Financial Risk is one of the significant concerns of every business. To understand the techniques of risk management, it is essential to realise the concept and types of risk. Risk is referred to like the chances of having an unexpected outcome. Any action that leads to loss of any type is termed as Risk. There are different types of risks that business firms can come across and needs to overcome.
The risks can be mainly classified into the following models:
Business Risk: These types of risks are usually faced by business enterprises to maximise the profit and value of shareholder. As the companies undertake high-cost risks to launch the new product for enhancing the higher sales in the market.
Non- Business Risk: The risks that arise out of economic and political imbalances is defined as Non- Business Risk. Business firms cannot control these types of firms.
Financial Risk: Financial Risk is the risk that involves financial loss to the business firms. It generally arises due to the losses and instability in the financial market caused by changes in stock prices, interest rates, currencies and more.
Types of Financial Risks:
It is one of the high-priority kinds of risk in every business. Financial Risk is induced due to the movement in the market as it includes the gathering of various factors. Due to this, financial Risk can be classified into multiple types such as Credit Risk, Market Risk, Legal Risk, Liquidity Risk, and Operational Risk.
Credit Risk: When any firm fails to fulfil the obligations towards their counterparties, then it is called as Credit Risk. It can be classified into Sovereign Risk and Settlement Risk. Sovereign Risk arises due to difficulties in the policies of foreign exchange. Whereas, on the other hand, settlement risk occurs when one party makes the payment, and the other party fails to fulfil the obligations.
Market Risk: It arises due to the change in prices of financial instrument. It can be further classified as Directional (caused due to movement in stock price, interest rates, etc.) and Non-Directional Risk (volatility risks).
Legal Risk: This risk arises from legal constraints such as lawsuits and legal notices. Whenever a company faces the financial loses out of legal proceedings, it is a legal Risk.
Liquidity Risk: This risk arises out of an inability to execute the transactions in the market. It can be classified into Funding Liquidity Risk and Asset Liquidity Risk. Asset liquidity risk arises due to insufficient buyers or insufficient sellers against the buying and selling the orders.
Operational Risk: This risk arises due to operational failures such as technical failure and mismanagement. It can be further classified into Model risk and Fraud risk. It arises due to the lack of controls and model risk to the incorrect model application.
Stages in Financial Risk Management:
Identification of the risk: The risk can be managed by identifying the financial risk and the cause of the same. It is good to start with the balance sheet of the company as it specifies the liabilities, debt, risk of the rate of interest, exposure of foreign-exchange, etc. The cash flow statement and the income statement shall be observed to see how it fluctuates, and the impact of the same on the organisation.
Quantifying the exposure: It is necessary to analyse the risk or to put the numerical value of risk identified by the firm. The analysis can take place with the help of statistics such as the method of regression and standard deviation to measure the exposure of the company to various factors of risk.
Decision making: After analysing the source of risk, the firm should decide the way to deal with the risk. The decision should be made by taking into consideration the multiple factors such as the aim of the company, business environment, its appetite and the cost of mitigation to reduce the risk.
To reduce the financial risk, the organization should reduce the volatility of the cash flow, fix the rate of interest on loans, manage the cost of operation, improvise the payment terms, exposure of the price of the commodity, variations in the price of raw materials.
The financial risk is usually managed by the owner or managers of the organisation. The organisation also take the consultation from the Financial Risk Manager to manage risk faced by them and to recommend the actions for the welfare of the company.