Financial Risk is one of the major concerns of every business across fields and geographies. This is the reason behind the Financial Risk Manager FRM Exam gaining huge recognition among financial experts across the globe. FRM is the top most credential offered to risk management professionals worldwide. Financial Risk again is the base concept of FRM Level 1 exam. Before understanding the techniques to control risk and perform risk management, it is very important to realize what risk is and what the types of risks are. Let's discuss different types of risk in this post.
What Is Financial Risk?
The possibility of losing money in a business venture or investment is referred to as financial risk. In other words, financial risk is a danger that can translate into the loss of capital. It relates to the odds of money loss.
In case of a financial risk, there is a possibility that a company’s cash flow might prove insufficient to satisfy its obligations. Some common financial risks are credit, operational, foreign investment, legal, equity, and liquidity risks.
In government sectors, financial risk implies the inability to control monetary policy and or other debt issues. Learn more about how financial risk is associated with different sectors, be it business, government, market, or individuals.
Types of Risks
Risk can be referred to like the chances of having an unexpected or negative outcome. Any action or activity that leads to loss of any type can be termed as risk. There are different types of risks that a firm might face and needs to overcome. Widely, risks can be classified into three types: Business Risk, Non-Business Risk, and Financial Risk.
- Business Risk: These types of risks are taken by business enterprises themselves in order to maximize shareholder value and profits. As for example, companies undertake high-cost risks in marketing to launch a new product in order to gain higher sales.
- Non- Business Risk: These types of risks are not under the control of firms. Risks that arise out of political and economic imbalances can be termed as non-business risk.
- Financial Risk: Financial Risk as the term suggests is the risk that involves financial loss to firms. Financial risk generally arises due to instability and losses in the financial market caused by movements in stock prices, currencies, interest rates and more.
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Types of Financial Risks
Financial risk is one of the high-priority risk types for every business. Financial risk is caused due to market movements and market movements can include a host of factors. Based on this, financial risk can be classified into various types such as Market Risk, Credit Risk, Liquidity Risk, Operational Risk, and Legal Risk.
Market Risk:This type of risk arises due to the movement in prices of financial instrument. Market risk can be classified as Directional Risk and Non-Directional Risk. Directional risk is caused due to movement in stock price, interest rates and more. Non-Directional risk, on the other hand, can be volatility risks.
Credit Risk:This type of risk arises when one fails to fulfill their obligations towards their counterparties. Credit risk can be classified into Sovereign Risk and Settlement Risk. Sovereign risk usually arises due to difficult foreign exchange policies. Settlement risk, on the other hand, arises when one party makes the payment while the other party fails to fulfill the obligations.
Liquidity Risk:This type of risk arises out of an inability to execute transactions. Liquidity risk can be classified into Asset Liquidity Risk and Funding Liquidity Risk. Asset Liquidity risk arises either due to insufficient buyers or insufficient sellers against sell orders and buys orders respectively.
Operational Risk:This type of risk arises out of operational failures such as mismanagement or technical failures. Operational risk can be classified into Fraud Risk and Model Risk. Fraud risk arises due to the lack of controls and Model risk arises due to incorrect model application.
Legal Risk:This type of financial risk arises out of legal constraints such as lawsuits. Whenever a company needs to face financial losses out of legal proceedings, it is a legal risk.
Financial Risks for Businesses
Why do businesses face financial risks? Financial risk may be due to several macroeconomic forces, fluctuating market interest rates, and the possibility of default by large organizations or sectors. When individuals run businesses, they face financial risk in making decisions that jeopardize their ability to pay debts or income. Building a business from the ground up is expensive. Often companies need to seek capital from outside sources for their steady growth. This funding requirement creates a financial risk for the company/ business seeking an amount and the investor/ stakeholder investing in the company’s business.
The danger associated with borrowing money is called credit risk or default risk. If the borrower cannot repay the loan (it becomes default), the investors suffer from reduced income from loan repayments, interests, and principal. Creditors often experience an increment in costs for debt collection.
Another term—specific risk, is used when only one or some companies struggle with financial situations. This type of danger that relates to a company or group of companies concerns capital structure, exposure to default, and financial transactions. Thus, specific risk reflects investors’ uncertainty about collecting returns and potential monetary loss.
Furthermore, businesses also experience operational risk. This type of risk is posed when businesses have flawed financial reasoning or poor management, i.e., they fail to succeed in their undertakings based on internal factors.
Financial risks affect businesses in different shapes and sizes. Financial risk awareness is a must. However, knowing the dangers and strategies to protect oneself does not eliminate the risk; it mitigates the harm and reduces the chances of negative outcomes.
Financial Risks for the Market
Often financial markets are a hub of financial risks as several circumstances can impact them. When a critical market sector struggles with a financial crisis, it affects the monetary status of the entire marketplace. The 2007 -2008 global financial crisis bears testimony to marketplace risk. As the businesses closed, the investors lost fortunes, and the government was forced to reconsider its monetary policy.
Additionally, other events impact the market, too, such as volatility. It brings uncertainty regarding the fair value of market assets. Volatility is measured as implied volatility. This statistical value is represented as a percentage that reflects the stakeholders’ confidence that market returns match the marketplace’s valuation as a whole. It gives insights into the market on the rise vs the market in decline. So, volatility risk can lead to steep price swings in stock market shares.
Market interest rate changes and defaults can pose financial risks. Defaults occur mainly in the debt or bond market when issuers or companies fail to pay their debt obligations. Defaults harm investors severely. At the same time, changes in the market interest rate tend to push individual securities into unprofitability for investors. They are forced into lower-paying debt securities or negative returns.
Asset-backed risks arise when asset-backed securities become volatile when the value of the underlying securities also changes. A common category of asset-backed can be understood by the following example. A borrower who took money for a certain period pays off the debt early. This early payment ends the income stream from repayments. It also gets rid of the possible income from significant changes in interest rates.
Financial Risks for Governments
Financial risk for a government arises in the following situations:
- government losing control of its monetary policy
- its inability or unwillingness to control inflation
- government defaulting on its bonds
- other debt issues
A government issues debt in the following form:
- Funding wars
- Building bridges
- Building infrastructure
- Paying for general day-to-day operations
For instance, the US government issues debts that are called treasury bonds. Several governments have defaulted on debt, including Venezuela, Russia, Argentina, and Greece. Some governments only delay debt payments, while some pay less than the agreed-upon amount. In both cases, it leads to financial risk for investors/stakeholders.
Financial Risks for Individuals
You, too, can fall prey to financial risks if you make poor decisions. A common cause of financial risk can be taking an unnecessary day off from work. Other causes include highly speculative investments. Individuals must understand that every undertaking has a potential risk attached. There are dangers beyond one’s control. Therefore, it is vital to fully realize the consequences.
Liquidity risk has the following two situations for investors:
- Market liquidity risk: Involves assets and securities that cannot be sold or purchased at a rate that compensates for the losses in a volatile market. It arises when there are many sellers but few buyers.
- Funding/ Cash flow liquidity risk: The possibility that a company might not have the necessary capital to pay its debt. Thereby it gets forced to default and harms stakeholders.
Individuals are also exposed to speculative risks wherein a profit or gain has uncertain success. An investor’s improper research before investing leads to chances of speculative risks. It happens when they reach too far for gains or invest a significantly large portion of their net worth into a particular investment.
Do you have an inflow of foreign currencies? You can also be exposed to currency financial risks as the following factors affect your calculated finances:
- Interest rate changes
- Monetary policy changes
- Changes in prices due to market differences
- Political changes
- Natural calamities
- Diplomatic changes
- Economic conflicts
Pros and Cons of Financial Risk
Risk is the other side of the reward. Financial risk is a situation of uncertainty. It exists to different degrees. The term “risk” has a negative connotation, and financial risk has the ability to spread from one business to another or to an entire sector/ market/ world, making it all the more a serious issue. Therefore, understanding and assessing the degree of financial risk associated with an asset can lead to better and more informed business decisions. The pros and cons of knowledge of financial risks are as follows:
Pros of Financial Risks
Cons of Financial Risks
Tools to Monitor Financial Risk
Several tools help individuals, governments, and businesses calculate the degree of financial risks they might encounter. Some commonly used methods to analyze financial risks associated with long-term investments are as follows:
- Fundamental analysis: Measures a security’s intrinsic value. It evaluates all aspects of the underlying business, such as the firm’s earnings and assets.
- Technical analysis: Evaluates securities via statistics. It considers historical returns, share prices, trade volumes, and other performance data.
- Quantitative analysis: Evaluates a company’s historical performance using specific financial ratio calculations.
- Statistical and numerical analysis: Identifies potential risks using statistical methods.
If you monitor financial risk via any of the analysis techniques mentioned above, ensure that you analyze trends over a long time. This way, you will better grasp the trends of fluctuations and progress towards a better financial goal. It is important to understand that a risk history does not always imply a future risk too.
How to Identify Financial Risks?
The following practices help identify financial risks:
- Considering the risk factors a company might face is a prerequisite for identifying financial risks.
- Reviewing corporate balance sheets
- Studying statements of financial positions
- Exploring weaknesses within the company’s operating plan
- Comparing metrics to other companies of the same industry.
- Employing statistical analysis techniques to identify the company’s risk areas.
How to Handle Financial Risk?
Completely eliminating financial risks can be difficult and expensive but mitigating the risks is easier and inexpensive. An individual or a company can neutralize financial risks by diversifying investments, holding the right amount of insurance or sufficient funds for emergencies. Different income streams are also a good option for tackling financial risks.
Why Is Financial Risk Important?
Understanding, evaluating, and mitigating financial risk is crucial for an organization’s long-term success. Financial risk often comes as a major hurdle in the path of accomplishing finance-related objectives such as paying loans timely, carrying a healthy debt amount, and delivering products on time. So, completely comprehending the causes of financial risks and adopting the right measures to prevent it can help a company yield better returns.
Is Financial Risk Systematic or Unsystematic?
Financial risk is an unsystematic risk because it does not impact every company. It is specific to each company as it depends on an organization’s operations and capital structure.
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Real-World Example of Financial Risk
Several companies have experienced some huge financial blows. An unfortunate popular history points to the June 2018 closure of Toys “R” Us. In September 2017, the company announced its bankruptcy. The company’s CEO also released a statement that the company was working with creditors to restructure the $5 billion of long-term debt. As per reports, much of the company’s financial risk originated from a 2005 US $6.6 billion leveraged buyout by investment firms— KKR & Co., Bain Capital, and Vornado Realty Trust.
In March 2018, Toys “R” Us announced that it would liquidate its 735 US locations to pull off from the dwindling revenue strain amid looming financial obligations after a disappointing holiday season. It also faced difficulty selling its properties. This situation is an example of the liquidity risk associated with real estate.
In November 2018, the debt holders Angelo Gordon and Solus Alternative Asset Management took control of the bankrupt company and created plans to revive the chain. In February 2019, a new company staffed with ex-Toys “R” Us execs, Tru Kids Brands, reported that it would relaunch the brand and opened two new stores that year. Recently, Macy’s has partnered with WHP Global, and together they are working on bringing back the Toys “R” Us brand.
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