Risk management is essential in capital markets to ensure investors understand the securities they buy. Underwriters review entities’ accounts, and rating agencies assign credit ratings to stocks and bonds. Investors must do their own research, and government regulators audit rating agencies and brokerage firms to ensure accurate risk information.
Corporations and other institutions raise money by selling securities to investors in the capital markets. Risk management in the capital markets is necessary to ensure that investors understand the nature of the securities they buy. Additionally, securities laws in many countries require investment firms to make public financial reports and other material related to securities. Therefore, risk management in capital markets often has a legal mandate.
The risk management process begins when underwriters review the accounts of entities that plan to issue shares or sell bonds on the open market. Underwriters are responsible for determining whether these entities can afford to pay debt payments and whether capital infusions from stock purchases will allow these companies to expand and grow in value. Investment firms may refuse to underwrite initial public offerings (IPOs) of shares and the launch of other types of securities if the purchase of such securities would expose investors to excessive levels of principal risk. In many cases, the companies that trade newly launched securities also buy some of the stocks and bonds, which means that these companies are often reluctant to trade high-risk securities.
When an investment firm decides to go ahead with launching a new security, the next stage in the capital markets risk management process typically involves rating agencies. Agents employed by these firms review the securities and attempt to gauge the level of primary risk that buyers of each security will be exposed to. These agencies assign credit ratings to stocks and bonds. Low-risk securities received the highest ratings, while high-risk securities received the lowest rating. The yield paid on the bonds depends in part on these ratings, and so-called junk bonds pay the highest yields because the issuers of these bonds are more likely to default on the debt.
Individual investors and brokers, acting on behalf of consumers and businesses, compare the potential returns available with certain types of securities against the principal level of risk to which investors are exposed. Consequently, risk management in the capital markets often involves consumers doing their own private research on particular corporations or municipalities to determine if they want to risk investing some of their own funds in these institutions. Most people base their decisions on their own findings along with advice from their brokers and evaluations from securities rating agencies.
In the absence of risk management, investors would have no sure way of identifying low-risk investments from speculative securities. Government regulators in many countries routinely audit rating agencies and brokerage firms to ensure that these companies provide consumers with accurate risk information. However, most types of securities have little or no principal collateral, which means that the risk management process in the capital markets is not sufficient to eliminate all investment dangers that investors must face.
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