Risks associated with keeping money in cash Flashcards
What is inflation risk
this is the risk that any interest paid will
be lower than the rate of inflation. For example, if the annual rate of inflation were to be running at 2% but the rate of interest received was only 1%, the spending power
of the cash would be lower at the end of the year than it was at the start. Over time this can have very serious consequences
Which method is most used to measure inflation?
CPI
What is default risk
Historically this was seen as a very remote risk – the idea that a bank might fail
being seen as almost laughable. Since the credit crisis at the end of the last decade, this is no longer the case. Their
creditworthiness is very important and as such they will all have a credit rating, in the same way we all have a “credit file, or credit rating” which is assessed when we want to
take out a personal loan, mortgage or other form of credit agreement. The higher the firms credit rating the lower the risk and as such you would find returns
What happens if a financial deposit taker defaults?What protection is in plcae?
Where a financial deposit taker does default, the investor may be covered by the Financial Services Compensation
Scheme (FSCS). For cash investment, this provides for up to £85,000 per investor, per financial institution to be returned in the event of the collapse. The aim of the FSCS
is to pay out the majority of claims within 7 days in the event of a bank failure with more complex cases taking longer.
What is interest rate risk?
This is where the rate of interest is
variable, the investor faces the risk that the interest rate will fall. Current interest rates are lower than investors have seen for decades (which brings inflation risk into play
too). For those who rely on interest from deposits, perhaps to top up a pension, this can have very serious consequences.
What is re-investment risk?
This happens when you invest in a fixed
term deposit and receive interest as income. When the deposit matures interest rates have fallen significantly and so it is not possible to reinvest the funds at a similar
interest rate to sustain anywhere near the same level of income.
A new risk is that of negative interest rates, which essentially means you are paying the bank for the privilege of running your account. This sounds absurd but we only
have to look to Denmark or Japan to see that this is happening already.
What is currency risk?
For those investors placing money offshore, there are two additional risks.
Firstly, that a movement in exchange rates against them could result in their deposits losing value in sterling terms and secondly that the country in question may be less
financially viable (e.g. high inflation, low levels of regulatory supervision leading to increase risk of firm collapse etc..) than the UK. This has come into focus in recent years with countries like Greece and Portugal struggling to meet commitments and also with the falling value of the pound
after the ‘Brexit’ vote
