Financial risk is an inherent part of the investment and applies to businesses, government, individuals, and even financial markets. It basically represents the chance that the parties involved (shareholders, investors, or other financial stakeholders) will lose money.
For example, for the government, it could mean a failure of monetary policy and default on bonds or other debt. For the companies, it could mean being unable to pay a debt and losing value on investment. Similarly, individuals face such risk if their financial decisions jeopardize their ability to pay the debt. Financial markets face such risks due to macroeconomic forces.
Such risks are essentially the result of market movements. Therefore, all entities across the world put extensive effort into managing their financial risks. In this article, we will focus mainly on the financial risks faced by corporations.
In order to survive and also thrive, corporations need to identify the risk first and then look for a solution to the same. There are many professional certifications, such as FRM, that help train the professionals for identifying and managing the type of risks.
Types of Financial Risk
Most financial risk falls under two categories – systematic or non-systematic. Systematic risk is due to external factors and affects the whole economy, such as the recession. Non-systematic risks affect specific sectors or companies, and one can minimize them by careful planning. Apart from these two broad categories, we can further classify financial risk into the following types;
Fluctuations in the price of the financial instruments cause market risk. We can mainly divide market risk into Directional and Non-directional risk. Directional risk is the outcome of the fluctuation in the prices of stock, interest, and so on. Non-directional risk can be volatility risk. Other types of market risk are – Absolute Risk, Relative Risk, Basis Risk, and Volatility Risk.
The risk that one of the parties may fail to fulfill their obligations towards the other is Credit Risk. It can be further divided into Sovereign and Settlement risk. Sovereign risk arises due to the difficult foreign exchange policies, whereas settlement risk arises when one of the parties fails to fulfill its obligation.
This type of risk arises due to the incapability of the parties to execute a transaction. Liquidity risk can be of the following type – Asset Liquidity Risk and Funding Liquidity Risk. Asset liquidity risk is due to insufficient buyers or sellers against the counter order, while the funding liquidity risk arises due to lack of funds.
As the name suggests, these types of risks arise due to mismanagement or technical failures. Operational risk can be divided into Model Risk and Fraud Risk. While Fraud Risk arises due to the lack of controls, Model Risk can be due to incorrect model application.
This risk arises due to lawsuits and other legal proceedings. Many see legal risk as part of the operational risk.
Political risks result from unstable political conditions or any new legislation that may affect a company or a sector.
Financial Risk Management
The process of understanding and finding a solution to the risk that a business is facing or could face is known as financial risk management. Managing financial risk does not only mean averting a risk but also defining the type of risks that an organization could face or is willing to take. Additionally, it also involves recognizing the type of risks that the business would look to avoid at every cost. In all, risk management is all about making strategies about the risks that a business is willing to take or avoid.
Plan of action is of the utmost importance when it comes to financial risk management. The procedure, policies, and practices that an organization follows help with a sound plan of action. The plan of action will make it clear for employees on what they can and cannot do, decisions that need to be made, and overall responsibility, as well as the potential risk that could arise.
Risk identification and management is a challenging task. If assessed wrongly, the risk could have severe consequences for the organization or the whole economy. One big example of mismanagement of risk was the subprime mortgage meltdown. The lenders did not consider the individuals’ credit scores and continued to give mortgage loans. On the other hand, investment firms bought these mortgages, packaged and resold them as mortgage-backed securities (MBS).
Therefore, formal training, such as in the form of FRM certification, is often required for the managers.
What Financial Risk Managers do?
Financial risk manager gets training in identifying and reducing (or, if possible, eliminating) the risk in the business. A financial risk manager typically performs the following functions:
- Define the risk management process
- Understand and agree on risk identification, assessment, and analysis process
- Evaluate risk and budget
- Establish risk appetite
- Define risk reporting and maintain records
- Define contingency plans and precautionary actions
- Review risk policies
- Develop proposals
How can Individuals Manage Risk?
Financial risk can be both at the company level and at the individual level. While companies hire financial risk managers to assess and manage the risks, individuals usually have to manage the financial risks on their own. Individuals can manage financial risk in the following ways;
- An individual should understand the type of risks that could be relevant to them.
- They should have a clear understanding of systematic risk and unsystematic risk.
- After assessing the risk and understanding the type of risks, proper insurance covering the risk should be taken.
- Diversifying investment rather than putting all eggs in one basket would also help mitigate the risks.
- An individual should always have an exit strategy for the investment made.
Continue reading – Business Risk vs. Financial Risk.