“Possibility of loss or injury” that’s how Merriam-webster.com defines risk. The term ‘risk’ can have multiple meanings depending on the context in which it is used. However, generally, it means unfavourable outcomes. Every business faces several types of risks, amongst which financial risk is one of the most critical risks.
Businesses that take uncalculated financial risk might have to suffer a significant loss of capital or investment. However, it can be strategically managed and minimised with the help of an effective financial management strategy and an expert financial risk manager. Continue reading to delve deeper into the meaning of financial risk, types of financial risks, and the role of a financial risk manager in minimizing it.
What is Financial Risk?
Risk implies the future uncertainty of an expected outcome. Along the same lines, financial risk refers to the possibility of loss that a business might have to suffer in the future. There could be many internal and external reasons underlying the financial risk. However, generally, financial risk arises due to external factors like government regulations, competition, macroeconomic forces, market interest rates, and a slump due to economic reforms.
Ideally, there are four types of financial risks – market risk, credit risk, liquidity risk and operational risk.
Different Types of Financial Risks
- Market Risk
This type of financial risk arises due to the changes in the prices of financial instruments. There are two types of market risk, namely, directional, and non-directional risk. Directional risk is caused due to fluctuations in stock price, interest rates, and others. Meanwhile, non-directional risk can be due to volatility risk.
- Credit Risk
Credit risk arises when a business fails to fulfil its monetary obligations towards its counterparts. There are two kinds of credit risks, namely, sovereign risk and settlement risk. Sovereign risk usually arises due to complicated foreign exchange policies. Settlement risk, on the other hand, arises when one party makes the payment and the other party fails to do so.
- Liquidity Risk
This risk arises when businesses are unable to liquidate their cash due to volatile market conditions. Funding liquidity risk and asset liquidity risk are two types of liquidity risks.
These types of financial risks arise either due to insufficient buyers or insufficient sellers.
- Operational Risk
It arises due to operational failures such as mismanagement. Operational risk can be classified into two types, namely, fraud risk and model risk. Fraud risk arises due to lack of control, whereas, model risk arises due to incorrect model application.
- Legal Risk
Legal risk arises out of legal constraints. When a business loses finances due to legal proceedings, it is referred to as legal risk.
Other Types of Risks Businesses Face
When a business faces threats from external factors like competition, consumer preferences, government policies, and others, it can be referred to as business risk. These risks can endanger the company’s success and can also lead to a decrease in profits.
Under the umbrella of business risk, there are various other kinds of risks, like strategic risk, operational risk, reputational risk and more. These risks hamper the growth of a business. It may also lead to the business failing to meet its targets.
Volatility risk refers to the risk that an investment portfolio experiences due to changes in value. Volatility risk is often used in the field of investment and trading.
Inflation risk is also called purchasing power risk. When the return on investment of an asset is hindered by inflation, it is referred to as inflation risk. Primarily, this type of risk examines how inflation can reduce investment returns. Inflation risk is more relevant and helpful for investors.
Market risk arises when the value of an asset changes due to economic changes. Specific market risks, equity risk, interest rate risk, and currency risk are some of the types of market risk.
Liquidity risk means when assets or securities cannot be converted into cash or cannot be liquidated fast enough to escape a volatile market. This type of risk affects businesses, corporations, and individuals.
Though businesses pose enormous risks, financial risk is one of those risks that hinder the smooth functioning of businesses. This is where efficient financial management and the intervention of a financial risk manager comes into the picture. Let’s take a closer look at understanding what financial management is and who is a financial risk manager.
What is Financial Management?
Financial management refers to planning, executing and controlling the financial activities of an enterprise. Functions of financial management involve estimation of capital requirement, determination of capital composition, management of cash, investment of funds, disposal of surplus and others.
Who is a Financial Risk Manager (FRM)?
Financial risk managers possess specialized knowledge in assessing and managing financial risk and working with banks, insurance companies, accounting firms, and asset management firms. You can explore different online and offline financial management courses offered by Emeritus India in collaboration with globally renowned universities.
Some of the responsibilities of an FRM include identifying threats to assets, analysing business risk, and offering a solution to business risks. Furthermore, they are also responsible for developing strategies to counteract the effects of the fluctuating market on businesses and their finances. They work in various fields, from financial services to marketing, to determining risk and providing a solution.