What are financial risks and its types [Explained]

financial risk and its types

Table of Contents

Financial risks are the risks associated with the financial market. 

It can include the transactions happening through the banks, or trades made through the market. It is one of the major concerns of investors and businesses making financial decisions. 

Usually, risks could be categorized as:

  1. Business risk
  2. Non-Business Risk
  3. Financial Risk

HOW DOES FINANCIAL RISK ARISE?

Financial risks occur due to the movement of Markets. The market involves the movement of stock rates, currencies, or any other financial instrument. There is a financial risk for businesses. 

Countless transactions for sales and purchases, loans and investments, or any other kind of transactional business activity arise financial risks.

Legal transactions, foreign government policies or currencies, stakeholders, mergers, debt financing are factors that can result in financial risks.

Things that get affected by financial fluctuations are changes in revenues, prices, decrease in profits, and makes it more difficult to follow through the plans or handle budgets and services efficiently.

TYPES OF FINANCIAL RISKS PRESENT

There are 4 major types of Financial risks present in the market:

  1. MARKET RISK
  2. LIQUIDITY RISK
  3. CREDIT RISK
  4. OPERATIONAL RISK

MARKET RISK

Market Risks can be directional and non-directional. One can face market risks whenever there is a change in the stock market or currencies. All these changes affect the market and businesses in many ways.

Even the changing conditions in specific businesses affecting their competition in the market also affects financial performance. 

To avoid Market risk one needs to save their market place and identity by offering value propositions to their customers. 

LIQUIDITY RISK

It occurs when transactions don’t happen. Liquidity risks involve financial risks such as Asset liquidity risk and Funding liquidity risk.

Asset liquidity risks occur when there are insufficient buyers or sellers in the market. It is associated with relative ease for a business to convert its assets into cash when in need.

Funding liquidity risks occur when there is a problem in general daily liquidity that is cash flow.

Cash flow management is one of the crucial subjects that needs attention for any business to avoid such liquidity risks.

CREDIT RISK

Credit risk involves the following risks:

  1. Credit event
  2. sovereign risk
  3. Settlement risk

A company can phase these types of risks when it provides financing to customers assuming they will make a payment on default.

Sovereign risks usually happen when there is difficulty in providing credits due to foreign exchange policies.

Settlement risks occur when the settlement is not fulfilled by both parties. Such as one party makes its part of the deal but the other one fails to do so.

OPERATIONAL RISK

Operational risks occur in companies and businesses when their growth plan and operations for the future and happening currently don’t go as planned. These companies might collapse with their plans and therefore operational risks occur.

There are two types of risks under operational risks

  1. Fraud risks
  2. Model risks

Fraud risks happen when fraudulent activities are happening in businesses. These activities lead to huge financial losses for the business.

Model risks are financial risks that occur due to model plans that didn’t get the right execution or failed during operations.

LEGAL RISKS

Whenever a business is faced with lawsuits or any other kind of legal proceedings, It has to face financial risks. Therefore any kind of risks due to legal constraints are considered to be legal risks. 

HOW TO MANAGE FINANCIAL RISKS

To manage financial risks, The feedback of news and stakeholders could be considered. Some directional changes or modification changes to the products can be done using customer’s feedback to avoid any kind of Market risks. 

A business should always be updating its product and adapting to the market. Any company should not be dependent on a single product as this could lead to an overlap of business at any time. Companies can also move to newer areas to expand their market. This way the business won’t stagnate in one market and will get more opportunities to avoid financial risks.

Some insurance companies have policies that can cover the risk of default and nonpayment of clients. This avoids the credit risks that might be caused due to big debts. These debts overtime turn up into unmanageable financial losses. 

Considering help from factoring companies that help businesses with the return of money added with a rate of interest and fees. These companies provide around 80% of the invoice value to the business. 

There are a lot of third-party companies that help businesses to avoid operational risks. They can assess if your business is operating in a risk-free way and have a reliable model for the future. 

Cash flow management should be followed by companies to avoid liquidity risks. Consider tracking the cash flow. High cash-intensive operations are to be considered by companies adequately. 

HOW TO MEASURE FINANCIAL RISKS

Some of the methods to measure risks in financial investments are:

  1. Standard deviation 

Standard deviations inform us about how much is the current return on investment different from the historic normal returns.

  1. Values at Risk

These risks assess the company’s associated risk at the time of investment. It enables us to know the maximum potential loss that can happen with the investment.

  1. Beta

The systematic risk amount of industrial or individual security about the whole stock market is measured by Beta.

  1. R-Squared

High R-squared funds with actively managed funds are avoided by investors. It is statistically significant to measure how fitted data is to the regression line.

  1. Sharpe Ratio

The performance is assessed that has been adjusted by the associated risks.

Sortino and Treynor Ratios are two more variations of the Sharpe Ratio that are used to measure financial risks.

ADVANTAGES AND DISADVANTAGES OF FINANCIAL RISKS

WORKFORCE GROWTH

Hiring new employees is considered as an advantage as it provides more team to work with, more human resources and distributing the responsibilities as well as serving new customers with services. 

But the downside to Workforce growth is that it comes as an additional expense for human resources. If the future model does not pan out well then this extra human resource can be a liability. Therefore people hire interns or seasonal workers to work with so that there is not future pressure of a large number of employees.

EQUIPMENT INVESTMENT

Whenever a company invests in equipment for a company it’s taking a risk at different levels. The risks here involved can be big or small. They can increase debt balance and cause large cash expenses. As an upside potential, this equipment can also create profits, efficiency in work capital, and net income.

EXTERNAL INVESTMENT

One can have a debt-free experience with capital and connections with investors when working with outside investors. This can be taken advantage of by venture capital, stockholders, and angel investors. All these benefits do exist but also have some disadvantages that coexist with.

External investments would make a company diluted within its ownership and will cause managerial control problems

CONCLUSION

In this blog, we got an idea of What financial risks are, their types, How financial risks arise, How to manage and measure them, and what are the pros and cons of financial risks. 

We went through various aspects of financial risks and how a business is exposed to various factors such as foreign currency rates, government policies, or the stock market. We also got an idea of how A lot of situations in financial management can be both advantageous and disadvantageous for business in different aspects. A list of different ways on how to measure financial risks was also provided for us.

If you happen to be interested in the field of finance and want to get your hands on similar resources, Verzeo’s finance internship program is the right pick for you to progress in the field.

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