written by Juan Pablo Calle, On October 11, 2022
Before spending time to seek techniques that assess and mitigate risk, it is important for the analyst to know what financial risk is and what its practical manifestations are. Financial risk can be understood as the probability of having a negative and unexpected result due to market changes. These risks can be caused by poor cash flow management or by below expected revenue-related risks.
They can occur for different reasons:
- Inadequate management.
- High debt.
- Changes in exchange or interest rates.
- Market transactions or investments with a high level of vulnerability.
- Lack of information for decision-making.
There are 5 main types of financial risk: market risk, credit risk, liquidity risk, legal risk, and operational risk.
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Let's look at each one in detail.
1. Market risk
Among the types of financial risks, market risk is one of the most important. This type of risk has a very broad scope, as it appears due to the dynamics of supply and demand.
Market risk is largely caused by economic uncertainties, which may impact the performance of all companies and not just one company. Variations in the prices of assets, liabilities, and derivatives are included in these sources of risk.
For example, this is the risk to which an importer company paying its supplies in dollars and then selling the final product in local currency is exposed. In the event of devaluation, that company may suffer losses that would prevent it from fulfilling its financial obligations.
The same applies to innovations and changes in the market. One example is the commercial sector. Companies that have managed to adapt to the digital market to sell their products online have experienced an increase in revenue. Meanwhile, those that have resisted these transformations show lagging competitiveness.
2. Credit risk
In financial risk management, credit risk is of paramount importance. This risk refers to the possibility that a creditor will not receive a loan payment or will receive it late.
Credit risk is therefore a way of determining a debtor's capacity to fulfill its payment obligations.
There are two types of credit risk: retail and wholesale.
The first refers to the risk involved in financing individuals and small businesses, whether through mortgages, cards, or any other form of credit.
Wholesale credit, on the other hand, arises from the organization's own investments, whether in the form of sales of financial assets, mergers or acquisitions of companies.
The case of subprime mortgages in the United States, which led to the economic crisis of 2008, explains how credit risk materializes when it is not managed properly.
Subprime mortgages were high-risk, high-interest loans granted to people who were unemployed or did not have a stable income.
Banks began to broad profile's scope of subprime mortgage applicants in order to increase income. However, since the applicants could not pay, the delinquency of the debts increased.
This situation led to the bankruptcy of thousands of banks in the United States and compromised the good name of others, such as JP Morgan Chase.
3. Liquidity risk
Financial risk management must consider a company's liquidity, as every organization must ensure that it has the sufficient cash flow to pay off its debts. Failing to do so may ruin investor confidence.
Liquidity risk is just that. It is possible that a company will not be able to fulfill its commitments. One of the possible causes of thereof is poor cash flow management.
A company can have a significant amount of equity but at the same time a high liquidity risk. That is because it cannot turn those assets into money to meet its short-term expenses.
Real estate or bonds, for example, are assets that can take a long time to turn into money. That is why each company must verify whether it has current assets to pay off short-term commitments.
4. Operational risk
Finally, among the types of financial risks, there is also operational risk. There are different types of operational risk. These risks occur due to a lack of internal controls within the company, technological failures, mismanagement, human error, or lack of employee training.
Eventually, this risk almost always leads to a financial loss for the company.
Operational risk is one of the most difficult to measure objectively. In order to be able to calculate it accurately, the company must have created a history log with the failures of this type and recognized the possible connection between them.
These risks can be avoided if a specific risk is considered to be able to trigger further risks. A broken down machine, for example, not only implies the expense to repair it. It also causes losses for production downtime, which can lead to a delay on product deliveries and even affect the company's reputation.
Major companies such as Intel and Facebook have suffered great economic losses because they did not anticipate operational risks.
It has also happened with several of the world's largest banks, such as Riggs Bank, Barings Bank, or Crédit Lyonnais in France.
In conclusion, the types of financial risks are different for each company depending on the activities it carries out. However, it is essential to identify potential risks and assess their impact.
