1. Financial Risk Definition
Financial Risk refers to the unpredictability of potential financial loss that can occur in an investment decision.
Generally, financial firms take on a lot of financial risks and thus gain the profits (and losses), usually, they try to choose the type of risk to which they need to be uncovered.
Financial risk is defined as the risk to a financial portfolio from movements in the market prices such as interest rates, equity prices, foreign exchange rates, and commodity prices.
When a corporation is exposed to an event that can cause a shortfall in a targeted financial measure or value, this type of risk is called financial risk.
The more the organization resorts to debt financing, the greater the financial risk as it creates fixed interest payments due to debt or fixed dividend payments on preferred stock.
Thereby causing the number of residual earnings available for common stock dividends to be more variable than if no interest payments were required.
The financial measure or value could be earnings per share, return on equity, or cash flows, to name some of the important ones.
2. Financial Risk Examples
Financial risk is the probability or uncertainty that stockholders or investors will lose the money as a result of the financial decision.
Financial risks consist of market risk, credit risk, market liquidity risk, operational risk, and legal risk.
Financial firms tend to manage financial risk actively. Nonfinancial firms, on the other hand, might decide that their core business risk (say chip manufacturing) is all they want exposure to and they, therefore, want to mitigate market risk or ideally eliminate it altogether.
Risks can also be classified as core risks and noncore risks. The distinction is important in the management of risk.
In attempting to generate a return on invested funds that exceed the risk-free interest rate, a firm must bear the risk.
The core risks are those risks that the firm is in the business to bear and the term business risk is used to describe this risk.
In contrast to core risk, risks that are accidental to the actions of a business are known as noncore risks.
To understand the difference, consider the risk associated with the uncertainty about the price of electricity.
For a firm that produces and sells electricity, the risk that the price of electricity that it supplies may decline is a core risk.
However, for a manufacturing firm that uses electricity to operate its plants, the price risk associated with electricity (i.e., the price increasing) is a noncore risk.
Yet changing the circumstances could result in a different classification. For example, suppose that the firm producing and selling electricity is doing so on a fixed-price contract for the next three years.
In this case, the price risk associated with electricity is a non-core risk.
3. Types of Financial Risks
1. Liquidity Risk
Liquidity risk is defined as the particular risk from conducting transactions in markets with low liquidity as evidenced in low trading volume and large bid-ask spreads.
Under such conditions, the attempt to sell assets may push prices lower, and assets may have to be sold at prices below their fundamental values or within a time frame longer than expected.
Traditionally, liquidity risk was given scant attention in risk management, but the events in the fall of 2008 sharply increased the attention devoted to liquidity risk.
The housing crisis translated into a financial sector crisis that rapidly became an equity market crisis.
2. Operational Risk
Operational risk involves financial loss due to human error, physical accident or technical failure in the operation of a firm that also involves management failures.
Operational risk (or op risk) should be mitigated and ideally eliminated in any firm because the exposure to it offers very little return (the short-term cost savings of being careless, for example).
Operational risk is typically very difficult to hedge in asset markets, although certain specialized products such as weather derivatives and catastrophe bonds might offer somewhat of a hedge in certain situations.
Generally, operational risks are managed by self-insurance or third-party insurance.
3. Credit Risk
Credit risk is defined as the risk that a counterparty may become less likely to fulfill its obligation in part or in full on the agreed-upon date.
Thus credit risk consists not only of the risk that a counterparty completely defaults on its obligation, but also that it only pays in part or after the agreed-upon date.
The nature of commercial banks traditionally has been to take on large amounts of credit risk through their loan portfolios.
Banks are very careful and spend much time to manage their credit risk exposure.
Nonbank financials, as well as nonfinancial corporations, might instead want to completely eliminate credit risk because it is not part of their core business.
However, many kinds of credit risks are not readily hedged in financial markets, and corporations often are forced to take on credit risk exposure that they would rather be without.
4. Business Risk
Business risk is defined as the risk that changes in variables of a business plan will destroy that plan’s viability, including quantifiable risks such as business cycle and demand equation risk.
Along with that non-quantifiable risks that involve variation in competitive behavior or technology.
Business risk is sometimes simply defined as the types of risks that are an integral part of the core business of the firm and therefore simply should be taken on.
The securitization of credit risk via credit default swaps (CDS) is a prime example of credit risk (the risk of default) becoming a market risk (the price of the CDS).
4. Financial Risk Management
- Risk Control Process
The most common methods involved in risk control process:
Identifying the risks, analyzing risks, monitoring risks, restriction for risk, eliminating certain risks, reviewing and evaluating.
- Strategic Risk Management
Strategic Risk Management process is all about capital budgeting, pricing products on a risk-adjusted basis, analyzing the performance on a risk-limit basis.
- High-Risk Management
Extreme dangerous events that can threaten the survival of a corporation are referred to as high-risk events.
High-risk management plays a very important role to minimize the impact of potentially high-risk events and having in place an early warning system that, if possible, could identify a potential disaster.
- The Process of High-Risk Management Includes
Analyzing the past data to identify any patterns suggesting the potential emergence of high risk, testing of the impact of high risk on the financial condition and reputation of the firm.
Emergency planning for certain scenarios, preparing futuristic actions to be taken to effectively communicate with stakeholders when a high risk occurs
Learning from previous major problems and being prepared for future plans.
- Risk Management Culture
Building a risk management culture among the organization with a primary motive to create a situation where Operational, Strategic, and Catastrophic Risk Management takes place in an organization without the direct intervention of the Risk Officer or the Risk Committee.
- The Process of Risk Management Culture Includes
Identification and measurement of all the firm’s risks, identification of the best risk management practices.
Developing supporting documentation which can be used by management, communication with all interested parties, reinforcement by training employees.
Often in referring to risk, the terms risk appetite and risk tolerance are used interchangeably.
However, there is a difference and COSO distinguishes between the two terms as follows:
Risk appetite covers broadly all the levels of risks that management believes acceptable on the other hand risk tolerance means it will set the acceptable level of variation around objectives.
For example, a company denies to accept risks that could result in a significant loss of its revenue base is expressing appetite.
When the same company says that it does not wish to accept risks that would cause revenue from its top-10 customers to decline by more than 10% it is expressing tolerance.
Risk tolerances maintain a greater assurance to management to work within.
That means the company operates within its risk appetite and maintains a greater comfort so that the company will achieve its objectives.
Basically, the firm’s risk appetite is the amount of risk exposure that the board decides the firm is willing to accept/retain.
When the risk exposure of the firm exceeds the risk appetite threshold, risk management processes are implemented to return the exposure level back within the accepted range.
5. Managing Risks
A firm’s retention decision refers to how a firm elects to manage any identified risk.
This decision is not just a risk management decision but also contributes to the capital structure.
Of course, each identified risk faced by the firm can be treated in a different way.
As will be explained, for each of the three choices—retention, neutralization, and transfer of risk.
1. Retained Risk and Risk Finance
The aggregate of all the risks across the firm that it has elected to bear is called its retained risk.
Because if a retained risk is realized it will adversely impact the firm’s earnings, a firm must decide whether a retained risk is to be unfunded or funded.
An unfunded retained risk is a retained risk for which potential losses are not financed until they occur.
In contrast, a funded retained risk is a retained risk for which an appropriate amount is set aside upfront (either as cash or an identified source for raising funds) to absorb the potential loss.
2. Risk Neutralization
If a firm elects not to retain an identified risk, it can either neutralize the risk or transfer the risk.
Risk neutralization is a risk management policy whereby a firm acts on its own to mitigate the outcome of an expected loss from an identified risk without transferring that risk to a third party.
This can involve reducing the likelihood of the identified risk occurring or reducing the severity of the loss should the identified risk be realized.
3. Risk Transfer
For certain identifiable risks, the firm may decide to transfer the risk from shareholders to a third party.
This can be done either by entering into a contract with a counterparty willing to take on the risk the firm seeks to transfer or by embedding that risk in a structured financial transaction, thereby transferring it to bond investors willing to accept that risk.