Financial Exposure
A term used to describe investor risk, expressed as the investor’s potential loss from investing
What is Financial Exposure?
Financial exposure is a term used to describe investment risk. It is a calculation of the amount of money that an investor might potentially lose from an investment. An investor’s financial exposure may be expressed as an absolute monetary amount – e.g., $10,000 – or as a percentage of the amount of money that they have invested.
Summary
- Financial exposure is a term used to describe investor risk, expressed as the investor’s potential loss from investing.
- Investors attempt to limit their financial exposure through measures such as diversification and hedging of investments.
- The term financial exposure is also applied to the banking industry, showing a bank’s exposure to potential loss through various types of loans.
Understanding Financial Exposure
Financial exposure is often stated in relation to a particular asset class. For example, if an individual invested $100,000 – $30,000 in stocks and $70,000 in bonds – then the investor’s financial exposure to the stock market is 30% of his total investment funds.
Financial exposure doesn’t only apply to traditional investments like bonds and stocks. An investment is basically any asset to that has a financial value and therefore, is exposed to a potential financial loss.
For example, you also have financial exposure through the purchase of a home, a car, or any other asset of substantial value. If you buy a house and then the real estate market declines to the point that your property is worth less than what you paid for it, then you will incur a financial loss when you sell the home. Thus, you have a financial exposure of the money that you have invested in buying your home.
The term financial exposure is also commonly applied to companies in the banking industry.
Ways to Limit Financial Exposure
As previously noted, financial exposure is a measure of investment risk. One key aspect of investing is managing risk because it can help an investor to achieve overall greater profits in the long term. Limiting financial exposure in traditional investments is typically accomplished through diversifying investments. There are generally two steps or phases involved in diversification.
The first step in diversification involves investing in different asset classes, such as stocks, bonds, and commodities. Major asset classes are not usually closely correlated, which means that when one asset class is declining, another may be increasing in value.
Therefore, by investing in different asset classes, an investor may be earning profits in one asset class while another asset class is suffering losses. The profits earned in the improving asset class, thus help to limit the investor’s overall risk of loss.
The second step in diversification consists of making a variety of investments within each asset class that an investor holds investments in. For example, a bond investor can diversify their investments in the bond market by investing in a mix of low-risk bonds and higher-risk bonds that offer higher potential yields by investing in both short-term and long-term bonds, and by investing in a mix of government bonds and corporate bonds.
With stock market investments, investors maintain a diversified portfolio by investing in the stocks of companies in different industries and by investing in small-cap, mid-cap, and large-cap stocks. A stock investor may further diversify their portfolio by investing in both foreign and domestic stocks.
You can further limit your financial exposure by hedging your existing investments. For example, you may hedge your risk exposure in a stock whose price has strongly advanced by purchasing put options on the stock, which will offer you protection against a future decline in the stock’s price.
Financial Exposure in the Banking Industry
It is also common to speak of financial exposure in relation to the banking industry or to any company or individual that acts as a money lender. Financial exposure for money lenders is usually broken down by the various types of loans that the lender has extended to borrowers.
A bank’s financial exposure may be expressed as the amount of exposure it has in unsecured loans, in loans made to a particular industry or even to a single company, in loans made to foreign entities and domestic entities, and in the potential risk of loss the bank has through exposure to fluctuations in currency values.
For example, if a bank has extended $100 million total in loans and $30 million of that amount is in unsecured loans, those not backed with collateral, then the bank’s financial exposure to unsecured loans is 30% of its loaned capital.
Keep Learning
CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:
