Islamic finance will arrive on the high streets of many countries, the challenge would be to operationalise the equity considerations of the Sha’ria and make this mode of financing widely accepted amongst a constituency which transcends Muslim communities.

International Finance. .

International Finance can be defined as the branch of economics which studies the dynamics of exchange rates and foreign investment and studies how these affect international trade. Financing is defined as the methodology of allocating financial resources or funds to maximize returns on a productive enterprise. It can also be dealt as a study of the ways individuals, businesses and organizations raise, allocate and manage monetary resources over time taking into account the associated risks. Financing can also be labeled as effective management of wealth and other assets. In terms of corporate or business finance, financing is known as the science of allocating financial resources such as stocks, bonds and other portfolio investments in an optimal manner to maximize the wealth or income of the business unit. The major decisions undertaken for the successful allocation process takes into account capital budgeting, financing and dividend policy. While capital budgeting takes into account the Internal Rate of Return (IRR) on the invested capital, the financing decisions are rested on the financing options available to a company to raise resources for the organization or company in question. In terms of the IRR or the Net Present Value (NPV), the capital invested is said to give a positive yield or return if the IRR or NPV is found to be greater than the cost of invested capital defined as the total financial resources in vested in a business. Financing deals with investing in debts (bonds or loans from lending institutions) or equities (common stock or preferred stock) and dividend policy is concerned with dividing the gains through corporate finance among the stockholders of the company in terms of dividends.
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International Finance is concerned with the same methodology of allocating financial resources and about international trade but is constrained by the movements of capital and currencies between countries and the difference in the exchange rates between different currencies. The capital budgeting techniques used in this case as against traditional finance entails international cash flows and local tax rates and the required return on investment or the cost of capital adjusted for the degree of risk in that country or the sensitivity of the project. Foreign capital markets are a major source of equity and debts for most domestic and foreign subsidiary operations. International trade is heavily influenced by the volatility in the foreign capital markets and the limited steps to full capital account convertibility undertaken by many countries. Exchange rates, as mentioned previously, are a predominant factor in determining international finance as international exports or imports can suffer losses in earnings as a result of exchange rate fluctuations. Forward Currency Contracts between the two concerned parties can help to somewhat avert this possibility. One of the leading international bodies promoting sustainable private sector investment in developing countries thereby increasing its growth potential and the possibility of trade interactions with the developed world is the International Finance Corporation (IFC). Established in 1956, IFC is a member of the World Bank Group and is the largest multilateral source of loan and equity financing for private sector projects in the developing countries. In addition to providing technical assistance to businesses and governments in the developing world, it helps private companies in the developing nations mobilize resources in the international financial markets. International Finance is now becoming all the more encompassing with issues such as fair trade, globalization, Multi-national corporations and multinational banking coming under its ambit. With globalization becoming the buzz word of the modern era, rapidly integrating world production, consumption markets and the widespread diffusion of modern technology has contributed to the widening of the sphere of international finance. International Finance should effectively address these issues and the problem of exploitation by MNC’s of the physical and human resources of poor developing countries can also be ameliorated by the principles of International Finance.

Financial Intermediary

A financial intermediary is an individual, or, more often, a financial institution that mediates between two or more parties in a financial context. Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities. The classic example of a financial intermediary is a bank that transforms bank deposits into bank loans. As such, financial intermediaries channel funds from people who have extra money (savers) to those who do not have enough money to carry out a desired activity (borrowers). Typically the first party is a provider of a product or service and the second party is a consumer or customer.
In the U.S., a financial intermediary is typically an institution that facilitates the channelling of funds between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers). This may be in the form of loans or mortgages. Alternatively, they may lend the money directly via the financial markets, which is known as financial disintermediation.
>Functions performed by financial intermediaries:
Financial intermediaries perform five major functions
(1) they facilitate the acquisition of payment for goods and services, e.g. through the use of cheques;
(2) the financial system provides economies of scale and economies of scope that allow an individual to invest in a portfolio of assets, which would be much more difficult in the absence of financial intermediaries;
(3) they ease the liquidity constraint on households and firms which arises when the liquidity available for certain purchases is at variance with the immediate flow of income available; e.g. the use of mortgages allows households to purchase homes today instead of thirty years from now when they have saved up enough money to pay for it;
(4) they allow for the spreading of risk e.g. bank loans spread the costs over all customers in the event of default;
(5) they can reduce the risk of moral hazard and adverse selection created by the information asymmetry that exists between lender and borrower (the lender usually has incomplete information about how the borrower will use the money loaned) because financial intermediaries can develop expertise in things like monitoring borrowers' activities and market conditions.
>Types of financial intermediary:
-Financial intermediaries include:
-Banks
-Building societies
-Credit unions
-Financial advisers or brokers
-Insurance companies
-Collective investment schemes
-Pension funds

Raising Capital.

To understand financial markets, let us look at what they are used for, i.e. what is their purpose? Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend money in the form of loans and mortgages.
More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. A good example of a financial market is a stock exchange. A company can raise money by selling shares to investors and its existing shares can be bought or sold.

financial markets fit in the relationship between lenders and borrowers:
>Lenders:
1.Individuals.
Many individuals are not aware that they are lenders, but almost everybody does lend money in many ways. A person lends money when he or she:
-Puts money in a savings account at a bank;
-Contributes to a pension plan;
-Pays premiums to an insurance company;
-Invests in government bonds; or
-Invests in company shares.
2.Companies.
Companies tend to be borrowers of capital. When companies have surplus cash that is not needed for a short period of time, they may seek to make money from their cash surplus by lending it via short term markets called money markets.
There are a few companies that have very strong cash flows. These companies tend to be lenders rather than borrowers. Such companies may decide to return cash to lenders (e.g. via a share buyback.) Alternatively, they may seek to make more money on their cash by lending it (e.g. investing in bonds and stocks.)
>Borrowers:
Individuals borrow money via bankers' loans for short term needs or longer term mortgages to help finance a house purchase.
Companies borrow money to aid short term or long term cash flows. They also borrow to fund modernisation or future business expansion.
Governments often find their spending requirements exceed their tax revenues. To make up this difference, they need to borrow. Governments also borrow on behalf of nationalised industries, municipalities, local authorities and other public sector bodies. In the UK, the total borrowing requirement is often referred to as the Public sector net cash requirement (PSNCR).
Governments borrow by issuing bonds. In the UK, the government also borrows from individuals by offering bank accounts and Premium Bonds. Government debt seems to be permanent. Indeed the debt seemingly expands rather than being paid off. One strategy used by governments to reduce the value of the debt is to influence inflation.
Municipalities and local authorities may borrow in their own name as well as receiving funding from national governments. In the UK, this would cover an authority like Hampshire County Council.
Public Corporations typically include nationalised industries. These may include the postal services, railway companies and utility companies.
Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid of Foreign exchange markets.