What Are 5 Financial Risks?
Financial risk refers to the possibility that you could incur losses on any business or investment decision you make. There are various types of financial risks, including credit, liquidity and operational risk. Liquidity risk refers to how easily and cost-effectively an investment can be exited; its effect can be particularly notable with certain investments.
1. Market Risk
Market risk refers to the possibility of incurring losses as a result of changes in market price and interest rates, affecting businesses, individuals, and government sectors alike. It can include unexpectedly higher interest rates; fluctuations in raw material costs; exchange rate changes that impact debt repayments; for instance if your business must make foreign currency loans then its exchange rate fluctuation can cost money while lending it out can expose you to credit risk; credit risk arises if recipients of borrowed money fail to fulfill their obligations like paying back loans timely.
Financial markets operate continuously, creating new prices every second that make identifying potential losses difficult. Professional analysts use tools like Value at Risk (VaR) to estimate risks accurately.
All investments involve some degree of market risk. When the market falls, so too will your investments. Even safe investments such as certificates of deposit (CDs) could lose value should conditions worsen in the marketplace.
Commodity price risk refers to any change in commodity prices such as steel, aluminium, gold and foodgrains that affects production processes and goods/services offered. Many companies rely on such materials in their production of goods/services; steel manufacturers would be susceptible to an increase in aluminium prices that impacts product quality; or grain producers might experience price decreases due to global food shortages; thus these firms need to protect themselves by diversifying their portfolio and employing risk mitigation strategies such as diversifying and managing risks accordingly.
2. Credit Risk
Credit risk refers to the probability that a borrower or counterparty will default on debt obligations, potentially disrupting cash flows and increasing costs associated with debt collection. Lenders need to assess and monitor credit risks carefully in order to reduce potential losses; lenders can reduce risks by setting higher minimum credit score requirements from borrowers, regularly monitoring portfolio loans for changes in borrower creditworthiness, and conducting five C’s of credit risk analyses.
Financial risks in business can take the form of both short-term and long-term threats. Short-term risks might include issues like meeting operating expenses with cash generated, and weathering economic ups and downs; long-term threats include no longer competitive products and failing to adapt quickly enough to changing market conditions.
No matter the form, all types of financial risk come with some degree of uncertainty, prompting investors to require higher returns than risk-free rates to offset more volatility in investments. Credit risk should also be included as an element of financial risk because it allows for the possibility of frequent and significant losses.
Banks, NBFCs and other lending institutions use five Cs as criteria when assessing the creditworthiness of loan applicants: character/capacity/collaterals. While these criteria do not always follow rigidly for approval decisions, different lending institutions may place greater weight on one aspect than another; online lending portals tend to prioritize character/capacity while traditional banks might place greater value on collaterals.
3. Liquidity Risk
Liquidity risk refers to the risk that there won’t be enough cash available to cover debt payments or meet other financial obligations. Companies typically incur this type of risk when taking on too much debt in order to finance operations and invest in profitable projects without enough cash available for expenses; individuals may also incur it if investing in risky speculative investments.
Liquidity risk in trading terms refers to an inability to buy or sell assets and securities at reasonable prices due to high volume volatility or other market conditions, creating funding demand in excess of available supply – creating additional market and credit risks that must be carefully balanced to avoid liquidity risk.
Asset Liability Management, or ALM, refers to a company’s ability to convert current assets to cash quickly in order to meet short-term liabilities. Real estate and bonds are two examples of long-term assets which take longer to convert to cash; businesses must therefore carefully manage their asset liability management (ALM).
To assess liquidity risk, a firm should regularly measure its current assets against current liabilities and use ratios like current ratio, working capital or acid test to measure all current assets such as inventory and accounts receivable; acid test quick ratio or quick ratio measures only liquid assets such as cash equivalents or bank deposits; net cash flow liquidity excludes non-cash current assets such as inventory accounts receivable or any non-cash current assets such as accounts receivable. Likewise, stress tests can also help assess liquidity risk as they simulate what could happen in case an important counterparty defaults or there is significant drop in collateral value supporting derivative contracts.
4. Subprime Mortgages
Subprime mortgages provide less-than-ideal borrowers with access to housing loans at high interest rates that can cause serious financial trouble, contributing substantially to the 2008 financial crisis in America. They can also come equipped with features like interest-only payments or adjustable-rate mortgages (ARMs) which make paying monthly mortgage bills difficult once it starts adjusting.
These loans, also referred to as securitized packaged mortgages, allow lending institutions to generate profit by selling these mortgages to investors for profit. With this money generated through selling securitized packaged mortgages to investors, lending institutions can use the proceeds from these sales for further mortgages or investments that generate income; making more people afford homes while simultaneously increasing demand.
However, when these mortgages go bad and foreclosure rates increase nationwide, housing markets become unstable and home prices decline precipitating a recession as seen in the US from 2007-2009. Overusing securitized mortgages was one of the key causes behind 2008 financial crisis.
As soon as borrowers default on mortgage payments, their credit scores take a hit and it becomes more challenging to qualify for other mortgages in the future. Therefore, it’s essential that everyone carefully manage their finances and avoid taking on too much debt.
Read Also: How Do You Calculate Finance
5. Operational Risk
Financial risk identification is vital to the growth and success of any business. Utilizing various analysis techniques, you can track your company’s progress while monitoring market fluctuations over time. Tracking risk factors over time allows you to better comprehend trends and make more informed decisions.
Operational risk, in business terms, refers to the possibility that your cash flow won’t cover debt repayments and other obligations. This could be caused by any number of factors including an economic downturn, rising interest rates or raw material costs or decisions by management which affect output capacity negatively.
These risks can cause significant losses for your business if left unmanaged, but can be easily prevented through proper implementation of systems and procedures that protect from them. You should hold brainstorming sessions with your team in order to identify potential operational risks; but only identify them; do not attempt to analyze or mitigate suggested threats in these brainstorm sessions.
The global economy can be unpredictable and unnerve economists & companies alike. Although numerous circumstances can impact financial markets, three primary risks stand out: credit risk, liquidity risk and operational risk. Tsunami-like effects from market turmoil are felt across business, investors, governments and borrowers. Credit risks such as inability to repay loans while government sectors experience problems controlling inflation or defaulting bonds can have far-reaching repercussions for social stability and international relations alike – sudden downturns can have profound ramifications on all involved parties involved – businesses need to adapt quickly or risk becoming victims themselves of these disruptions!