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Financial risk is everywhere - What tools can be used to manage it?

Financial risk is the speculation of losing money in financial markets - it includes both investments and business operations. It is the risk no one wants to suffer, but everyone involved is willing to take due to enticing returns. Many studies have emerged around managing financial risk because it cannot be avoided.

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:

1. Defining financial risk

One has to assume the possibility of a financial risk to anything that is associated with investments, business, and general financial transactions. It is the assumption that whatever money you have put in an investment or a company, that you will suffer losses. Now, where the loss will stem from depends on where you have used those finances and the types of risk. 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 to someone, you need to assume credit risk. If you have invested in stocks, there is a liquidity risk and investment risk in general. If you have opened a business, you have to assume operational risk. Companies have to assume all financial risks related to defaults, operations, and market risk. Even the government has to assume some financial risk when trying to control their monetary conditions. No one is exempt from financial risk.

Financial risks happen due to macro-economic conditions, such as changes in the market conditions and a rise in volatility. For example, financial default in large amounts, whether by a collective of individuals or a company, can also set 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.

2. 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 the 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.

3. 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 the risk but also accepting the consequences of the financial risk or transferring it elsewhere. This encourages proactive management of financial risks, which will sustain investment or business growth. Therefore, to identify your risks, assess your investment or your business to understand what could be affected and what could you 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 and etc. You need to know both the costs 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 the business policy, or changes in the market industry. For an individual, it could be a change in his portfolio or adding new assets to grow his net worth. For a government, it could be a similar act thing at a state level. Here, it would help if you thought about how these changes will affect your investment or 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 and etc 

4. 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 of the methods 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

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.

Everyone faces risk once in their life, and as financial activities have become a daily occurrence, financial risks were bound to appear. Without it, we would not be able to understand the weakness of our financial activities and transactions. Knowing about financial risks helps us to take steps to reduce and prevent potential financial risks in the future. 

Last update: 06/08/2021

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