Financial Risk Explained for Dummies

What is financial risk?

Financial risk is a category of risk that involves the possibility of financial losses and is applicable to businesses, governments, individuals, and financial markets.

Put differently, financial risk is a type of risk that indicates the possibility that parties (investors, shareholders, entrepreneurs, owners, and other financial stakeholders) involved in investments and business endeavours will lose money.

Types of financial risk

Financial risk can be categorised into various types of risks as described below.

Credit risk

Credit risk refers, inter alia, to the possibility that one of the parties involved in a financial transaction or contract may fail to fulfill their obligations towards their counterparties. For instance, a creditor default on payables or a borrower on the repayment of a loan. This type of financial risk is referred to as settlement risk.

Sovereign risk, also called country risk, is also classified under credit risk. Sovereign risk refers to the risk that a government could default on its debt obligations (sovereign debt) like government bonds. It can also describe the possibility that the treasury or central bank of a government will enact difficult exchange policies that will significantly lower or nullify the value of its forex contracts.

Liquidity risk

Liquidity risk, also called funding risk, refers to a situation when you are hindered or unable to raise cash fast, for example selling assets when you need the cash to execute a financial transaction.

Liquidity risk can be categorised into different sub-categories, namely:

• Asset liquidity risk also referred to as market liquidity risk refers to the risk that a business or individual wants to sell an asset, but is not able to do so, unless the asset is sold below its market value, incurring a loss.

• Funding liquidity risk is the risk that an entity or individual will not be able to honour their short-term financial obligations when due. Put in other words, funding liquidity risk occurs due to the lack of funds.

• Currency risk, also called exchange-rate risk or FX risk, is the possibility of losing money due to unfavourable and unpredictable changes in the value of one currency to another currency. Businesses that trade across different countries or investors who invest in financial markets in foreign countries are exposed to currency risk.

• Interest rate risk refers to the probability of an unexpected fluctuation in interest rates caused by announcements of a country’s central bank, related to changes in a government’s monetary policy, triggering investment losses. Fixed-income assets, such as bonds, are especially vulnerable to interest rate risk.

Many analysts see currency risk and interest rate risk as part of market risk.

Market risk

Market risk, also called systematic risk, is the risk of losses on financial instruments caused by unanticipated fluctuations in factors that affect the performance of an entire financial market. Price volatility often occurs due to factors such as inflation, exchange rates, recessions, fiscal deficits, geopolitical events, and interest rates.

The most common types of market risks are currency risk, commodity risk, interest rate risk, and equity risk.

• Currency risk

See description above under liquidity risk.

• Commodity risk refers to the adverse effect of changes to a commodity’s price, causing a negative effect on future market value and income of commodities such as grains, crude oil, metals, and gold, to name but a few.

• Interest rate risk

Refer to description above under liquidity risk.

• Equity risk is the risk that an investor will incur losses on investments in equity (shares in a company) when the shares of a company are subjected to swift price changes.

Legal risk

Legal risk is the risk of potential loss that a business or individual could encounter due to legal issues, such as lawsuits or other legal proceedings.

The risk to face legal action could arise from a number of causes regarding the products, services, actions, inaction, compliance, and other events of an individual or business.

Regarding a company, legal action can be initiated by its suppliers, customers, other businesses, employees, or shareholders.

Legal risk includes the risk that a counterparty in a contract or financial transaction will not be liable to keep to its obligations under the law. One of the most common reasons for the occurrence of such a situation is that transactions are not adequately well-documented to be legally enforceable.

Political risk

Political risk refers to the risk of financial losses that may occur because of uncertainty about government decisions and actions, unstable political conditions, political disruptions, or any new legislation. This type of risk is also called geopolitical risk.

Individuals, businesses, economic sectors, the overall economy, and financial markets may all be affected by political risk.

Factors that can contribute to financial risk are:

• Political decisions by governments about currency valuation, taxes, trade tariffs, regulations with regard to investments, labour laws such as a minimum wage, and environmental regulations.
• Political disruptions such as riots, acts of terrorism, coups, wars (civil or regional), and even political elections.

Operational risk

Operational risk comprises all the risks and uncertainties a business faces and may encounter in its day-to-day operations. Operational risk can be caused by mismanagement or technical failures.

Examples of operational risk are theft, fraud (internal and external), staff turnover, computer hacking, failure to follow internal policies, unrealistic marketing plans, inaccurate budgeting, unrealistic financial projections.

Even catastrophic events such as hurricanes, floods, and pandemics (Covid-19) are contributors to operational risk.

Reputational risk

Reputational risk, also known as reputation risk, is the threat to the good name, profitability, or sustainability of a business, caused by unfavourable, disapproving, and negative public perceptions of the products and services of a business.

It is a type of risk that can occur as a result of:

• the actions and decisions of the company itself, or
• the actions of an employee or employees.