In the financial world, exposure is the sum of money an investor has put into a specific asset. It stands for the potential loss on investment for the investor. Financial exposure can be described in terms of dollars or as a proportion of a portfolio of investments.
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 ways in finance. Exposure can vary based on its method of expression, the market you are exposed to and what you are risking.
The partition of assets within a portfolio of investments is referred to as market exposure. It speaks about the sum invested in a specific kind of security, investment, industry, or geographical area. Although it is more frequently reported as a percentage, market exposure can also be expressed in monetary terms. The market exposure to gold for a $10,000 portfolio, for instance, is 33% if $3,000 of that portfolio is devoted to gold. The market exposure to US stocks is 20% if the portfolio has $2,000 allocated to US stocks. The market exposure to real estate is zero percent if the portfolio contains no real estate investments.
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 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.
An investor's exposure to a specific currency is referred to as currency exposure. The value of currencies like the US dollar, British pound, and euro is continually changing. This implies that currency owners are susceptible to changes in exchange rates.
Investors are said to have currency exposure if changes in exchange rates have the potential to affect an investment's value. For instance, a UK-based investor who holds a portfolio of US-listed stocks is exposed to the US dollar in terms of currency. The portfolio of US-listed stocks will be worth less in sterling terms if the US currency drops versus the pound.
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 refers to the amount of risk an investor has taken on a particular investment. It refers to the quantified loss potential of investment or activity.
Last but not least, stock exposure describes how much of a stock an investor is exposed to. Stock exposure can be defined in terms of dollars or as a percentage of the investor's overall holdings. For instance, if an investor buys £5,000 worth of Unilever shares, their financial stock exposure is $5,000. The investor's stock exposure to Unilever is 25% of the portfolio, or £20,000, if the portfolio is £20,000. The investor is exposed to more stock-specific risk the larger their percentage stock exposure is.
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.
Consider an investor who favours technology stocks but is pessimistic on equities related to utilities. A 15% portfolio allocation to technology equities and a 0% allocation to utility stocks is possible for this individual. The risk associated with an investment increase with the percentage-based level of exposure to that investment. A portfolio with 100% exposure to stocks, for instance, is more at risk from stocks than one with 60% exposure to stocks and 40% exposure to bonds. The portfolio with a 100% weighted in equities is likely to perform worse than the portfolio with a 60% exposure to equities if equities perform poorly.
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 riskier 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 is a further means of lowering financial exposure. This entails having numerous diverse investments in a single portfolio. An investor might purchase 20 different stocks as an example, rather than only holding one stock and being 100% exposed to it. A mere 5% exposure to each stock would result from this. As a result, the portfolio's stock-specific risk would be greatly decreased. An investor might purchase 20 different stocks as an example, rather than only holding one stock and being 100% exposed to it. A mere 5% exposure to each stock would result from this. As a result, the portfolio's stock-specific risk would be greatly decreased.
Similar to this, an investor might purchase four distinct exchange-traded funds (ETFs) rather than just owning one and having 100% exposure to it. As a result, each ETF trade would have a 25% exposure, which would lower the portfolio's risk. To lessen exposure, an investor could also diversify by asset type. The exposure to stocks would be 100% if the investor held solely equities. An alternative would be to divide the portfolio equally among stocks, bonds, and real estate. At that point, 33.3% of each asset type would be exposed.
Another strategy to lessen financial exposure is to hedge. Hedging is a risk management strategy used to cut down on investment loss exposure. In order to try and lower the likelihood of losses in an existing asset, it entails taking an offsetting position in an asset. The hedge will offer security if the value of the existing asset does drop. The investor's exposure to the existing asset is thereby decreased because of the hedge.
The quantity of money invested in a specific asset is referred to in finance as exposure. It stands for the maximum amount an investor could lose on a certain investment. Financial exposure can be expressed as a proportion of an investment portfolio or in monetary terms. Risk management in trading and investing includes a lot of monitoring of exposure. Portfolio exposure needs to be regularly evaluated.
Investors frequently examine how much exposure they have to various equities, industries, asset classes, and geographical areas. It's critical to realize that a high exposure to a single investment raises the stakes for other investments.
Source: CMC Markets UK