Financial risk is the speculation of losing money in financial markets; it includes both investments and business operations. It is a risk no one wants to suffer, but everyone involved is willing to take due to the enticing returns. Many studies have emerged around managing financial risks because it cannot be avoided. However, with the right tools, financial risks can be identified and minimised.
Here, we look at some of the aspects of financial risk, why it is important, how to identify financial risks, and what tools can be used to manage them:
- What is financial risk?
- Types of financial risks
- Pros and cons of financial risk
- Financial risk management
- How do you conduct a financial risk assessment?
- Tools to measure and mitigate financial risk
What is financial risk?
One has to assume the possibility of a financial risk for anything that is associated with investments, business, and general financial transactions. It is an assumption that whatever money you have put into an investment or a company, you will suffer losses. Where the loss will stem from depends on where you have used those finances and the type of risk.
Defining financial risk
Companies have to assume all financial risks in business related to defaults, operations, and market risk. Even the government has to assume some financial risk when trying to control its monetary conditions. No one is exempt from financial risk.
Financial risks happen due to macro-economic conditions, such as changes in market conditions and a rise in volatility. For example, financial defaults in large amounts, whether by a collective of individuals or a company, can also cause this change in the economy, leading to financial risks (e.g. subprime mortgage crisis in 2007-08).
Financial risk is everywhere, and it comes in all variations. However, it does not have to be daunting - years after several financial crises, researchers are coming up with new risk management tools to mitigate the financial risks.
The importance of financial risk
Although everyone tries to avoid financial risk, it is not as criminal as people make it out to be. Financial risk is often a necessary component of the market industry, and it exists at different levels. Financial risk can be difficult to handle and hard to overcome if it becomes a very high risk. Still, it can be mitigated with the right financial tools. There can be no growth in your company or portfolio without financial risk. If the risk can be mitigated, it will offer the investor or business owner a number of positives. It leaves you with a better understanding of financial risk and the ability to make informed decisions in business or investments. Analysing the financial risk helps you determine the market value of the financial operation. Dealing with financial risk will also leave you with analysis tools that will benefit you in the long term. Risk should not be taken as an opposite of reward, but rather the other side of the same coin.
Identifying financial risks
Identifying financial risks can be a daunting task. It means observing everything to figure out all the potential threats that you could face in the future. However, once you do identify all the financial risks associated with your company, capital, or assets, you can organise them as per priority and mitigate them step-by-step. Mitigation includes not only preventing or reducing financial risk but also accepting the consequences of the financial risk or transferring it elsewhere. This encourages proactive financial risks management, which will sustain investment or business growth. Therefore, to identify your risks, you should assess your investment or your business to understand what could be affected and what you could do if something goes wrong. As such, there are 3 main factors you should consider to identify potential financial risks:
- Compliance: This applies to everyone - the government, companies, and individual investors. Compliance refers to adhering to laws and rules surrounding your financial operations. Such can include taxes on investments, the corporate obligation to pay taxes, report on their financial operations, etc. You need to know both the cost of compliance and the penalties for non-compliance and act accordingly
- Strategic: Different parties will have different kinds of strategic risks. For example, a company's strategic risk will be associated with operations, such as acquisitions, changes in business policy, or changes in the market industry. For an individual, it could be a change in their portfolio or adding new assets to grow their net worth. For a government, it could be a similar thing at a state level. Here, it would help if you thought about how these changes will affect your investment, business, or the overall health of your financial operation
- Financial: A company or an individual needs to assess its financial transactions to identify the risks it could face, such as liquidity, inflation, loss in investments, etc.
Types of financial risks
There are various types of financial risk, such as interest rate risk, credit risk, currency risk, foreign exchange risk, operational risk, and many others. If you have lent money to someone, you need to assume credit risk. If you have invested in stocks, there is a liquidity risk and an investment risk in general. If you have opened a business, you have to assume operational risk.
Real world financial risks examples
Consider the European sovereign debt crisis as an example of financial risk, which resulted in the collapse of banking institutions, a large level of government debt, and rapidly growing bond yield spreads on government assets in various European countries. It began in 2008 with Iceland's banking system collapsing. The financial crisis of 2007–2008, the Great Recession of 2008–2012, the real estate market crisis, and property bubbles were all major factors. The crisis was eventually managed by the European Union's financial guarantees and the International Monetary Fund (IMF).
By the end of 2009, Greece, Spain, Ireland, Portugal, and Cyprus defaulted on their government debt without getting help from the European Central Bank, the IMF, and the European Financial Stability Facility.
Lenders sought higher interest rates from Eurozone governments in 2010, as high debt and deficit levels made it more difficult for these countries to pay their budget deficits in the face of generally lackluster economic growth.
Several of these nations, notably Greece, Portugal, and Ireland, had their sovereign debt reduced to junk status by international credit rating agencies during the crisis, exacerbating investor concerns.
Pros and cons of financial risk
Financial risk, by its very nature, has a negative connotation. While risk is the flip side of reward, there are still some good reasons for assuming financial risk:
- For Growth: Risk is an inherent component of business, and for growth and expansion into new markets, businesses may require debt financing. Although financial risk appears to be a burden on a business, if a business is able to perform and earn higher revenues through growth and expansion, such risk must be accepted
- Taxes: Many businesses claim losses as a tax deduction that can be amortised over several years. Reduced tax liabilities and risk management on the part of a business can transform financial risk into a long-term advantage
- Warning: Financial risk serves as a warning to investors and management to take particular precautions to avoid future damage
- Valuation: Financial risk inherent in specific businesses or projects aids in analysing income via the risk-reward ratio, which indicates whether the firm or project is worthwhile or not. Financial risk may be quantified using numerous ratios, which makes it simple to comprehend the function of risk in a company
Regardless, there are disadvantages to having financial risks:
- The impact: In the case of governments, financial risk can result in defaults on bonds and other obligations from financial institutions, wreaking havoc on both the domestic and global economies
- Uncontrollable: Financial risk coming from global events, natural disasters, wars, interest rate changes, and changes in government regulations that a corporation operating in a particular market cannot control
- Long-Term Effects: Financial risk, if not managed properly and with the appropriate techniques, can result in financial and reputational damage to the entire firm, as well as a loss of investor and lender confidence. Overcoming such setbacks can be extremely tough for a corporation
Financial risk management
Financial risk has the greatest impact on your cash flows. However, there are numerous techniques for anticipating and avoiding financial hazards through the use of a sound investment and financial risk management plan. However, a financial risk management strategy does not safeguard a business from all financial losses and potential dangers. While certain risks are anticipated, others are hidden, unanticipated, or do not receive prompt attention.
What is financial risk management?
Financial risk management is an organisation's strategy plan for dealing with and controlling current and expected financial risks. Financial risk managers not only predict hazards that a business may encounter, but also test potential treatments and evaluate the situation when solutions are implemented. Managers mitigate risks through the use of certain instruments, like measuring formulas or financial risk management softwares.
Types of financial risk management
There are numerous types of risks that financial managers must consider when developing investment strategies, and the following discusses a number of them in detail:
- Market risks: For instance, market risks, where market changes have a significant impact on the business's marketplace and on the performance of the entire sector at the same time. Investors and analysts utilise the value-at-risk strategy to mitigate market risk. VaR modelling is a statistical risk management technique that measures both the potential loss of a portfolio and the probability of that loss occurring. Based on the measurements, a company can decide the next steps. While the VaR approach is well-known and regularly used, it is subject to several assumptions that restrict its precision
- Credit risks: Credit risk is the possibility of losing money as a result of a borrower's inability to make payments on any sort of loan. Credit risk management is the process of reducing losses by determining the sufficiency of a bank's capital and loan loss reserves at any point in time. When businesses provide loans to one another, they may incur credit risks. A business must guarantee that it has sufficient cashflow to pay its debts on schedule. One strategy to control credit risk is to work with rating organisations such as Moody's and Standard & Poor's, which utilise various CRM techniques to continuously evaluate the credit risk associated with investing in thousands of corporate and government-backed bonds
- Operational risks: Operational risk is the risk of loss caused by insufficient internal people, systems, processes, or external events. In contrast to other categories of risk, operational hazards are not revenue-driven, are not intentionally incurred, and cannot be totally eradicated. The risk persists as long as people, processes, and systems remain defective and inefficient. However, it can be handled within acceptable risk tolerance levels in terms of financial risk management through measuring the costs and pros of suggested improvements within the business
- Liquidity risk: Asset liquidity and operational funding liquidity risk are both included in the concept of liquidity risk. The ability of a corporation to turn its assets into cash and generate cash flow daily in the event of a sudden, large cash flow shortfall is referred to as asset liquidity. Revenue downturns pose a significant danger if the company suddenly finds itself unable to pay its fundamental operating expenses, such as payroll, taxes and insurance. The importance of cash flow management in a company's performance can't be overstated, which is why analysts and investors use measurements like free cash flow to gauge a company's investment potential
Benefits of financial risk management
Financial risk management is an important part of running a successful company. Teams of trained professionals devise ways to minimise losses. Financial risk management is designed to keep the company successful and avoid financial errors that could lead to disaster. It predicts not only potential problem areas but also potential opportunities. This allows the company to move swiftly on what it considers to be strong investment possibilities and optimise the financial gain, which benefits everyone involved. Whenever a corporation makes a decision, financial risk management plays a role in that decision.
Another significant component in financial risk management is competition. The team can predict how the market will react to competition, allowing the company to devise a strategy that considers a multi-player field. A company with a well-thought-out financial risk management strategy can remain aggressive in the market while staying within its own risk and opportunity scenarios. In another way, the corporation forecasts what will most likely happen in the financial market and devises a strategy to grow the business despite the risks. Although no business can completely avoid risk, it can reduce its impacts to negligible levels with competent risk management.
Financial risk management problems
Practices in risk management are not without flaws. Despite the tools available, one of the major issues is their ineffective use.
Value at risk (VaR), for example, is a common risk metric, but it can only tell us how much money the company expects to lose at a specific degree of confidence. It does not consider the distribution of losses that are greater than VaR. VaR does not guarantee the success of risk management. The financial market's liquidity determines the success of VaR implementation. When a market is illiquid, daily VaR measures become meaningless. If a company is trapped with a portfolio that can't be exchanged, a daily VaR metric isn't a good indicator of the portfolio's risk because the company is stuck with it for a long time.
Risk managers also make errors when estimating the likelihood or size of losses. They could even use the incorrect distribution. For a financial organisation with several positions, the correlation between the various positions may be mismeasured. Miscalculation of known risk is a typical issue in risk management.
Lastly, because no one can predict future occurrences accurately, it is difficult and costly to evaluate all hazards in a risk measuring system.
Financial risk management techniques
There are no exhaustive lists of different techniques for risk management. Various companies implement different techniques to manage financial risk. Although most companies take care of the basic things, such as:
- Having the right amount of insurance in place at the back end to ensure that the company is secure. A company must have insurance to compensate for losses it cannot afford
- A company that maintains sufficient emergency funds. Emergency reserves serve as a buffer against unforeseen financial dangers
- Investing in various assets; diversification of investments decreases the risk of financial oblivion. Companies should diversify their investments and think of them as investment insurance that will protect them in a downturn or on a company's rainy day
Examples of financial risk management
Examples vary on the kind of risk. Every risk type has its own way of mitigating the crisis. For example, let's say a company wants to borrow from a bank at a certain rate per annum. The company must account for three factors:
- The principal that needs to be repaid to the bank
- The cost of securing that loan, which could include providing further evidence that the company is financially secure. That means having a good balance, steady cash flow, and complying with taxes
- Assuming risks should the company delay or default on their payments
To manage this risk, the company would ensure, prior to even applying to the bank, that it has sufficient emergency funds and back up capital, in case revenue falls short, or has sufficient collateral to secure the borrowing.
How do you conduct a financial risk assessment?
Financial risk is an unavoidable part of running a company, and the best strategy to manage it differs by industry. You'll need to identify and analyse financial risks before creating a proactive financial risk management plan to produce financial risk reduction solutions.
Identify the risk
You may adopt a proactive approach to protecting your company's cash flow and increasing performance by recognising financial threats. Study your company's financial statements to determine its status and to identify potential risks. Identify what the key revenue streams are and how consumer credit terms affect that revenue. Examine how your cash flow changes over time, as well as how your revenue growth compares to the previous quarter and year. Take note of your current and long-term debts and determine the impact of an increase in interest rates.
Analyse the risk
Once you've identified financial risks, you can start studying each one to see how likely it is to occur and what the implications will be.
First, see how consistent your revenues are. A large profit margin allows you to absorb any negative effects on your cash flow that your analysis uncovers. Evaluate the potential risks and the impact this would have on your business.
By assessing the risks, you can easily determine which risks are of priority. Risks should be identified and analysed periodically, semi-annually, or annually, depending on your organisation.
Create a proactive plan
After you've assessed your company's financial risks, you can devise a strategy for dealing with them in a cost-effective manner. Choose appropriate controls to assist you mitigate recognised financial risks or successfully manage them if they occur. You should update your financial risk management plan depending on when you undertake your regular risk identification and analysis exercises.
Tools to measure and mitigate financial risk
There are various types of tools available for governments, businesses, and individuals to calculate the financial risk they are shouldering. Each type of party can use one or several risk management tools in finance described below. For long term investments, the following methods are what financial experts use to determine the risk associated with it, such as funds, stocks, and investing in general:
- Fundamental analysis: this method involves evaluating everything to measure the value of the investment or the business. Such may include income, existing assets, expenditure, losses, etc.
- Technical analysis: look at the past performance data of the individual investment of similar businesses to measure the value and the risks
- Quantitative analysis: this means calculating the financial ratios to see the ratio between risks and rewards. For example, measuring the debt-to-capital ratio in a business through debt by total company capital - if the debt proportion is high, it means it is a risky venture for the company. The same calculation can be used to see the ratio between business expenditure and income
Financial risk is inherent in every business and investment. Since the beginning of economic development, businesses have been hit with various forms of the financial crisis, which could have been prevented had the company understood the nature or identified the financial risks. It cannot be avoided, but it can be minimised and utilised to promote growth, which many businesses have not done through financial risk management. Businesses can use some tools and techniques to manage the risks posed by the market.
Of course, these are not the only tools to manage financial risk. There are so many ways to hedge against financial risks that require intricate steps (e.g. buying a certain kind of asset to offset the risk). And this intertwines with hedging against investment risks. Other examples include businesses automating their operations to cut back operating costs which also reduces their operational risks. In individual investment, diversifying and asset allocation according to their needs (tactical or strategic asset allocation). The government also uses these tactics to measure their financial risks and mitigates them accordingly.