Financial Risk is the risk which is associated with Financial transactions, Financing and Investment. This risk can be related to losing money or risk of default or fraud or threat of uncertainty.
The Financial risks apply to everybody from Government, Banks, Financial Institutions, Businesses, Traders, Investors, Brokers, Self-Employed and Individuals who became a party to any financial transactions.
In simple words, Financial Risks is the risk of losing money or losing valuable assets or having valuable asset but losing its value to full or some extent.
We can say that Financial Services or Transactions contain inherent or unavoidable risk. In broader terms, the Financial Risk can be associated with a range of scenarios such as Financial Markets, Business Administration, Unforced Events, Fraud and Manipulation, Not being Aware and Governing Bodies.
It is necessary to understand the Financial Risk and its various types and understand how to be cautious to minimize the risk. These Risks can be defined or classified in following forms such as Market Risk, Investment Risk, Operational Risk, Credit Risk, Liquidity Risk, Compliance Risk, Systematic Risk, Fraud or Manipulation Risk and Losing Money or Inappropriate Transfers.
While making Financial Decisions or executing Financial Transactions, you may encounter or face these risks as described below:
- Market Risk: These risks arise due to the uncertainty or changes in the market or prices. We can say that Market risk is associated with fluctuation in prices of an asset.
The threat can be both direct or indirect:
For example: If you Buy Shares of Reliance Industries, the amount of its share may fall due to normal fluctuation in the market, i.e. direct market risk, on the other hand, if share drops due to falling/rise in the value of crude oil, it might be the result of indirect market risk.
- Investment Risk: These risks are associated with Investments and Trading activities. These risks are mainly related to fluctuations in the market or wrong decisions making or investment done at the wrong time.
- Credit Risk: These risks arise of the uncertainty occurs due to the failure of an entity to keep their promise of payment or making default of payment. For example, If you lend money to your friend for two months, and he doesn’t repay, it will lead to credit risk to you as you won’t be able to manage your obligations further.
- Operational Risk: These risks arise due to institutional uncertainties of the organization. This risk is associated with Financial losses caused due to the failure of internal processes, systems, procedures and management. These risks may also arise of the negligence or accidental human mistakes by intentional fraudulent activities in the organization. These risk may occur with internal as well as external factors associated with the organization.
- Liquidity Risk: These risks arises due to the inability to effectively executing the transaction. These risks can be classified into two categories, i.e.,
(a) Asset Liquidity risk arises due to insufficient buyers or sellers in the process of liquidating the asset and
(b) Funding Liquidity risk occurs due to the inability to convert asset or investment quickly in liquid form due to drastic change in their price.
- Compliance or Legal Risk: These risks arise when companies may lose money due to the organization’s inability to abide by the agreement of Legal and Regulatory guidelines. If any companies are facing such challenges, they may face huge penalties or risk of closure or banned from specific market or activities. For example, Companies, Financial Institutions or Banks face sanctions, financial penalties, lawsuits and legal proceedings in case of such breach or failure.
- Funding Risk: These types of risks arises due to the uncertainty of whether the Investors will provide sufficient funds. We can say that risk is associated with the impact of cash flow on the project wherein higher funding cost is associated, lack of availability of funds or timelines in funding project is not met.
- Reputational Risk: These risks arise due to the uncertainty about the events of how the image of the entity will be perceived. These risks are associated with the activities of failure on the part of the organization meeting their financial commitment, and they may suffer Reputational Risk due to the same.
- Political Risk: These risks arise due to the uncertainty about Government policies and actions. They can be the result of unstable political conditions, change in government, new procedures, rules or legislation passed by the government may affect the company or the sector as a whole.
- Systematic Risk: These risks arise of the specified events triggering and creating an adverse effect in a particular market, industry, country or globally. For example, the crash of Lehman Brothers in 2008 triggered the severe effects on US Financial market crisis which later ended up affecting many countries globally. Usually, such risks are associated with the same industry but may affect interrelated sectors as well.
- Fraud and Manipulation Risk: These risks arise due to the deliberate events of Fraud, Manipulation, Cheating or Stealing within the organization or with consumers, suppliers of regulatory agencies or persons.
- Losing Money or Inappropriate Transfers: These risks arise of the situations of events when someone loses money by mistake or does inappropriate transfer where details are inputted incorrectly.
These were the full rate of risks associated with dealing with Finance or executing Financial Transactions of any nature. What could be the measure to minimize or mitigate these risks, let’s discuss the Risk Management tips to be cautious while handling such transactions:
Basic process flow to identify risk and finding measures to minimize or eliminate the risk:
- Define Possible Risk and Risk Situations.
- Assessment and Analysis of the Risk.
- Define and Evaluate Budget and Risk.
- Evaluate and Define Risk Appetite.
- Define Record Maintenance process and Risk Reporting.
- Define Contingency Plans and Precautionary Measures and Actions.
- Review Risk Policies.
- Develop Proposals and Alternative Solutions.
Steps to Eliminate Financial Risk:
- Define Cash Flow or Liquidity requirement to be maintained.
- Define and Manage Operational Cost.
- Well defined Payment Terms.
- Fixed-Rate of Interest on Loans and Borrowings.
- Rigorous Billing and Credit Control Mechanism and Process.
- Well defined Credit Terms and maintain them.
- Understand Price Fluctuations and price sensitivity associated with your product or raw material and take measures for minimizing the risk of fluctuation.
- Ensuring the right people at the right job with the right degree of supervision is needed to reduce the risk of fraud and manipulation.
- Ensuring timely checks and audit minimize the risk.
- Due to proper diligence of the people, projects and processes.
- Clear understanding and check on systematic and unsystematic risk.
- We are taking appropriate Insurance or Hedging help in minimizing and eliminating risk.
- Diversification of investment is also an effective measure to minimize risk.
- Must have an exit strategy on the investments made.
Financial Risks are both Company and the Individuals. Companies can hire financial experts in the company to assess and manage the risk involved and taking the necessary steps to minimize and reduce the effects of the same. Still, on the other hand, most individuals who can’t afford to hire financial experts have to manage these risks themselves. Therefore we have included the process of risk evaluation and steps useful in taking corrective action or using them to mitigate or minimize the risk.