Wealth Management Series: Customer Risk Profiling

Risk profiling is important for determining a proper investment and asset allocation for a portfolio. Every single person has a different risk profile as the risk appetite depends on psychological factors, loss bearing capacity, investor’s age, income & expenses and many such other things. Investing in the financial market carries some inherent risk which depends on some internal and external factors.

There are internal risks that an organisation is exposed to and these are usually within the control of the organisation. These include management decisions, financial risk such as profits and losses and operational risk which pertains to the manpower that a company employs. While these are the overall risks that concern the financial markets, these risks will impacts the customers who have invested in any product in relation with the specific financial market (Equities, Bonds, Mutual Funds, etc).

And there are external factors on an organisation. These are not under the control of the organisation. It includes risks such as interest rate risk, foreign exchange, etc. So, it is always essential for a customer to know how much she is ready to take, before investing in any financial instrument. Here are the most common risk profiles for investors:

 

Conservative

This is a category of people whoseek safety of capital, minimal risk and minimum or low returns.

* Possible Allocation – Equity: 0-10%; Debt and others: 90-100%

Moderately Conservative

This category of customers is willing to take small level of risk for potential returns over medium to long term.

*Possible Allocation – Equity: 10-30%; Debt and others: 70-90%

Moderate

Customers with Moderate Risk Profile are looking for relatively higher returns over medium to long term with modest risk.

*Possible Allocation – Equity: 40-60%; Debt and others: 40-60%

Moderately Aggressive

They are seeking to maximise returns over medium to long term with high risk

*Possible Allocation – Equity: 70-90%; Debt and others: 10-30%

Aggressive

Aggressive Risk Profile Customers are willing to take significant risks to maximise returns over the long term.

*Possible Allocation – Equity: 90-100%; Debt and others: 0-10%

The risk profile of a customer may change over time, depending on the changes in her life cycle. Hence, what was right and worked for a customer at the younger age may not be the same when her at the age of  45 or 50.

Investment Products

Customers should be having the knowledge on the various Investment Products as below –

Equity :

Equities are issued by registered corporations to raise capital either to fund their new business or expand their existing operations. Equity is a share in the ownership of the company through Participation in voting – voting rights on corporate governance policies

Share in the profits in the form of dividends.

Stocks are riskier than bonds as they receive lesser priority in the case a firm runs into trouble.Stockholders have residual claimant right and right to vote.

Equities are generally classified as Common Stock and Preferred Shareholders

Common stock

It is a common stock and not a preferred stock

Participates in the gains – dividend

Represents the ownership share in the corporation (entity)

Enjoys voting rights and residual claim in case of liquidation (after the payment of preferential creditors) 

Preferential stock

Preferential participation in dividends – fixed rate of dividend

Usually issued to cover the debt portion of the capital

Does not have voting rights but has a preferential claim in case of liquidation

It can be either convertible or non-convertible.

Based on Market Share, Stability, and Profits, there are other categorizations like below :

Blue chip Stocks

Penny Stocks

Income Stocks

Growth Stocks

Value Stocks

Different types of issue

Public issue – When the issue is made to the new investors  to become shareholders of the issuing company. Generally classified into IPO (Initial Public offer) and FPO (Further Public offer)

Rights Issue –  When an issuer  makes an issue of  equities to the existing shareholders for a consideration

Bonus Issue –  When an issuer  makes an issue of  equities to the existing shareholders without a consideration either out of free reserves or share premium account on a specified ratio

Private placement – Privately placed equities to a select group.  This can be either QIP (Qualified  Institutions Buyers) or Preferential allotment

Bonds :

Bonds are long-term debt securities that mature between 10-30 years.

Issuer of bonds is obliged to pay fixed interest rate known as coupon rate periodically, usually ½ yearly or annually.

In addition to coupon interest payment, issuer of bonds also pay the par or face value of the bonds at maturity.    

Bonds have the following characteristics:

Maturity

Call provision

Put provision

Convertibility

Secured & unsecured

Interest and yield

Discount and premium

Bonds yields

     – Running yield (interest yield) – coupon payment only

     – Redemption yield (yield to maturity) – coupon payment with capital gains/loss.

Derivatives :

A derivative is an instrument whose value depends on the values of its basic underlying variables

The derivative itself is merely a contract between two or more parties

Its value is determined by fluctuations in the underlying asset

 The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes

Need for Derivatives

To hedge risks

To speculate (take a view on the future direction of the market)

To lock in an arbitrage profit

To change the nature of a liability

To change the nature of an investment without incurring the costs of selling one portfolio and buying another

Derivative Instruments

Forward Contracts

Futures Contracts

Forward Rate agreement

Swaps

Options

Futures Contracts

A futures contract is an standardized agreement to buy or sell an asset at a certain time in the future for a certain price

Forward Agreements

Forward Agreements is an agreement between two specific parties to buy or sell an asset at a specified time and at a specified price.

Salient features of Forward Agreements are:

They are bilateral contracts and hence exposed to counter-party risk.

Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.

The contract price is generally not available in public domain.

On the expiration date, the contract has to be settled by delivery of the asset.

If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being

Options

Options are instruments which gives the holder the right but not the obligation to buy (sell) a certain product at a certain time in the future at a pre-fixed price.

The premium charged for this benefit called the “Option Premium” is also known as the “Option Value”.

Foreign Exchange :

Forex trading is the simultaneous buying of one currency and the selling of another.

Currencies are traded through a broker or dealer

Currencies  are traded in pairs (e.g.)

the Euro and the US dollar (EUR/USD).

the British pound and the Japanese Yen (GBP/JPY).

When one buys, say, US Dollars, one, in effect is buying a share in the American economy

Price of the currency is a direct reflection of what the market thinks about the current and future health of the  economy of the country issuing the currency.

FX Forward

FX forward contract is an agreement to purchase or sell a set amount of a foreign currency at a specified price for settlement at a predetermined time in the future. “Closed” forward contracts must be settled at an exact date.

A currency forward is essentially a hedging tool that does not involve any upfront payment

It can be tailored to a particular amount and delivery period, unlike standardized currency future. Currency forward settlement can either be on a cash or a delivery basis, provided that the option is mutually acceptable and has been specified beforehand in the contract.

Currency forwards are over-the-counter (OTC) instruments, as they do not trade on a centralized exchange. Also known as an “outright forward.”