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Corporations and other institutions raise money by selling securities to investors in the capital markets. Risk management in capital markets is necessary to ensure that investors understand the nature of the securities that they purchase. Additionally, securities laws in many nations require investment firms to make financial reports and other securities related materials publicly available. Therefore, risk management in capital markets is often legally mandated.
The risk management process begins when underwriters review the accounts of entities that are planning to issue stocks or to sell bonds on the open market. Underwriters are responsible for determining whether these entities can afford to honor debt payments and whether capital infusions from stock purchases will enable these firms to expand and grow in value. Investment firms can refuse to proceed with underwriting initial public offerings (IPOs) of stocks and the launches of other kinds of securities if purchasing such securities would expose investors to excessive levels of principal risk. In many instances, the firms that market newly released securities also purchase some of the stocks and bonds which means that these firms are typically reluctant to trade high-risk securities.
When an investment firm decides to press ahead with the launch of a new security, the next stage in the process of risk management in capital markets usually involves ratings agencies. Agents employed by these firms review the securities and attempt to gauge the level of principal risk that purchasers 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 receive the lowest rating. The yield paid on bonds depend in part on these ratings and so-called junk bonds pay the highest yields because the issuers of these bonds are the most likely to default on the debt payments.
Individual investors and brokers, acting on behalf of consumers and businesses, compare the possible returns available with certain types of securities with the level of principal risk that investors are exposed to. Consequently, risk management in capital markets often entails consumers doing their own private research on particular corporations or municipalities to determine whether they wish to risk investing some of their own funds in these institutions. Most people base their decisions upon their own findings along with the advice of their brokers and the assessments of the 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 are providing consumers with accurate risk information. Nevertheless, most types of securities have few if any principal guarantees which means that the process of risk management in capital markets is not sufficient to eliminate all the investment dangers that investors must face.