Types Of Financial Risks
Risk is the probability of an adverse event and its consequences. Financial risk refers to the likelihood of the occurrence of an event that has adverse financial consequences for an organization.
The concept should be understood in a broad sense, including the possibility that the financial results may be higher or lower than expected. In fact, given the possibility that investor’s financial betting on the market, these movements in any direction can generate both profits and losses based on the investment strategy.
1. Market risk
Market risk, which is also called market price change risk or market price risk is the risk of financial losses that arise because of the market prices of certain values such as interest rates, share prices, commodities or exchange rates, etc. change. Market risk is referred to as systematic risk. Market risk also plays a key role in trading in financial derivatives.
The market risk depends on the type of security traded and the geographical boundaries of the trade and is differentiated according to their parameters:
Interest rate risks
If interest rates suddenly rise or fall, market volatility may also increase. Changes in interest rates affect asset prices, as the level of spending and investments in an economy increases or decreases, depending on the direction of the interest rate change. As interest rates rise, consumers typically spend less and save more. If the interest rate falls, they tend to spend more and save less. Interest rate risk can affect any market, including equities, commodities, and bonds.
Foreign exchange risk
Exchange rate risk, also known as currency risk, is linked to the fluctuation of currency prices. When currency prices change, it becomes cheaper or more expensive to buy foreign exchange depending on the direction of the change. The exchange rate risk increases when the trader is active in international forex markets. However, the trader may also be indirectly affected by holding shares in a company that trades heavily abroad, or by trading commodities traded in foreign currencies. In addition, a country with a higher level of debt has a higher currency risk.
Commodities, such as oil, gold and maize, may be subject to sudden price changes if any kind of political, legislative or seasonal change occurs. This risk is referred to as commodity price risk. Commodity price changes can affect traders, investors, consumers and producers.
The commodity price risk, however, goes beyond the risk of price changes to the commodities themselves. These are the cornerstone of most commodities. Therefore, price changes for raw materials can have far-reaching consequences for companies and consumers. Price changes put the entire supply chain under pressure, which ultimately has an impact on economic performance.
Equity prices can be very unstable, even more than the other asset classes. The price of a security can change very quickly and often the value falls. This process is known as equity price risk. While there are several factors that affect stock prices, there are only two types of stock price risk: systematic and unsystematic. The first risk relates to the general industry, while the unsystematic risk belongs to a particular company.
2. The credit risk
It arises from the possibility that a party from a financial contract has failed to meet its obligations. Such a mismatch between cash flows can have various causes, whereby the following sub-risks, in particular, can be differentiated:
The information risk
Includes the risk that the debtor provides false information and that the creditor, therefore, makes a wrong decision with regard to the claim.
The default risk
Expresses the risk that the debtor will not be able to meet his payment obligations or will not be able to meet them in full due to a deterioration in the economic situation.
The deadline risk
This refers to the risk that the debtor’s payments will be received with a delay.
Comprises the risk that the agreed collateral can only be realised at a lower value than the planned value.
3. Liquidity risk or financing
The liquidity risk of investment determines the ability of an investor to sell his securities at any time at a market price. This situation always occurs when one wants to sell the assets, without such a sales contract, measured against the usual market turnover volume, leading to noticeable price fluctuations.
If you want to carry out securities transactions quickly and easily, you should closely observe the depth and breadth of the market, because these two factors play a major role: if a large number of open sales orders are offered at the current market prices, the market has depth. This also applies vice versa if many open buy orders are offered at prices below the current price level.
A broad market is also referred to when there are not only a large number of securities orders on the market, but also when the market often has very high trading volumes.
The liquidity risk is often also dependent on demand or supply. If the market is tight or illiquid, it becomes more difficult to buy or sell securities. Often there is no turnover on the stock exchange. Nevertheless, quotations are made. For this type of securities at a certain price, there is either only supply or only demand. The supply is referred to as the asking price, the demand as the bid price. With these conditions, you must expect that your buy or sell order is not possible immediately, only under bad conditions or only in parts. In addition, this illiquidity due to supply or demand makes transactions more cost-intensive.
4. Operational risks
The operational risk is the risk of unexpectedly suffering high losses due to deficits in information systems or internal controls. Operational risks include human error, IT system interruptions and deficiencies in the organizational structure and processes. Operational risks are difficult to quantify and are therefore usually recorded by management assessments and internal controlling. The growing importance of controlling results in particular from the progressive automation of operational banking operations, which entail accumulation of operational risks due to high processing speeds and transaction volumes.
5. The country risk
Country and transfer risk is the term used when a debtor from abroad is unable to make his repayment and interest payments on time or at all. This situation can arise in the event of a lack of transferability or a lack of willingness to transfer on the part of the country in which the foreigner is domiciled.
In this context, country risk also includes the risk of political and economic instability. This means that payments may not be made abroad due to a lack of foreign exchange or transfer restrictions.
This transfer risk cannot be hedged, because events that have a stabilizing effect can lead to state influence in the political and social system, especially on the servicing of the respective foreign debt and on the suspension of payments to the respective country.
The foreign exchange and capital markets are intertwined worldwide. Therefore, political events such as changes in the constitutional system can generate price enhancing impulses or a positive basic mood. Furthermore, changes in the economic order, political power relations, national and international crisis situations, revolutions or forces of nature can have both positive and negative effects on the development of the currency markets.
6. System risk
In general, the functional efficiency of the international financial order is at risk due to chain reactions of devaluation speculation that can no longer be controlled or (as in the wake of the subprime crisis) a loss of confidence and the resulting collapse of banks. In particular, the risk that, as a result of the inability of a participant in a payment system to meet its obligations, or of errors in the system itself, other participants in other areas of the financial system may also run into difficulties.