Financial Risk Management is the process of identifying risks, analyzing them and making investment decisions based on either accepting or mitigating them. These can be quantitative or qualitative risks, In banking, for instance, the Basel Accords are a set of regulations adopted by international banks that help to track, report and expose credit, marketing and operational risks.
There Are Several Different Types Of Risks That One Need To Know Before Making Financial Management
Operational Risk :
as defined by the Basel II framework – is the risk of indirect or direct loss caused by failed or inadequate internal people, systems, processes or external events. It includes other risk types such as security risks, legal risks, fraud, environmental risks and physical risks (major power failures, infrastructure shutdown etc.). Unlike other types of risk, Operational risks are not revenue driven, incurred knowingly or capable of being eliminated. As long as people, processes and systems remain imperfect and inefficient, the risk remains.
Foreign Exchange Risk:
foreign Exchange Risk is also known as currency risk, FX risk or exchange rate risk. It is incurred when a financial transaction is made in a currency other than the operating currency – which is often the domestic currency – of a business. The risk arises as a result of unfavourable changes in the exchange rate between the transactional currency and operating currency.
An aspect of Foreign Exchange Risk is Economic Risk or Forecast Risk; the degree to which an organization’s product or market value is affected by unexpected exchange-rate fluctuations. Businesses whose trade heavily relies on the import and export of goods, or who have diversified into foreign markets are more susceptible to Foreign Exchange Risk.
Credit Risk:
Credit risk is the risk that a borrower or client defaults on their debts or outstanding payments. With borrowed money, in addition to the loss of principal, additional factors such as loss of interest, increasing collection costs etc., must be taken into account when establishing the extent of the Credit Risk. Financial analysts use Yield Spreads as a means to determine Credit Risk levels in a market.
One of the simplest ways of mitigating Credit Risk is to run a credit check on a prospective client or borrower. Other means are to purchase insurance, hold assets as collateral or have the debt guaranteed by a third party. Some methods corporations use to mitigate Credit Risk arising from non-payment of client dues, are to request advance payments, payment on delivery before the handover of goods or not provide any lines of credit until a relationship has been established.
Reputational Risk:
Reputational Risk is also known as Reputation Risk and it is the loss of social capital, market share or financial capital arising from damage to an organization’s reputation. Reputation Risk is very difficult to predict or realize financially, as Reputation is an intangible asset. It is however intrinsically tied to Corporate Trust and is the reason why Reputation damage can hurt an organization financially. Criminal investigations into a company or its high-ranking executives, ethics violations, lack of sustainability policies or issues related to the safety and security of either product, customer or personnel are all examples of what can damage an entity’s reputation.
The growth of technology and the influence of social media can now amplify minor issues on a global scale. This has led to boycotts as a form of consumer protest. In extreme cases, Reputational Risk can even lead to corporate bankruptcy. For this reason, more organizations are dedicating assets and resources to better manage their reputation.
How Do You Identify Financial Risks?:
Identifying financial risks involves considering the risk factors a company faces. This entails reviewing corporate balance sheets and statements of financial positions, understanding weaknesses within the company’s operating plan, and comparing metrics to other companies within the same industry. There are several statistical analysis techniques used to identify the risk areas of a company.
How Do You Handle Financial Risk?
Financial risk can often be mitigated, although it may be difficult or unnecessarily expensive for some to eliminate the risk. Financial risk can be neutralized by holding the right amount of insurance, diversifying your investments, holding sufficient funds for emergencies, and maintaining different income streams.
Why Is Financial Risk Important?:
Understanding, measuring, and mitigating financial risk is critical for the long-term success of an organization. Financial risk may prevent a company from accomplishing its finance-related objectives like paying loans on time, carrying a healthy amount of debt, or delivering goods on time. By understanding what causes financial risk and putting measures in place to prevent it, a company will likely experience stronger operating performance and yield better returns.
Is Financial Risk Systematic or Unsystematic?:
Financial risk does impact every company. However, financial risk heavily depends on the operations and capital structure of an organization. Therefore, financial risk is an example of unsystematic risk because it is specific to each company.
What Are Financial Risk Management Strategies?:
Financial risk management strategies are a plan of action or policies that are designed to deal with various forms of financial risk. The strategies are important for any firm or individual to manage the inherent financial risks that come with operating within the economy and financial system.
Some Risk Management Strategies Include:
Risk Avoidance:
elimination of activities that can expose the individual to risk; for example, an individual can avoid credit/debt financing risk by avoiding the usage of credit to make purchases.
Risk Reduction:
mitigating potential losses or the severity of potential losses; for example, an individual can diversify their investment portfolio to reduce the risk that their investment portfolio experiences a severe negative drawdown.
Risk Transfer:
the process of transferring risk to a third party; for example, an individual may purchase a life insurance policy to offload the risk of premature death to the insurer.
Risk-Retention:
the process of accepting responsibility for a particular risk, for example, an individual deliberately not insuring their property.
At the corporate level, the same risk management strategies may be applied
Conclusion:
Financial risk is the possibility of losing money on an investment or business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk.
Financial risk is a type of danger that can result in the loss of capital to interested parties. For governments, this can mean they are unable to control monetary policy and default on bonds or other debt issues. Corporations also face the possibility of default on debt they undertake but may also experience failure in an undertaking that causes a financial burden on the business.
