Financial Risk is a danger that is ever present in any money-related decision one makes. It gives the odds of losing money made on any investment. Financial risk is not a one-dimensional concept, different types of decisions have different levels or degrees of risk associated with them. For example, you may have heard the phrase “high risk high reward.”
This means that a situation, while risky, has the potential to yield some great returns. People who take on high financial risks to make high profits are more vulnerable to loss than risk-averse people. However, people with low financial risk appetite often let go of good opportunities. This is why it’s important to find the right balance between risk and reward.
Financial risk can affect different entities, such as the market, businesses, governments, or individuals. The long-term success of any plan depends on effective risk management, so it’s important to grasp its intricacies. In this blog, we’ll look in detail at what financial risk is, how it affects different entities, its different types, and how one can identify and control it.
What is Financial Risk?
To put it in simple terms, financial risk is the possibility or potential for making a loss, and it is inherent in any investment or business decision. It can affect any decision maker – an individual, a corporation, or even a government, and do so in different ways. Some types of risks are credit risk, market risk, and liquidity risk. For a business, financial risk may involve being unable to pay back the loans needed to start a venture. For an individual, it can be financially risky to heavily invest in an unproven asset. For governments, financial risk can come from being unable to control their monetary policies or inflation. Understanding Financial Risk meaning is important because only then can one make plans to successfully identify and handle them.
Understanding Financial Risks for Businesses
Businesses face various financial risks due to factors such as fluctuations in market interest rates, changes in demand and supply, and changes in government policies. Among the many Financial Risks in Businesses, one of the most prevalent is credit risk. This is the danger that a business will not be able to repay the loans it took to grow or to get off the ground. Another risk businesses face is operational risk.
This relates to the chance of incurring a loss due to poor management decisions, irrational reasoning, human error, and technological failure, among other internal factors. Some other types of financial risks faced by companies are market risk, legal risk, specific risk, reputational risk, and compliance risk. Businesses often hire teams that use risk management strategies and assessment tools to mitigate such risks.
Understanding Financial Risks for the Market
The market is prone to fluctuations. Financial Risks in market happen because of factors such as market volatility, interest rate changes, currency risk, systemic risk, commodity risk and liquidity risk. You may have heard the phrase “Mutual Funds are subject to market risks.” This means there is a chance that any investment you make in mutual funds might not do well due to market conditions. Such was the case during the 2008 global financial crisis. The mutual fund scene saw a big downtrend for a few months because markets around the world failed. In such cases, it’s important to monitor the market conditions before making any big decisions, because we saw the mutual fund market bounce back within two years. As an investor, you should stay vigilant, diversify your portfolio, and consider risk factors when making decisions.
Understanding Financial Risks for Governments
Not even governments are immune to financial risks. Some factors that give rise to Financial Risks in Governments are being unable to control inflation, volatility in exchange rates, economic downturns, defaulting on debt, and poorly enforcing monetary policies. When a country faces the factors above such as defaulting on debt it can lead to some dire situations, as we can see in the case of Venezuela. Such cases emphasise the importance for governments to effectively manage financial risks on a national scale by implementing sound monetary and fiscal policies, establishing systems to address potential crises and safeguarding the stability of their economies.
Understanding Financial Risks for Individuals
Of course, financial risk is also present on an individual level. There are many vulnerabilities an individual faces such as:
- Losing their job and thus their income due to layoffs
- Not having enough savings for emergencies
- Not having health insurance and getting hit with big medical bills
- Falling victim to fraud
- Being poor at debt management
Financial Risks in individuals also include the underlying risks when investing. Assets like stocks, bonds, funds, gold, and real estate can lose value due to market volatility or unforeseen circumstances. One might not find buyers for their assets which is known as liquidity risk. Individuals who hold foreign currencies are vulnerable to currency risk.
To reduce these risks, one can benefit from the expertise of a financial advisor. A financial advisor can help create a personalised risk management strategy and offer guidance to optimise financial fitness.
Types of Financial Risks
There are different types of Financial Risks that an entity can face:
Credit Risk –
Credit risk is the chance that someone, like an individual, company, or government who borrowed money might not pay it back on time or at all. If you take a loan to start a new business, you are exposing yourself to a degree of credit risk because of the uncertainty of success in your venture. It can be further classified into two types – Settlement risk and sovereign risk. Settlement risk occurs when one party makes a payment, and the other party doesn’t meet its obligations, while sovereign risk emerges from challenging foreign exchange policies.
Liquidity Risk –
Let’s say due to certain circumstances, you want to sell an asset. Now because of some reasons like not being able to find buyers or not getting a good price, you are unable to make a sale. This is known as asset liquidity risk. In such conditions, there are many sellers, but not enough buyers. Another type is cash flow or funding liquidity risk. It is the chance that a company may lack the necessary funds to meet its debt obligations, potentially leading to default.
Market Risk –
This risk influences the value of investments and stems from market fluctuations. Due to various kinds of shifts in market conditions such as changes in interest rates, inflation, or international and domestic developments, the value of assets like stocks or bonds can decrease. This is known as market risk.
Legal Risk –
This is the chance that there will be a financial loss due to legal reasons, such as lawsuits. These lawsuits can happen because of various reasons like copyright infringement, non compliance with regulations, or contractual disputes.
Operational Risk –
These kinds of risks arise from internal processes. Operational risk is the danger of financial loss due to failures of systems, bad management, human errors, fraud, and poor decision-making. If a manager uses flawed reasoning and applies incorrect mathematical models, it can lead to what is known as model risk. When deceptive practices, intentional misconduct, dishonest actions, or an overall lack of control leads to financial losses, it is called fraud risk.
To help mitigate these different kinds of financial risks, businesses and individuals employ professionals with specialised knowledge, such as a certified financial risk manager. A financial risk manager has the skills and insights needed to identify, assess, and manage these different financial risks effectively and safeguard against unforeseen challenges.
Financial Risk Pros and Cons
While the word ’risk’ in itself is negative, understanding, identifying, and managing risk can lead to some benefits as well. Most of the time, risk is directly proportional to reward. The bigger rewards you want, the more risk you’re going to have to take. Often, substantial progress cannot be made without exposing oneself to a certain degree of risk. Here are some pros and cons of financial risk:
|It helps one make more informed decisions.
|Often stems from factors outside of one’s control.
|Provides the opportunity to earn higher returns on investments and enables growth.
|Exposure can cause some pretty big financial losses.
|It can be used to determine the worth of an asset. For example, assessing the worth by asking “Is the return on this investment worth the level of risk I’m exposing myself to?”
|Loss can be hard to overcome.
|One can identify risk by various mathematical models, algorithms, and other analytical tools.
|Failure to control risk can lead to it spreading across various sectors. It can cause volatile conditions which are hard to control.
|It helps promote financial awareness and facilitates strategic planning, such as diversification.
|It requires time and expertise to manage and can induce stress and anxiety. It can even make one ignore opportunities for growth, due to fear of financial loss.
How to Identify Financial Risks?
Before you can effectively handle financial risks, you have to identify them. Here are some steps you can take to successfully do so:
- Conduct a thorough risk assessment. This means evaluating the different types of risks to financial stability, such as market fluctuations and economic conditions. Understand the associated degree of risk with a company or an asset. For example, every mutual fund scheme comes with a risk-o-metre, which tells the level of risk you will be taking by investing in it.
- Market analysis is another way to identify risk. Keep an eye on the market trends and economic indicators, such as inflation and interest rates.
- Carefully review different financial documents such as balance sheets and cash flow statements to get a good view of the trends in revenue or debt levels of a company.
- Take a good look at the competition. Does a new player threaten the financial stability of your business or a business you want to invest in?
- Explore and study the past performance. Use different financial metrics and ratios to compare different companies to get a more informed overview.
- Use different analytical tools to identify risk areas. You can also conduct scenario analysis, which means systematically evaluating future events and their impacts on the financial landscape. You have to create hypothetical scenarios to assess how variations in economic conditions, market trends, or external factors might affect your investments or business.
How to Handle Financial Risk?
Since financial risk can arise from factors outside one’s control, it’s not possible to fully eliminate it. It is however possible to mitigate its effect and efficiently handle it. Here are some ways you can handle financial risk:
- Hedging – Hedging is used to reduce the risk of uncertainty. One can strategically use tools like options contracts to counteract the potential impact of unfavourable price changes. Simply put, one can mitigate risk in one investment by making another.
- Diversification – You should spread investments across different assets to reduce risk. Diversification helps mitigate the impact of poor performance in any single investment by allocating resources across different assets such as stocks, bonds, gold, and real estate. A diversified portfolio is one of the best ways to handle financial risk.
- Having an emergency fund – For individuals, an emergency fund can be the safety net that not only protects them from unforeseen circumstances but also gives them peace of mind. When you know you have a contingency in place, you can make decisions confidently.
- Having different income streams – It’s a good idea to not rely on a single income stream because depending solely on one income stream can make you more vulnerable to financial risks, economic fluctuations, job instability, or unexpected financial challenges such as medical bills.
- Insurance – Unexpected events such as disasters and accidents can cause financial losses. Businesses also face financial risk in the form of lawsuits, so they buy liability insurance to protect themselves. Insurance is a good way to shield oneself from such financial risks.
- Through comprehensive quantitative analysis – This is done by assessing the historical performance of a business or fund by using ratios such as debt-to-capital ratio and capital expenditure ratio.
In the finance world, financial risk is an ever-present force that affects various entities such as businesses, governments, individuals, and the market. Those who know how to identify potential risk areas and how to effectively handle them are propelled into new heights, whereas those who jump in without properly assessing it can get pulled under. This is why having a clear understanding of financial risk is important. However, because risk often stems from unexpected circumstances outside of one’s control, managing it can be a daunting task.
This is where financial risk managers come in. A certified financial risk manager can assess and forecast risk for individuals, investors, or businesses and come up with strategies to mitigate its impact. He or she can use scenario, fundamental, technical, and quantitative analysis to optimise risk to reward ratio, make sure one doesn’t miss out on good opportunities due to fear of risk, and help make informed, confident decisions.