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What is Financial Risk? Types and How to Measure Financial Risk?

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Financial risk is usually related to financing all small business operations. Most small-time owners involve the possibility of losing large amounts of capital when using debt financing to start or operate their company, which implies a very large risk to the business. Financial risks may be related to investing in other companies. 

# What is Financial Risk?

Financial risk is an inherent part of the investment that applies to businesses, the government, the individual, and even the financial markets. Financial risk is a type of risk that a business will not be able to meet its debt payment obligations. This can result in potential investors losing their money invested in the company. The more debt a company has, the greater the financial risk for it.

# What is Financial Risk Management?

Procedure for dealing with uncertainties arising from financial markets. Attempts to assess the financial risks facing an organization and develop management strategies in line with internal priorities and policies. Strategies for risk management often include derivatives.

# How Does Financial Risk Arise?

The three main sources of financial risk are:

  1. Some financial risks arise from an organization’s risk of changing market prices, such as interest rates, exchange rates, and commodity prices, etc.
  2. Financial risk arising from and in transactions in derivatives transactions with other organizations such as vendors, customers, and counterparts
  3. Financial expansion arising from the organization’s internal functions or failures, especially people, processes, and systems

# How to Measure Financial Risk? 

Data and analytics:-  It is very important for measuring financial risk to any organization. Businesses run on data, and they need to leverage their business’s internal data and complement it with external data to understand the risks.

Artificial intelligence (AI) and machine learning (ML):- It calculations are gaining traction to help companies make all kinds of risky decisions. AI and ML drive all analytical decision-making with greater speed and precision, and companies using automated technologies can reap maximum benefits. 

As you know, most businesses face a variety of financial risks that can stunt their earnings and growth. Identifying these risks – and taking steps to reduce those risks is a very important part of the overall growth strategy of any business.

# Who Manages Financial Risk?

Responsible for managing risks in any small business is their business owners and senior managers. This only happens when a business involves multiple departments and activities. Any business that wants to bring in a dedicated financial risk manager for risk management and can make recommendations to act on behalf of their company. The Global Association of Risk Professionals is recognized globally as the premier accreditation for financial risk management professionals. 

If you want to obtain FRM certification, for that, candidates must have at least two years of work experience and must pass rigorous examination risk on subjects of market risk, credit risk, operational risk, and investment management.

# Diversification

  • Sometimes the risks that are partly driven by forms of diversification are financial risk, market risk, and inflation risk, etc.
  • A very important issue in diversification is the relationship between assets, such as increasing profits with low correlation. By the way, this is not an observable quantity, as you can never know with complete certainty the future returns on any asset.
  • The cost of diversification is that those correlations must be recognized and understood, and because they are not continuous, it may be necessary to unbalance portfolios that will reduce transaction costs due to buying and selling any asset. increases
  • One risk of diversification is that as an investor or fund manager diversifies, their ability to monitor and understand losses may decline due to poor assets or unexpected correlations.
  • Share prices in any business are driven by many factors, such as the general health of the economy which will increase the correlation and reduce the benefits of diversification.
  • Your business has a wide range of returns over a substantial period of time that an index fund may experience; Therefore an index fund by itself is not “fully diversified”. Diversity can also be achieved by diversifying asset classes.

# Types of Financial Risk

  • Credit Risk: Credit risk in any organization is likely to fail to pay off a creditor (such as a bank or lender) or another party (such as a supplier). You can also take credit risk by extending credit to your customers, due to the possibility of default on payment.
  • Liquidity Risk: This type of risk arises due to the inability of the parties to execute the transaction by any business. Liquidity risk can be of the following types – Asset Liquidity Risk and Funding Liquidity Risk. The risk of asset liquidity is due to insufficient buyers or sellers against counter orders, whereas fund liquidity risk arises due to lack of funds in any organization.
  • Equity Risk: This is the third type of financial risk. When the market becomes volatile, it becomes difficult for all the companies to price their equity shares. Market value often goes down, which does not seem to be good news for any organization. This volatility of the equity stock market is called equity risk, which comes with the financial risk of the organization.
  • Operational Risk: Operational risk is a catch-all term of your business that covers all other risks that your business may face in its daily operations. For example, staff turnover, theft, fraud, lawsuits, unrealistic financial projections, poor budgeting, and inaccurate marketing plans can all pose a threat to your bottom line if they are not anticipated and handled properly.
  • Market Risk: As the name itself suggests, market risk is the risk that comes out of the market in which your business operates. This is often related to the possibility of losses due to things like market volatility, interest rate increases or raw material costs, fluctuations in foreign exchange prices, etc.
  • Legal Risk: This type of financial risk arises only from legal hurdles such as lawsuits. Whenever a company faces financial losses from legal proceedings, it is called legal risk.
  • Political Risk: Such risks arise from unstable political circumstances or any new laws that may affect a company or sector. Political risks, for example, are some of the risks such as poverty, terrorism, heavy changes in the economy and so on.

# Differences Between Financial Risk & Business Risk 

MeaningFinancial risk is the risk arising due to the use of debt financing in the capital structure.The risk of insufficient profits to meet expenses is known as a business risk.
EvaluationLeverage Multiplier and Debt to asset ratio.Variability is EBIT(Earnings before interest and taxes).
MinimizationIf the firm does not use debt funds, there will be no risk.The risk cannot be minimized
Connected withUse of debt capitalEconomic environment
TypesCredit risk, Market risk, Liquidity risk, operational risk, equity risk, legal risk, political, etc.Compliance risk, operational risk, reputation risk, financial risk, strategic risk, etc.
Disclosed byThe difference in the return of equity shareholders.The difference in net operating income and net cash flows.

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