What Are The Risks and Purpose of Financial Instruments?
Financial instruments are assets that can be considered sources of capital or can be traded by a business. There are many different types of financial instruments. Most of them provide an efficient and reliable flow of capital to investors.
Generally, such assets can be in the form of cash, a legal agreement to receive cash, or some other type of financial instrument.
Nevertheless, financial instruments come with a wide range of risks as well. So, let’s discuss the risks and purposes of financial instruments in detail.
Overview of Financial Instrument Risks
It is common for buyers and sellers to enter into a financial or commodity instrument-based structure that is standardized for electronic trading. These agreements typically involve cash or evidence of an ownership interest in equity.
There is always a risk involved in such financial instruments and legal contracts. Therefore, financial instrument risk means the potential for losses that can result from fluctuations in the value of financial assets involved in the contract.
Financial instrument risks affect an organization and different types of financial instruments in many different ways, such as stocks, bonds, currencies, and commodities.
A financial instrument’s risk can vary in nature and originate from numerous factors, such as fluctuations in interest rates, exchange rates, macroeconomic factors, and general market sentiment.
Moreover, company-specific factors, such as regulatory issues or management changes, can also result in such risks.
It is important to rely on professional accounting services in Malaysia to carefully evaluate and manage financial instrument risks. Various risk mitigation techniques, such as diversification and hedging, are used for this purpose.
Failure to control the risks of financial instruments can result in massive losses for a company.
Types of Financial Instrument Risks
Whether you are trading electronic financial instruments or brokered ones, you have to consider many different types of financial instrument risks, such as:
Credit Risk
The risk that arises when an involved party fails to meet its financial obligations.
Market Risk
It arises due to the impact of market conditions on a company and massive volatility in the firm.
Liquidity Risk
It is a common risk for entities that have insufficient funds to meet the financial obligations originally set in a financial instrument agreement.
Legal Risks
These risks are also prevalent in legal agreements and financial contracts of companies with poor legal frameworks or regulations.
Operational Risks
These risks arise from technical malfunctions or operational mistakes committed within a company.
Interest Rate Risk
Changes in interest rates have a significant impact on a company’s assets, leading to interest rate risks.
Currency Risk
Changes in interest rates have a significant impact on a company’s assets, leading to interest rate risks. Macroeconomic factors typically result in currency risks when different factors end up putting pressure on exchange rate movements.
Inflation Risk
Just like currency risk, inflation risk is also a result of macroeconomic or country-specific factors. Inflated prices affect the real value of an investment.
Purpose of Financial Instruments
The specific goals and purposes of financial instruments are heavily dependent on the type of financial instrument you are dealing with. Following are the major types of financial instruments and their purposes:
Debt Securities
These are the financial obligations that represent a right to be paid money, including a deposit.
Equity Securities
Shares of a corporation or any interest in or right to a share.
Interests
Different types of interests typically occur in a corporation, such as an interest in a trust, partnership, or the estate of an expired individual.
Contracts
These include options or contracts for the future supply of a commodity, Insurance policies, precious metals, guarantees, etc.
Role of Funds
Funds are considered collective financial instruments that have many other types. Most of the funds are available to retail investors, but they have a high degree of liquidity, so they come with various risks.
Generally, companies dealing with massive funds have to rely on professionals, such as accounting services in Malaysia, to properly handle the funds.
Some of the common risks specific to funds are:
- Redemption Risk: Open-ended funds have regular liquidity, but they can be withdrawn in case of an adverse market situation.
- Regulatory Risk: Multinational companies can face regulatory issues when they are operating in various countries.
- Diversification Risk: The funds invested in a very narrow range of assets can result in a lower degree of diversification than expected.
Conclusion
Overall, financial instruments hold great importance for any type of business or corporation. Being familiar with these different types of financial instruments’ risks is important to overcome them accordingly. Professional accounting services in Malaysia can help you understand more about such risks and deal with them in the best way possible.
