Financial Exposure: Definition, How It Works, Hedging, and Example

What Is Financial Exposure?

Financial exposure is the amount an investor stands to lose in an investment should the investment fail. For example, the financial exposure involved in purchasing a car would be the initial investment amount minus the insured portion. Knowing and understanding financial exposure, which is an alternative name for risk, is a crucial part of the investment process.

Understanding Financial Exposure

Investors are always seeking to limit their financial exposure while trying to maximize profits, which helps to maintain a balance of risk and reward.

For instance, if 100 shares of stock purchased at $10 a share appreciated to $20, selling 50 shares would eliminate the financial exposure. The original purchase cost the investor $1,000. As the shares appreciate, selling 50 shares at $20 returns the investor's initial stake.

This method is what is meant by "taking money off the table." It is also sometimes colloquially referred to as "playing with the house's money."

The only risk going forward would be for the profit made as the investor has already recouped the principal amount. Conversely, if the stock decreased from the original purchase price of $10 to $5 per share, the investor would have lost half the original principal amount.

Financial exposure applies not only to investing in the stock market but exists whenever an individual stands to lose any of the principal value spent. Purchasing a home is an excellent example of financial exposure. If the value of real estate declines and the homeowner sells at a lower price than the original purchase price, the homeowner recognizes a loss on the investment.

Reducing Financial Exposure

The simplest way to minimize financial exposure is to put money into principal-protected investments with little to no risk. Certificates of deposit (CDs) or savings accounts are two ways to reduce financial exposure drastically. Federal Deposit Insurance Corporation (FDIC) guarantees both the investment in CDs and the savings account up to the qualified coverage amounts of $250,000.

However, with no risk, an investment provides little return. Also, if there is little financial exposure, this leaves a conservative investor vulnerable to other risks such as inflation.

Another way to reduce financial exposure is to diversify among many investments and asset classes. To build a less volatile portfolio, an investor should have a combination of stocks, bonds, real estate, and other various asset classes.

Within equities, there should be further diversification among sectors, market capitalizations, and exposure to domestic and international markets. When an investor diversifies their portfolio successfully among many asset classes, it should reduce overall volatility. If the market turns bearish, non-correlating asset classes will minimize the downside.

Hedging

Hedging is another way to reduce financial exposure. There are many ways to hedge a portfolio or an investment. Airlines purchase crude oil futures contracts at current prices in anticipation of future passenger load as a hedge.

Later, if oil prices skyrocket and cause the airline industry to raise ticket prices and shrink margins, those hedged Airlines may be able to maintain lower ticket prices and grab market share from the competition.

An investor can hedge in the stock market by using options, inverse exchange-traded funds, or bear-oriented funds. Gold is one of the most common hedges, and it typically appreciates with an inflating dollar or volatile markets.

The Bottom Line

Investors must consistently manage risk and reward. The higher the risk, generally the upside potential is greater, but so are the chances for losses. Understanding one's financial exposure when picking investments is critical to success. Investors can take actions to mitigate financial exposure, such as through diversification and hedging, ensuring that their losses are minimal.