Mr. Adonis has sold a Michael Kors designer bag to Mr. Jeffery worth $900. Mr. Jeffery made a payment of $600 at the time of the sale and promised to pay the balance of $300 after 3 months from the sale date. Here we see a case of partly credit sale(Financial Exposure).
Mr. Adonis is undertaking the risk of not receiving that $300. Thus, the financial exposure of Mr. Adonis is to the extent of $300.
We may say that the loss that may be suffered in a transaction is the financial exposure.
Usually, the term financial exposure is associated with investments. It means the risk that the investor is undertaking concerning investment is his financial exposure. The losses that the investor will have to bear if his investment fails is the financial exposure. This can be expressed in monetary value or a percentage.
Let us have a look at some examples for a better understanding.
Unsecured loans of banks
Loans are a form of investment for banks. At the end of the term, the borrowers are supposed to pay the principal+interest to the banks. If it is an unsecured loan, it means that the loan is not backed by any security(asset). In case the borrower defaults, the bank is exposed to the risk of non-payment of both the principal and the interest.
Devaluation of Asset
Rachel purchased a building for $34,000. After a few years, she needed money and wanted to sell off the building. But the real estate market wasn’t doing well at that time. She could sell the building for only $28000. Thus, this was an unprecedented risk or financial exposure to the extent of $6000.
Let’s say Fatima’s total investment portfolio is $45000 which includes stock worth $30000 and bonds worth $15000. Here the financial exposure is to the extent of $30000 or 67% (rounded off) i.e., the stock value as they are uncertain.
Risk and return go hand in hand. If the tide rises for one, the other also rides the wave. But not everyone can undertake the burden of high risk. Hence investors always seek to abate their risk on investments.
How does Financial Exposure do so?
Investors always diversify their investment portfolios. A mixed bag is created with investments of low-risk, high-risk, medium risk and even zero-risk (savings accounts). Investors do not put all their money in the same class of stocks or even in the same line of business. They will often put their money into varied industries like pharmaceutical, real estate, cosmetic, and grooming products.
This is a strategy for reducing risk. Hedging is done to act as a cushion against the high-risk asset. Here, the assets are selected in such a manner that the loss of one asset will be absorbed by the profit of another asset.