Financial Exposure Explained

In finance, exposure refers to the amount of money that an investor has invested in a particular asset. It represents the amount of money that the investor could lose on an investment. Financial exposure can be expressed in money terms, or as a percentage of an investment portfolio.

For example, if an investor has $10,000 invested in stocks, the exposure to stocks, in dollar terms, is $10,000.

Calculating the investor’s exposure in percentage terms depends on the size of the investor’s portfolio. If the investor’s entire portfolio is worth $10,000 and $10,000 is invested in stocks, then the investor has 100% exposure to stocks. Yet, if the investor’s entire portfolio is worth $20,000 and with $10,000 invested in stocks, then their exposure to stocks is 50%.

Exposure is an important concept to understand in finance because it is tied to risk. Whether investing or trading, monitoring financial exposure on a regular basis is an important part of managing risk.

Types of exposures

The term exposure is used in many different ways in finance. Exposure can vary based on its method of expression, the market you are exposed to and what you are risking.

Market exposure

Market exposure refers to the division of assets within an investment portfolio. It refers to the amount invested in a particular type of security, investment, sector or geographic region. Market exposure can be expressed in money terms or as a percentage, although it is more commonly expressed as a percentage. For example, if a $10,000 portfolio has $3,000 allocated to gold, the portfolio's market exposure to gold is 33%. If the portfolio has $2,000 allocated to US stocks, the market exposure to US stocks is 20%. If the portfolio holds no property investments, the market exposure to property is 0%.

Financial exposure

Financial exposure, on the other hand, refers to the amount of money that can potentially be lost on an investment. For example, if an investor buys $5,000 worth of Facebook shares, the financial exposure is $5,000. The investor could potentially lose the entire $5,000 on the investment. It’s worth noting that leverage can increase an investor’s financial exposure.

Leverage exposure

Leverage gives a trader access to larger trades for a smaller initial outlay. For example, if an investor uses leverage of 10:1, a $10,000 trade could be placed with an outlay of just $1,000. In this scenario, the investor’s financial exposure is $10,000, even though the outlay is only $1,000. So by using leverage, the investor could lose more than the initial investment.

Currency exposure

Currency exposure refers to an investor’s exposure to a particular currency. Currencies such as the US dollar, pound sterling and euro are constantly fluctuating in value. That means that holders of a particular currency are vulnerable to movements in exchange rates.

If the value of an investment can be affected by movements in currencies, then the investor has currency exposure. For example, if a UK-based investor owns a portfolio of US-listed stocks, the investor has currency exposure to the US dollar. If the US dollar weakens against the pound, the portfolio of US-listed stocks will be worth less in sterling terms.

Companies that operate globally need to continually monitor their currency exposure. For instance, if a UK-based company buys raw materials from Europe and pays in euros, it has currency exposure to the euro. If the euro increases against the pound, the company’s costs will be higher.

Risk exposure

Risk exposure refers to the amount of risk an investor has taken on a particular investment. It refers to the quantified loss potential of an investment or activity.

Stock exposure

Lastly, stock exposure refers to an investor’s exposure to a particular stock. Stock exposure can be expressed in monetary terms or in terms of the proportion of the investor’s portfolio. For example, if an investor owns £5,000 of Unilever shares, then the stock exposure in monetary terms is £5,000. If the investor’s entire portfolio is worth £20,000, the investor’s stock exposure to Unilever is 25% of the portfolio. The higher the stock exposure in percentage terms, the more stock-specific risk the investor faces.

For example, say one investor has 50% stock exposure to Unilever and another investor has 5% stock exposure to Unilever. In this scenario, the investor with 50% stock exposure faces significantly more stock-specific risk.

If Unilever shares perform poorly, the investor with 50% stock exposure to Unilever will suffer worse returns. This is due to the fact that Unilever is a larger proportion of the investor’s portfolio.

How to determine exposure

Exposure depends on an individual’s goals and risk tolerance. There is no single way to determine it. In general, if a trader is bullish on a particular asset, he will have a larger exposure to the asset than he would if he was neutral or bearish towards the asset. In other words, if someone expects a particular investment to perform well, they will have a higher exposure to the investment, relative to other investments.

Here’s an example of breaking down market exposure: consider a UK investor who is bullish on US stocks and neutral on European stocks. This investor might allocate 30% of their portfolio to US stocks and 10% to European stocks. The exposure to US stocks is higher because the investor expects this region to do well.

Similarly, consider an investor who is bullish on technology stocks, but bearish on utility stocks. This investor might allocate 15% of their portfolio to technology stocks and 0% to utility stocks. The higher the exposure to a particular investment in percentage terms, the higher the risk associated with that investment. For instance, a portfolio with 100% exposure to equities has a higher risk from equities than a portfolio with 60% exposure to equities and 40% exposure to bonds. If equities perform poorly, the portfolio with the 100% weighting to equities is likely to perform worse than the portfolio with 60% exposure to equities.

Investors that are comfortable with risk often allocate a higher proportion of their portfolio to equities, and a smaller proportion to bonds. Because equities are more risky than bonds, these investors face higher total portfolio risks. In contrast, risk-averse investors often have less exposure to equities and more exposure to bonds. A risk averse investor may have 80% of his portfolio in bonds and only 20% in equities.

To lower risk, investors need to ensure that they are not overexposed to any particular investment type. Exposure can be reduced by selling an asset, by diversification or through hedging.

How to reduce financial exposure

There are many ways in which one can reduce risk of financial exposure, including diversification and investing in exchange-traded funds (ETF). The simplest way to eliminate exposure to a certain asset is to sell it, removing that asset from a portfolio. For example, if an investor has $2,000 worth of Apple shares and sells the entire holding, he will no longer have financial exposure to Apple shares. The financial risk associated with the shares will be reduced to zero.

Diversification

Another way to reduce financial exposure is through diversification. This involves having a variety of different investments in one portfolio. For example, instead of just owning one stock and having a 100% exposure to that stock, an investor could buy 20 different stocks. This would result in a stock exposure of just 5% per stock. This would significantly reduce the stock-specific risk within the portfolio. For example, instead of just owning one stock and having a 100% exposure to that stock, an investor could buy 20 different stocks. This would result in a stock exposure of just 5% per stock. This would significantly reduce the stock-specific risk within the portfolio.

Similarly, instead of just owning one exchange-traded fund (ETF) and having a 100% exposure to that ETF, an investor could buy four different ETFs. That would result in 25% exposure to each ETF trade and would reduce the risk of the portfolio. An investor could also diversify by asset class to reduce exposure. If an investor only owned stocks, the exposure to stocks is 100%. An alternative would be to divide the portfolio across stocks, bonds and property, with an equal weighting to each. Then, exposure to each asset class would be 33.3%.

Hedging

Lastly, hedging is another way to reduce financial exposure. Hedging is a risk management technique that is used to minimise losses from a particular investment. It involves taking an offsetting position in an asset to try and reduce the potential for losses in an existing asset. If the existing asset does decline in value, the hedge will provide protection. So, in effect, the hedge reduces the investor’s exposure to the existing asset.

Summary

In finance, exposure refers to the amount of money invested in a particular asset. It represents the amount that an investor could lose on an investment. Financial exposure can be expressed in monetary terms, or as a percentage of an investment portfolio. Monitoring exposure is an important part of risk management in investing and trading. Portfolio exposure needs to be monitored regularly.

Commonly, investors analyse their exposure to particular stocks, sectors, asset classes and geographic regions. It’s important to understand that having a high exposure to one particular investment increases overall risk.

Source: CMC Markets UK