What Is Financial Risk?

Financial risk is the possibility of losing money in a business venture or

investment. There are several types of financial risks, such as credit risk,
liquidity risk, and operational risk. Financial risk is a potential loss of capital to
an interested party.
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 as the chances of having an unexpected or negative
outcome. Any action or activity that leads to loss of any type can be termed a
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 non-
business risks.
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
Risk Types: The different types of risks are categorized in several different
ways. Risks are classified into some categories, including market risk, credit
risk, operational risk, strategic risk, liquidity risk, and event risk.
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 instruments.
Market risk can be classified as Directional Risk and Non-Directional Risk.
Directional risk is caused due to movements in stock price, interest rates, and
more. Non-Directional risks, 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.

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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 buy 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

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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.

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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:

Bonds
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.

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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

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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

 Often arises from

unpredictable outside
 Facilitates more informed decisions
forces
 Assists in assessing value, i.e., the risk-
 It can be uncontrollable
reward ratio
or difficult to overcome
 It can be recognized via analysis tools
 Can spread to different
sectors or markets

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 analyse 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.

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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 analyse 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,

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completely comprehending the causes of financial risks and adopting the right
measures to prevent it can help a company yield better returns.