Financial risks are an integral part of all business activities in the market. They emerged together with the money turnover and monetary relations such as investor – issuer, the creditor – borrower, buyer-seller, exporter – importer and others. When investigating the nature of business profits, Adam Smith emphasized the “risk charge” as a part of a business income structure in the form of compensation for possible losses associated with business activities.
What Is Financial Risk?
Simply put, FR is the probability of a certain company to lose money. Financial risk also refers to defaulting on bonds of a corporation or government, which of course will cause the bondholders to lose money. FR is a type of specific risk, i.e. pertaining only to a company or group of companies. This concept is typically used to reflect an investor's uncertainty of collecting returns and the accompanying potential for financial loss. To calculate risks, investors use a range of ratios such as:
Debt to capital ratio, which measures the amount of debt used versus the total capital structure of the company.
Capital expenditure ratio, which divides the cash flow from operations by capital expenditures to see how much money a company will have left to keep the business running after it services its debt.
Financial Risk Types
FR can take many forms. The most common of them are:
Credit. This type pertains to borrowing money. If a borrower is unable to repay the loan, they go into default. Credit risk is the possibility of a loss resulting from the borrower's failure to repay a loan or meet contractual obligations. As a result, an investor may not receive the owed principal and interest, which results in interrupted cash flows and growing collection costs. Correct assessment and management of the credit risk can minimize the degree of the loss. Interest payments are the investor's reward for assuming credit risk.
Currency (foreign exchange). This form can occur when a company is having a transaction with a foreign company under conditions when one currency is stronger than the other. As long as a company is dealing with a foreign company, it is always exposed to more or less currency risk. The foreign exchange (FX) risk can be caused by commodity prices, inflation, interest rates, and exchange rates. It is impossible to completely avoid the currency risk but it can be mitigated with the help of pre-hedging or dynamic hedging.
Equity. This is the risk that the general stock prices will change. When it comes to long term investments, equities provide a return that will hopefully exceed the risk-free rate of return. When investing in equity, it is believed that higher risk provides higher returns. Hypothetically, an investor will be compensated for carrying more risk and thus will have more incentive to invest in a riskier stock.
Interest rate. The interest rate risk is caused by the change in market rates and their impact on the probability of a bank. This type can affect the financial position of a bank and create unfavorable financial results. The probability that the interest rate will change at any given time can have either a positive or negative consequence for the bank and the consumer.
Liquidity. This risk refers to an impossibility to buy or sell a given security or asset quickly enough to prevent a loss or make the required profit. There are two subtypes of liquidity risk: asset liquidity and funding liquidity.
Financial risk is the probability of a specific company to lose money. FR can be associated with credits, foreign currency, equity, interest rate, liquidity, etc.