A Complete Guide to Financial Risk

Risk is the exposure to potential financial loss. There are different types of risk, such as business, financial, economic, environmental, etc. For example, a business is exposed to risk due to new competitors, changes in policy, price etc.

Let us read risk, its types and more in detail.

What is a risk? 

Risk refers to the exposure of an investment to potential financial loss arising from different circumstances. There are different types of risks. For example, in financial terms, there may be interest rate risk, default risk, liquidity risk, sector-specific risk, etc.

Risk is often made up of two components- the negative impact and the probability of uncertainty. Also, risk can be measured by many metrics, the most popular (in terms of finance) being alpha, beta, standard deviation, R-squared, and Sharpe ratio. For instance, if the standard deviation of a portfolio is 20%, then the investor knows that the returns can differ by 20%.  

Risks may be positive or negative. Positive risk refers to an opportunity for a business to increase its worth. However, negative risk refers to any threat that would decrease the worth of a business. 

• Risk is the divergence from anticipation
• There are different types of risk that vary in degree and affect people in different ways 
• Risk can be measured using standard deviation, beta, and Sharpe ratio 
•  The process of identifying, assessing and controlling potential risks to an organisation is known as risk management

Types of risk

There are broadly two types of risk- systematic risk and unsystematic risk. 

A. Systematic risk

It is a macro risk that affects the entire economy. This type of risk cannot be diversified and cannot be controlled by a specific company. For example, inflation, natural disasters, pandemic, terrorism, etc. There are three major types of risk under systematic risk- 

1. Interest rate risk– This refers to any change in the interest rates of the bank. The interest rates directly impact fixed-income securities like bonds. This is because bond prices are inversely related to interest rates. Therefore, any change in the interest rates will impact the cost of debt for companies.
2. Market risk– Investors usually make judgments based on sentiments in the market, assumptions, technical analysis, etc. Therefore, during a financial crisis, investors are usually not interested in investing due to the risk of uncertainty.
3. Inflationary risk– Inflation reduces purchasing power and makes things expensive in general. Inflation makes it expensive for the company to produce goods. Thus, inflationary risk can burden a company with additional costs and decrease its value. 

B. Unsystematic risk 

This is a type of risk which affects a specific company or a particular stock. It is micro in nature and can be diversified—for example, business risk, litigation risk, liquidity risk, etc. There are three major types of unsystematic risk-

1. Business/liquidity risk– This type of risk arises from a business’s inability to generate sales and profit. This may occur due to high competition in a particular sector, management issues, etc.
2. Financial/credit risk– This is a type of risk that is associated with credit default. For instance, loan defaults, failure in repayment of accounts payable and more.
3. Operational risk– This risk arises from unforeseen incidents in the day-to-day operations of an organisation. For example, significant errors in the manufacturing process, high employee turnover, security breaches, etc., fall under operational risks.

What is risk management?

Risk management is the process of identifying possible threats and responding to them in a way that creates the least (or no) adverse impact on the organisation. In order to manage risk, an organisation must define its risk tolerance and risk appetite.

What are the objectives of risk management?

Here are the five objectives of the risk management process-

1. Risk identification– An organisation must identify potential threats, including financial threats, sector-specific threats, economic threats, legal threats, etc.
2. Risk evaluation- Risks are then analysed for their impact and likelihood. 
3. Prioritise– After a thorough assessment of risks, an organisation needs to prioritise the risk based on an organisation’s vision and mission. 
4. Respond– After prioritising risks, an organisation needs to respond and act on strategies to minimise the same. 
5. Monitor– After taking the necessary action, an organisation needs to monitor results using different KPIs and take corrective actions accordingly.

Why is risk management important?

Risk management helps an organisation to prepare for unforeseen circumstances and aids in mitigating risks. When risks are efficiently managed, they reduce the cost for a company and increase efficiency.

Risk management also guides decision-making. Furthermore, the company is cushioned against any potential shocks and surprises. This helps the business remain more focused on achieving its goals.

Risk and diversification

Diversification is arguably the most popular risk management strategy that is adopted by investors. 

Diversification refers to creating a portfolio of different assets, like cash, ETFs, bonds, equity, etc., that have different levels of correlation with each other’s returns. Diversification helps safeguard against a portfolio’s volatility. Even though diversification does not guarantee gains, it helps in risk minimisation in the long run.

Conclusion

Risk is the likely happening of a negative event. Risk can be measured through various metrics and tools. Different types of risks may impact an organisation. Therefore, today’s dynamic business environment makes it imperative for an organisation to manage risks efficiently. Risk management may help foresee adverse events and prepare for them.

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