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4 types of financial risks

By | John Preston

Before looking at techniques to assess and reduce risk, it is important for the analyst to understand what financial risk is and what his practices are.

Financial risk can be understood as the probability of having a negative and unexpected result due to market movements.

These risks can be caused by poor cash flow management or risks related to lower than expected income.

There are different causes for which they can happen:

  • Inadequate administration.
  • High debt.
  • Exchange variations or interest rates.
  • Market operations or investments with a high degree of insecurity.
  • Lack of information to make decisions.

There are mainly 4 types of financial risks: market risk, credit or credit risk, liquidity risk, legal risk and operational risk.

1. Market risk

Among the classes of financial risks, one of the most important is market risk. This type of risk has a very wide scope, since it appears due to the dynamics of supply and demand.

Market risk originates in large part from economic uncertainties, which can impact the performance of all companies and not just one in particular. The variation in the prices of assets, liabilities and derivatives is part of these sources of risk.

For example, this is the risk to which a company that imports its inputs is exposed, paying in dollars and then selling the final product in local currency. In the event that it is devalued, that company may suffer losses that would prevent it from meeting its financial obligations.

The same applies to innovations and changes in the market. An example of this is the commercial sector. Companies that have been able to adapt to the digital market to sell their products online have experienced an increase in their income. Meanwhile, those that have resisted these transformations have lost competitiveness.

2. Credit risk or credit risk

In financial risk management, credit risk is of paramount importance. This risk refers to the possibility that a creditor will not receive payment on a loan or receive it late.

Credit risk is, then, a way of determining a debtor’s ability to meet its payment obligations.

There are two kinds of credit risk: retail and wholesale.

The first refers to the risk that occurs when financing people and small businesses, whether through mortgages, cards or any other form of credit.

Wholesale credit, for its part, originates from the investments made by the organization, whether they are sales of financial assets, mergers or acquisitions of companies.

The case of subprime mortgages in the United States, which caused the 2008 economic crisis, explains how credit risk materializes when it is not managed properly.

Subprime mortgages were high-risk, high-interest loans granted to people without a job or without a stable income.

Banks began to broaden the profile of subprime-style mortgage applicants in order to increase revenue. However, as the applicants could not pay, the delinquency of the debts increased.

This situation caused the bankruptcy of thousands of banks in the United States and compromised the good name of some others, such as the JP Morgan Chase bank.

3. Liquidity risk

Financial risk management must pay attention to the liquidity of a company, since every organization must ensure that it has sufficient cash flow to pay its outstanding debts. If you don’t, you may undermine investor confidence.

Liquidity risk consists of exactly that, the possibility that a company fails to meet its commitments. One possible cause is poor cash flow management.

A company can have a significant amount of equity, but at the same time a high liquidity risk. This is because you cannot convert those assets into money to meet your expenses in the short term.

Real estate or savings bond, for example, are assets that can take a long time to turn into money. Therefore, it is necessary for each company to verify if it has current assets to settle short-term commitments.

4. Operational risk

Finally, within the types of financial risks there is also operational risk. There are different kinds of operational risk. These risks occur due to the lack of internal controls within the company, technological failures, mismanagement, human errors or lack of employee training.

The consequence of this risk almost always results in a financial loss for the company.

Operational risk is one of the most difficult to measure objectively. In order to calculate it accurately, the company should have created a history of failures of this kind and recognized the possible connection between them.

These risks can be avoided if it is considered that a specific risk can trigger many others. A machine that breaks down, for example, does not only imply an expense to repair it. It also causes losses due to having interrupted production, which can lead to a delay in product deliveries and even affect the reputation of the company.

Large companies such as Intel or Facebook have suffered significant economic losses for not having anticipated operational risks. Likewise, it has happened with several of the largest banking entities in the world, such as Riggs Bank, Barings Bank or Crédit Lyonnais in France.

Through risk management software, companies of all industries and sizes can more easily manage their operational risks. With this tool they can identify and manage processes, risks, controls, events, establish action plans, generate reports, among other functions.


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