What is Financial Risk: Financial risk is an essential topic of concern for every business across the geographies and fields. It is the reason behind the increasing popularity and recognition of the Financial Risk Manager Exam (FRM) conducted across the world.
Financial risk refers to the probability of losing money on a trade or business venture. Some typical examples of financial risks include operational risk, liquidity risk, credit risk, and many more.
The Basics of Financial Risk
It can be severe and can cause a massive loss of capital to the concerned party or firm.
- For the government, it means that they are not able to control their monetary policy and default on contracts, bonds, and other debt-related issues.
- For corporates or firms, it means that they failed to pay off the debt they undertook from brokers or banks. It leads to a financial burden on the firm.
- Investors face this risk when they make the wrong decision, and this decision makes it hard for them to repay their debts and thus decreases their income and savings.
- Macroeconomic forces, change in the interest rate of the market and the probability of default by large corporations or sectors leads to financial risk in the monetary market.
There are many risks involved with the investment, and they are inevitable. They come in different sizes and with different intensities, affecting everyone. One cannot eliminate the risk but can try to mitigate its effects by just paying attention to the risk management strategies and their uses depending on the type of risk.
Types of Financial Risks
There are many types of risks including non-business risk, business risk, and finally, financial risk. Among all the financial risk is of more concern and should be considered above all. It occurs due to market movements (includes a host of factors). It is divided into five types Market Risk, Credit Risk, Liquidity Risk, Operational Risk, and Legal Risk. The explanation and factors causing each risk are as follow:
This type of risk arises because of fluctuation in the prices of monetary instruments. It is broadly classified into two types first, Directional Risk and second, Non-directional risk. The former results from the movement in the interest rates, stock price and some more whereas, the later is due to high volatility of the market.
This type of risk arises when an individual fails to meet the debts repayment and commitments towards the opposite party. It is classified into two types: Settlement risk and Sovereign risk. The former arises when one party makes the payment while the other party fails to meet the obligations, whereas the latter occurs because of complicated foreign exchange policies.
The inability to carry forward the transaction leads to liquidity risk. I can be classified into two types Funding Liquidity Risk and Asset Liquidity Risk. Asset Liquidity risk arises due to insufficient sellers or insufficient buyers against purchase orders or sales orders, respectively.
This type of risk arises due to operational failures, such as technical failures or mismanagement. It can be classified into Model Risk and Fraud Risk. The former occurs due to incorrect model application, whereas, the latter arises due to lack of control.
It is the risk arising out of legal and ethical constraints such as lawsuits. Whenever a firm faces monetary loss due to legal proceedings, it is termed as legal risk.
Whatever the risk might be, it depends on an individual’s attitude to fight against the odd conditions to mitigate their level. A good investor is one who makes the best strategies to overcome the hurdles in the way of investment or trade or business.