Types of Financial Risks
Risk can be defined as the probability of having an unexpected negative outcome. There are many risks that a business is exposed to. Strategic risks occur because of certain decisions made by management, such as expansion in new geographies, operating in a particular industry at a particular time, or the launch of a new product line. Compliance risks are subject to legislative and bureaucratic rules and regulations. These can include employee protection regulations and environmental regulations. Reputational risks result from company actions that tarnish its brand name, such as product failure, lawsuits against the company, or negative publicity due to an event. Financial risks are risks faced by the business in terms of handling its finances, such as defaulting on loans, debt load, or delay in delivery of goods. Other risks include external events and activities, such as natural disasters or disease breakouts leading to employee health issues. Managing financial risk is a high-priority risk for businesses, irrespective of the industry they operate in. It can be categorized into the following four categories:
- Market Risk
- Credit Risk
- Liquidity Risk
- Operational Risk
The first risk, market risk, arises due to movement in prices of financial instruments in the market. One sub-category of market risk is interest rate risk, which is the risk associated with the movement of interest rates. This can affect the price of interest-bearing assets, such as bonds or loans. For example, an increase in interest rates can lead to a loss of value of bonds issued by a company as the prices of the bonds decrease. To manage interest rate risk, various hedging instruments are available, such as interest rate swaps and forward rate agreements.
Equity price risk is another sub-category of market risk and is associated with the change in prices of equity shares of a company. It can be differentiated into two categories: systematic risk and unsystematic risk.
Systematic risk refers to the risk caused by market factors which affect the entire industry. It cannot be diversified. When an entire industry is affected by some event, it becomes a systematic risk. Unsystematic risk refers to risk that is specific to a company, such as management changes or fraud. This can affect the price of its equity shares. Suppose a company launches a new product. The market will have uncertainty in terms of response to the product that can lead to fluctuations in its share price. This risk is borne by the shareholders and is an unsystematic risk.
The most effective method of managing equity price risk is to create a diversified portfolio, including securities that have low or negative correlation among themselves. In this way, the losses from one security can be balanced with gains from the other. Derivative contracts to hedge the portfolio holdings are also a common way to manage this risk.
Another category of market risk is foreign exchange risk, the risk is associated with the fluctuations in currency values. It happens when a financial transaction is denominated in a currency other than the base currency of the business. Let's assume a company that is based in Hong Kong has clients in the USA and earns the majority of revenue in USD. This company faces a foreign exchange risk as the revenues need to be converted from USD to HKD, and is exposed to exchange rate fluctuations between the two currencies.
Foreign exchange risk is usually managed by hedging the exposure in one currency to another so that the fluctuations in the exchange rate do not impact the transaction. Various instruments, such as future and forward contracts, forex swaps, money market hedges, and currency swaps are available for managing foreign exchange risk.
Commodity price risk is another type of market risk and it relates to the change in the price of input raw materials (production inputs) needed by a business, which can impact the profit margins of the company. For a company that makes potato chips, potatoes are an important raw material. Any increase in the prices of potatoes will increase the cost of production for the company. So, there's a commodity price risk. Companies generally use long-term supply contracts to manage commodity price risks. Other measures can include passing the increase in price to the customers, looking for alternatives of the commodity, or hedging with other financial exposures.
The second risk, credit risk, happens due to default on loans. When the lenders lend money to borrowers, there's always a risk involved that the borrowers might not repay the loan. Suppose a company has borrowed two million dollars from a bank but is unable to repay because of losses incurred. This poses a credit default risk for the bank. There are various ways to manage credit risk, such as credit default swaps that provide protection against credit loss on an underlying reference entity because of a specific credit event.
The third risk, liquidity risk, is concerned with the short-term financial obligations of a company. It generally happens when a business that has immediate cash needs holds an asset that it cannot trade or sell at market value due to a lack of buyers. Suppose a company with one million dollars in assets, such as land, has no cash available. It runs a liquidity risk in this scenario. Companies generally take measures to increase their cash on hand to manage liquidity risk.
The fourth risk, operational risk, is mainly a result of internal failures in the operations of a business. One sub-category of operational risk is fraud risk, which can occur due to internal fraud deliberately caused by employees or external fraud due to theft or robbery. Financial reporting poses the biggest fraud risk to companies. To manage fraud risk, companies devise strong policies for governance, assessment, and prevention of fraud. Regular internal audits and transparent reporting systems are some of the measures taken to prevent such risks.
Operational risk can also include people risk, which are errors due to human actions, such as incorrect data entry. Employee training and regular assessment form important tactics to manage this risk.
Model risk, another type of operational risk, is the risk that the financial model used to capture the risks or value of a financial instrument does not perform accurately. This can result in mispricing of assets. Ensuring regular assessment of the models used, proper training of stakeholders, and maintaining transparent workflow are some of the measures to manage the model risks.
Another sub-category of operational risk is legal risk, which is primarily caused by a defective transaction, change in law, or a fine imposed for inappropriate actions of the business. The major sources of legal risk are contracts, regulations, litigations, and structural changes. Legal risk can be managed with the help of legal advisors who can analyze the contracts and formalities for the company.
Financial risks are risks faced by a business in terms of handling its finances. Managing financial risk is a high priority for most businesses. Financial risk is classified into four broad categories.
The first, market risk, arises because of movement in prices of financial securities in the market. The second, credit risk, arises because of non-repayment of loans. The third, liquidity risk, is concerned with the short-term financial obligations of a company and can occur when a company in need of immediate capital has valuable assets that have no buyers. The fourth and final, operational risk, occurs due to internal failures in operations of a business.
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Financial Risk - A Practical Exercise:
The following exercise will allow you to apply your knowledge of Financial Risk by (1) identifying different types of risk and (2) suggesting ways to manage financial risk.
You are a risk analyst at Boomer Skateboards, a company based out of Illinois that manufactures skateboards. Boomer has done extremely well in the United States and is looking to enter the Australian market. Because the Australian market is completely different than the United States, the company hired some researchers to provide data on the various risks. You have now received the results of the research (see below) and, while it is accurate, it is slightly disorganized. You decide that it is best if you organize the various risks into 4 categories (Market Risk, Credit Risk, Liquidity Risk, and Operational Risk) before presenting the details to management. In addition, you decide to provide a suggestion on how the company can reduce its credit risk that you identified in the research findings.
List of Risks:
- The funds required for capital expansion (i.e. building a factory, investing in the supply chain, etc.) will decrease the company's cash balance by roughly 85%.
- The Australian dollar can fluctuate against the US Dollar, leading to unintended gains or losses.
- There are differences in Contract law between the United States and Australia.
- Wholesalers in Australia (i.e. your new customers) are not as reliable for paying their accounts as your wholesalers in the United States.
- The company's expansion loan with the bank is at a variable interest rate and thus changes in interest rates can impact the borrowing cost of the company.
- The employees in the Australian location may be difficult to train from overseas and can lead to defects when assembling skateboards.
|Risk No.||Risk Classification|
|2||Market Risk (Currency)|
|3||Operational Risk (Legal)|
|5||Market Risk (Interest Rate)|
|6||Operational Risk (People)|
The company can reduce its credit risk with the following methods:
- It can only accept cash payments.
- It can tighten the credit terms (i.e. payments are required on shorter notice, penalties can be imposed for late payments, etc.).
- It can offer greater discounts to customers who pay early.
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