How do you define risk?
A risk is generally the chance of incurring damage, liability, loss or injury. It is any negative event that can be preemptively prevented. A financial risk is the probability that the return on investment is a smaller value than the expected return.
Financial risk can take on many forms. For example, it can be the possibility of a loss from investing in an organization holding debt. Or it could be a situations wherein the company’s cash flow cannot pay for its financial obligations. Financial risk is the potential to lose money, in the most basic sense.
What are the different kinds of financial risk?
Capital risk is the potential loss of part of or the entirety of an investment. It occurs when a company invests in assets that do not completely guarantee a full return. Stocks, real-estate and non-government bonds fit into this category. One can say that capital risk is the risk of not producing enough returns to pay back the initial investment.
Liquidity risk is when a company may be unable to meet short-term financial needs. It happens when an investment lacks marketability. The issue makes investments hard to monetize through immediate sale with the purpose of minimizing losses.
Default risk is the likelihood that entities are unable to pay for their debt obligations, resulting in default of payment. This type of risk occurs in any lending or investing transaction with credit involved.
When a counterparty cannot fulfill its side of the contract, it is called a delivery risk. It can also be described as a counterparty or settlement risk depending on the variables.
A settlement risk is when the counterparty fails to deliver payment or anything representing the terms of contract based on agreement.
Refinancing risk is the chance if an entity cannot replace an existing loan through borrowing. The result is the inability to refinance, hence the term. It is tied to credit rating, interest rates, and the credit market. The risk tends to increase when interest rates rise.
Reinvestment risk is the probability that future coupons from a bond will fail to be reinvested in the prevailing interest rate of the bond when it was acquired. Zero-coupon bonds are the only type who are exempt due to the non-existence of interim coupon payments.
Operating risk arises from the possibility of constraints, inadequate processes, technical issues, human error, and criminal activity. It is basically a risk that affects business processes.
Interest Rate Risk
Fluctuating interest rates can affect the value of investments or return. This risk is called interest rate risk. It is most likely to affect bondholders.
Exchange Rate Risk
Exchange rate risk is also known as foreign exchange (FX) risk. It is the possibility that changes in the exchange rate will reduce the value of investments. This risk arises from transactions dealing with currencies that have a different denomination than the base currency used by a company.
An example would be import and export. The rise and fall of exchange rate affects how much a company can get from exporting their products, or how much is charged when acquiring through import.
Risk comes in many forms no matter what industry a company chooses to partake in. Note however, that the definition of risk states that it can be preemptively prevented. Proper planning and controls reduces the risk involved in transactions and will allow a business more confidence in their financial activities.