What is equity risk and how it is useful in determining whether a financial instrument is a liability or an equity
Equity risk refers to the extent to which holders of a financial instrument are exposed to losing their investment in that financial instrument. Equity risk-takers take the risk of not receiving any return on their investment (e.g. dividends may or may not be paid) and also take the risk of not receiving back the amount they invested. They are entitled only to periodic returns once all the obligations of the company have been paid, and they are entitled only to the residual left over in the company on winding up after all liabilities have been repaid.
Equity risk-takers differ from debt investors who are entitled to periodic returns and can demand that their funds invested be returned. Debt investors bear credit risk and liquidity risk, but not equity risk.
The concept is useful in determining whether or not a financial instrument is a liability or an equity instrument of the issuer because it assists in determining the substance of the parties’ rights and obligations under the financial instrument.