Financial Risk
Financial risk is the risk associated with the probability of incurring a loss of financial assets. When it comes to financial markets, it is possible to define this category of risks as the amount of funds that can be lost due to trading operations or investment. For governments, financial risks can be associated with the inability to control monetary policy or failure to pay interest or principal on government securities. Companies may also face financial risk in terms of exposure to default.
Financial Risks that companies face
The severe impact of financial shock on financial markets can result in financial risks. Risks entail high entropy of the financial market, the signs of which are uncertainty and high volatility. For individuals, financial risk is the probability of partial or complete loss of cash or valuable assets as a result of business decision-making mistakes. It can compromise the capacity to generate income or repay a loan an individual has taken on.
Business risks depend on various external and internal factors and may have a great influence practically on every company. That’s why every business owner has to put a plan in place to anticipate possible financial risks and safeguard the business against future financial risks.
Sooner or later, almost every company actively operating in the market faces the need to attract external funds. The use of any financial instrument, including the attraction of external funding, entails certain risks. The possibility of losing money arises to both the company and to any investors or stakeholders who gave a loan to the business.
For entrepreneurs, credit risk is characterized by potential losses that result in full or partial non–payment of the loan. If the company fails to pay back the loan, it will defaut. Such loan borrowers tend to lower monthly payments or stop making required payments, making debt collection more complex. As a result, investors may lose the principal and interest accrued on loan.
Specific risk is the risk resulting from the characteristics of a particular industry or enterprise. It is associated with internal factors of the activity of the issuer or investor, negatively affecting investment efficiency. We can refer to specific risk when an investor is unsure that he will make investment's gains and financial returns.
Companies can also face operational risks, known as unexpected losses of the business that occur due to technical errors and failures, intentional and accidental employee mistakes in daily operations.
Financial Risks that governments face
For governments, financial risks are divided into several types. First of all, there are certain risks that the state will not fulfill its financial obligations, primarily on foreign sovereign debts, debts to international financial organizations, large private banks, and other creditors.
Internal risks can also be faced by the government. Internal risks are caused by the economic problems of the country, structural contradictions, demographic and social negative trends that require unplanned financial expenses. It may result in the inability of the government to keep an eye on monetary policy and manage inflation. Besides, it may fail to make its debt and interest payments.
The government securities market is the most important element of the stock market of any country. In countries with advanced economies, the government securities market carries out centralized temporary borrowing of available funds of commercial banks, various enterprises, and the population. Different government securities are actively used in conducting monetary policy and for the upkeep of roads, bridges, and other infrastructure.
Financial Risks arising on market
There are several types of financial risk that can arise on financial markets. Many factors influence it. For instance, the economic downturn from 2007 to 2009 showed that the state of a critical sector of the market has a great impact on the financial wellness of the market. At that time, business bankruptcies were on the rise, many investors suffered financial losses, and governments had to make changes to the monetary policy.
Volatility, deviations of the stock’s price over a period of time from the benchmark or the main direction of the market, makes the calculation of the actual value of a security more complicated. It reflects the stakeholders’ confidence that market returns match the individual assets and marketplace’s valuation. Known as implied volatility, it reflects expectations regarding future stock price movements in the market or future stock volatility. This measure can lead to sudden swings or big changes in the price of a security.
Default and a decrease or an increase in the market interest rate may also be related to financial risks. Default refers to the loss of solvency. It is the situation in which individuals, businesses are unable to pay the principal amount of the loan, commission, or accrued interests to a lender on time. At the same time, changes in interest rate offered on cash deposits affect the willingness of investors to build wealth on higher-risk securities.
Financial Risks that individuals face
Financial risks faced by people may proceed from bad decision-making. Investors should pay attention to the liquidity risk. The risk of liquidity of an asset is connected with the possibility of incurring losses when making transactions with financial assets due to adverse changes in the market price of the corresponding asset. Besides, an individual may face a funding liquidity risk. Funding liquidity risk is the possibility that the company, being solvent, does not have sufficient financial resources to fulfill its obligations when they mature and, as a result, it experiences the financial default.
Speculative risk is a risk which results in adverse and neutral consequences (losses) or favorable consequences (profit). When an individual takes a speculative risk, it may not only produce a profit, but also a loss. The probabilities of negative and positive outcomes for a particular risk, and the size of the consequences may differ significantly.
Investing in a foreign currency may also pose financial risk. Currency risks refers to the probability of incurring a loss of currency. It is associated with the changes in the exchange rate of the currency during foreign trade, credit, currency and other transactions.
Financial Risk management
Different methods of assessing and managing financial risks are available for businesses to reduce their negative impact.
The most commonly used financial risk analysis methods related to stock market are listed below:
- Fundamental analysis, a method of evaluating securities and their issuers using indicators reflecting the company's performance, the state of an industry and the country's economy as a whole.
- Technical analysis, the study of the correlation between price changes and market activity. On the chart, an investor can monitor supply and demand and investor sentiment. Technical analysis tools help predict the further price movements.
- Quantitative analysis, assessment of the following indicators: process (time, capital, labor), product (volume, nomenclature, defects and its number), customer satisfaction (how products meet customer expectations).
Besides, qualified traders and investors use hedging as part of an investment strategy. It is defined as the process of buying or selling an investment to help reduce the potential risk of loss of an existing position. When hedging, they use financial derivatives.
