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Different Types of Financial Risks and the Effective Ways for Risk Management

by Aug 19, 2019Management0 comments

Almost every business concern has to go through a phase of financial risk at one point or the other. The management is always highly concerned about any kind of financial risk that may attack the business. So, they are in the constant process of reviewing their financial strategies and reworking on the risk management techniques.

The increase in the possibility of financial risks has got the Financial Risk Managers gain high demand in the industry. Every company today makes sure that they have hired a good Financial Risk Manager who can rescue them from huge financial threats.

Before learning the various financial risk management techniques it is very important that you have a good idea about what is a financial risk and what are the various types of risk that need to be combated.

How can you define risk?

Risk is the term that is used to describe the situation that might bring out an unfortunate result. Risks always bring out some negative output. Therefore any action that can bring with it any kind of loss can be safely concluded as a risk.

There are various types of risks that you can relate to in your day to day lives. Similarly, every business organization also has to go through various kinds of risks. One of those risks can be termed as a financial risk.

Different types of risks faced by a business organization

Any business concern can face mostly 3 types of risks. These risks can be categorized as business-related risks, non-business risks, and the most important one is the financial risk. Below is a detailed discussion of these three types of risks.

Business-related risks:

Any business concern has to take some big risks every now and then to grow their business and increase the profit. This is called the leap of faith. If they succeed then it is great and if they fail then that is surely not good news for the business. There are times when businesses have to pay a good price for taking a risk. Therefore any risk that is knowingly taken by the management is termed as the business related risk or just business risk.

Non-business risk:

There are certain risks that are not under the control of the management of the business concern. They arise due to various political issues or financial disparity within the business. They have no direct relationship with the business. Thus they can be concluded to be non-business risks. These kinds of risks will keep arising from time to time a there are no sure ways to stop them completely.

Financial risk:

This type of risk is the one that the management is concerned about the most. As the name suggests, these risks involve finance or money. The financial risks arise when the company suffers from a severe financial crisis. These can be caused due to a wrong financial decision or due to the downfall in the price of shares of the company in the stock market.

The change in the rate of the currency or interest can also lead to severe financial risk in any concern. These risks should be monitored thoroughly to save a business from getting perished. That is why Financial Risk Managers are appointed in every concern to take care of these risks and save the company from huge losses.

What is the importance of risk management?

Risk is a very important factor that should be taken care of always. If the risks are not managed properly then they may bring huge losses with them. The art of managing risks is termed as Risk Management.

Every business concern today appoints a group of efficient Risk Managers who can save the business from every possible threat. Risk management strategies are important in every sector of society. They need to be implemented correctly or else there can be irreversible losses.

The Risk Managers are appointed to look after the various possibilities that can bring out some kind of unwanted threat with it. The Financial Risk Managers are only concerned about the various risks related to money within the concern. They have a very serious job to do.

Protecting the business from every possible financial threat is very important or else it may perish in no time. The Financial Risk Managers are always on duty monitoring the various financial decisions taken by the company. They will have to go through every document related to finance and consider all the possibilities that might lead to any kind of financial crisis.

If the possible risks within a business can be monitored from beforehand and managed well, then it can be prevented from facing huge losses. Effective risk management can take any business to new heights and bring in a good amount of profit.

Types of financial risks

There are many kinds of risks faced by any business that is related to finance. The various types of financial risks faced by a business are listed below:

  • Market risk

As the name suggests, market risks are entirely dependent on the various changes and fluctuations in the economic market. They can be directional risks or non-directional risks. The fluctuation in the price of shares, currencies, and rate of interests are termed as directional risks. On the other hand, the risks that are variable and cannot be chalked out from beforehand can be called as non-directional risks. The market risks can be further divided into equity risks, currency rates, interest rates, and price of items.

  • Financing risk

The financing risks are also as liquidity risks. These risks occur when the business organization fails to carry out the proper transactions. The liquidity risks take place if the management is unable to meet all its financial commitments and faces a great amount of loss. The financing risks are of two types, asset liquidity risks, and funding liquidity risks.

The asset liquidity risks take place when there are not enough buyers for the assets already present or enough sellers who can meet with the buying orders. The funding liquidity risk arises when the business does not have enough liquid funds to pay off its debts or fund any business procedure. The financing risks can be categorized into financing risks, market liquidity risks, and problems in cash flow.

  • Credit risk

When a business organization fails to meet its financial commitments and pay off the debts to its co-ordinates then there arises the situation of credit risk. This is a very common type of risk that is faced by most of the concerns and should be taken well care of from before.

The credit risks can be of the sovereign type or settlement type. In the sovereign credit risks, the government is involved. If the governing body of any country fails to pay off its debt and meet with all of its financial commitments then the situation is termed as sovereign credit risk.

In settlement credit risks the business concerns are involved. If a business body is unable to pay the credit amount it is obliged to pay to its counterpart then settlement risks take place.

The credit risks within a business concern can be further grouped into risks involving the customers, risks faced by the suppliers and the risks faced by the business counterparts.

How to manage financial risks effectively?

For any business organization to flourish well it should take all the possible measure to fight any kind of financial risk that might come its way. Every business body is hiring a good team of Financial Risk Managers who are in charge of all the possible threats that may hinder the business. These Financial Risk Managers have the duty of going through every possible situation and evaluating them thoroughly to detect the threats. Then they will have to apply the various risk management techniques that can control the severe unwanted outcome of these risks and protect the company from huge losses.

The Financial Risk Managers (FRM) are well trained in the subject of Risk Management. They have a good deal of knowledge about every effective technique that can control risks and change their unfavorable outcome to something that is less severe and manageable for the company.

Some of the effective methods of controlling financial risks are listed below:

Regression Analysis:

Regression analysis is the technique that is used to study the consequences on one variable entity when the other variable entity is changed. In this process, the FRMs have to monitor the various variable factors and see how they change when their counterparts are altered. If the rate of interest is increased then how will it affect the flow of cash within a business? Similarly, if the rate of interest is decreased then what effect is it going to have on the various counterparts that are related to it.

By monitoring these factors closely the FRMs can guide the management how they can monitor the variable entities correctly so that they do not affect the business adversely. In this way, the business can nicely avoid any kind of financial threat and losses.

Value at Risk Analysis:

Value at Risk, shortly known as VaR, is a very common technique employed by the FRMs to calculate the possible financial risks. Here the FRMs have to calculate the amount of money that can be lost by the company. They also determine whether there is a probability of the financial risk to take place or not and if yes then within how much of time.

For example, VaR of a company is written as 2% one year value at risk of 10,000. This means that the company is having a 2% chance of facing a loss of Rupees 10,000 in any year.

This is a very effective method of calculating risk as it gives a total idea of the upcoming threat to the management and they can prepare themselves from beforehand. The amount of money projected may not be exact. There can be variations. It can be more than the value shown or less than it. But there is a rough estimation of the loss that the company can incur in the future.

Security Analysis:

In this method, the FRMs have to analyze the security instruments of the company. The security instruments are basically the various financial items like the money taken as a loan by the company, shares of the company, and the warrants on the name of the company. There are also times where the contracts that may come in the future and the credits related to the business are also included in it.

The security analysis works on two modules, one is the fundamental analysis and the other is the technical analysis. The fundamental analysis depends on the various basic factors related to the business like the money-oriented documents and statements. The technical analysis, on the other hand, is employed to study the trend of the market and its movement.

Scenario Analysis:

This method of Risk Management is surely an effective one. In this process, the FRMs are supposed to study properly the whole business and pen down the various possibilities that can take place. It is all about using the brain and questioning oneself about the various scenarios that are likely to happen.

For example, what are the possible threats if the rate of interest rises by 25% or the share market sees a downfall by 50%?

In this way, they can prepare the business concern to handle the risks from beforehand and avoid huge losses.

The job of a Financial Risk Manager is very crucial in any business concern. He can prevent the company from suffering huge losses. Therefore with the knowledge of effective financial risk management, a Risk Manager can take a company to a new height.

Author Bio:

The author of this article is Michelle Johnson. She has completed her MBA from the University of Chicago. She is currently working with a reputed American Company as a Manager. Michelle is also a fantastic online tutor and helps students to complete their assignments in Finance, Marketing, Management, and Accounting. She has worked on more than 500 assignments.