Posted on: 22 May, 2019
Every investment or saving product has different risk and returns profile. Generally, for higher risk investors demand higher returns. For example, since stocks are riskier than fixed deposits, a rational investor will expect to earn a higher return from stocks compared to fixed deposits.
In Bangladesh, there is a tendency for investors to only concentrate on higher returns and ignore the risk part completely. This is why so many people in Bangladesh get caught in MLM (Multi-level marketing) Ponzi schemes. They concentrate on the upside and completely ignore the downside.
In this blog post, we discuss two very important risks people should be aware of.
Default risk is the risk or probability that borrower will be unable to fulfill the obligations of the contract. This is one of the most common forms of financial risk.
Let us look at an example of a fixed deposit. When we make fixed deposits in a bank or financial institution, we are effectively lending the money to that institution at a predetermined rate. The bank will take this money and lend it to others. If the borrowers of the bank fail to repay the money then there is a chance the bank will not be able to give us interest or principal back. This means that weak banks or financial institutions have a chance of not being able to repay the money at all.
Main takeaway: Investors should carefully consider the health of the bank/FI before making an FDR. Choosing the banks offering the highest interest rate is a risky strategy. For an additional 1% interest rate, sometimes the incremental risk is not worth it.
Counterparty risk is actually a type of credit risk. According to Investopedia
Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions.
As an example, you may trade in the stock market using a stock brokerage firm. The shares purchased by you will be recorded in CDBL against your BO account. However, you may also have investable cash with the brokerage. If the brokerage faces financial stress, it might be very difficult to retrieve the cash. In the worst case, the broker may sell your shares without permission and then use the cash proceeds.
Main takeaway: Choose your counterparties carefully to minimize counterparty risks. A good start is looking at the balance sheet and income statement. Counterparty risk goes up when the balance sheet has too much debt and profit is low. On the other hand, if the counterparty is owned by a big reputed institution that reduces the counterparty risk as we expect them to be bailed out in times of financial stress.