Financial risk is the possibility of losing money on an investment or business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk.
Financial risk is a type of danger that can result in the loss of capital to interested parties. For governments, this can mean they are unable to control monetary policy and default on bonds or other debt issues. Corporations also face the possibility of default on debt they undertake but may also experience failure in an undertaking the causes a financial burden on the business.
Financial markets face financial risk due to various macroeconomic forces, changes to the market interest rate, and the possibility of default by sectors or large corporations. Individuals face financial risk when they make decisions that may jeopardize their income or ability to pay a debt they have assumed.
Financial risks are everywhere and come in many shapes and sizes, affecting nearly everyone. You should be aware of the presence of financial risks. Knowing the dangers and how to protect yourself will not eliminate the risk, but it can mitigate their harm and reduce the chances of a negative outcome.
- Market risk
Among the types of financial risks, one of the most important is market risk. This type of risk has a very broad scope, as it appears due to the dynamics of supply and demand.
Market risk is largely caused by economic uncertainties, which may impact the performance of all companies and not just one company. Variations in the prices of assets, liabilities and derivatives are included in these sources of risk.
For example, this is the risk to which an importer company paying its supplies in dollars and then selling the final product in local currency is exposed. In the event of devaluation, that company may suffer losses that would prevent it from fulfilling its financial obligations.
The same applies for innovations and changes in the market. One example is the commercial sector. Companies that have managed to adapt to the digital market to sell their products online have experienced an increase in revenue. Meanwhile, those that have resisted these transformations show lagging competitiveness.
- Credit risk
In financial risk management, credit risk is of paramount importance. This risk refers to the possibility that a creditor will not receive a loan payment or will receive it late.
Credit risk is therefore a way of determining a debtor’s capacity to fulfill its payment obligations.
There are two types of credit risk: retail and wholesale.
The first refers to the risk involved in financing individuals and small businesses, whether through mortgages, cards or any other form of credit.
Wholesale credit, on the other hand, arises from the organization’s own investments, whether in the form of sales of financial assets, mergers or acquisitions of companies.
The case of subprime mortgages in the United States, which led to the economic crisis of 2008, explains how credit risk materializes when it is not managed properly.
Subprime mortgages were high-risk, high-interest loans granted to people who were unemployed or did not have a stable income.
Banks began to broad profile´s scope of subprime mortgage applicants in order to increase income. However, since the applicants could not pay, the delinquency of the debts increased.
- Liquidity risk
Financial risk management must consider a company’s liquidity, as every organization must ensure that it has sufficient cash flow to pay off its debts. Failing to do so may ruin investor confidence.
Liquidity risk is just that. It is the possibility that a company will not be able to fulfill its commitments. One of the possible causes thereof is poor cash flow management.
A company can have a significant amount of equity, but at the same time a high liquidity risk. That is because it cannot turn those assets into money to meet its short-term expenses.
Real estate or bonds, for example, are assets that can take a long time to turn into money. That is why each company must verify whether it has current assets to pay off short-term commitments.
- Operational risk
Finally, among the types of financial risks there is also operational risk. There are different types of operational risk. These risks occur due to lack of internal controls within the company, technological failures, mismanagement, human error or lack of employee training.
Eventually, this risk almost always leads to a financial loss for the company.
Operational risk is one of the most difficult to measure objectively. In order to be able to calculate it accurately, the company must have created a history log with the failures of this type and recognized the possible connection between them.
These risks can be avoided if a specific risk is considered to be able to trigger further risks. A broken-down machine, for example, not only implies the expense to repair it. It also causes losses for production downtime, which can lead to a delay on product deliveries and even affect the company’s reputation.