Understanding Financial Risk, Plus Tools to Control It (2024)

What Is Financial Risk?

Financial risk is the possibility of losing money on an investment or business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk.

Financial risk is a type of danger that can result in the loss of capital to interested parties. For governments, this can mean they are unable to control monetary policy and default on bonds or other debt issues. Corporations also face the possibility of default on debt they undertake but may also experience failure in an undertaking the causes a financial burden on the business.

Understanding Financial Risks for Businesses

Financial markets face financial risk due to various macroeconomic forces, changes to the market interest rate, and the possibility of default by sectors or large corporations. Individuals face financial risk when they make decisions that may jeopardize their income or ability to pay a debt they have assumed.

Financial risks are everywhere and come in many shapes and sizes, affecting nearly everyone. You should be aware of the presence of financial risks. Knowing the dangers and how to protect yourself will not eliminate the risk, but it can mitigate their harm and reduce the chances of a negative outcome.

It is expensive to build a business from the ground up. At some point in any company's life the business may need to seek outside capital to grow. This need for funding creates a financial risk to both the business and to any investors or stakeholders invested in the company.

Credit risk—also known as default risk—is the danger associated with borrowing money. Should the borrower become unable to repay the loan, theywill default. Investors affected by credit risk suffer from decreased income from loan repayments, as well aslost principal and interest. Creditors may also experience a rise in costs for the collection of debt.

When only one or a handful of companies are struggling it is known as a specific risk. This danger, related to acompany or small group of companies, includes issues related to capital structure, financial transactions, and exposure to default. The term is typically used to reflect an investor's uncertainty about collecting returns and the accompanying potential for monetary loss.

Businesses can experience operational risk when they have poor management or flawed financial reasoning. Based on internal factors, this is the risk of failing to succeed in its undertakings.

How Governments Offset Financial Risk

Financial risk also refers to the possibility of a government losing control of its monetary policy and being unable or unwilling to control inflation and defaulting on its bonds or other debt issues.

Governments issue debt in the form of bonds and notes to fund wars, build bridges and other infrastructure and pay for their general day-to-day operations. The U.S. government's debt—known as Treasury bonds—is considered one of the safest investments in the world.

The list of governments that have defaulted on debt they issued includes Russia, Argentina, Greece, and Venezuela. Sometimes these entities only delay debt payments or pay less than the agreed-upon amount; either way, it causes financial risk to investors and other stakeholders.

The Impact of Financial Risks on Markets

Several types of financial risk are tied to financial markets.As mentioned earlier, many circ*mstances can impact the financial market. As demonstrated during the 2007 to 2008 global financial crisis, when a critical sector of the market struggles it can impact the monetary wellbeing of the entire marketplace. During this time, businesses closed, investors lost fortunes, and governments were forced to rethink their monetary policy. However, many other events also impact the market.

Volatility brings uncertainty about the fair value of market assets. Seen as a statistical measure, volatility reflects the confidence of the stakeholders that market returns match the actual valuation of individual assets and the marketplace as a whole. Measured as implied volatility (IV) and represented by a percentage, this statistical value indicates the bullish or bearish—market on the rise versus the market in decline—view of investments. Volatility or equity risk can cause abrupt price swings in shares of stock.

Default and changes in the market interest rate can also pose a financial risk. Defaults happen mainly in the debt or bond market as companies or other issuers fail to pay their debt obligations, harming investors. Changes in the market interest rate can push individual securities into being unprofitable for investors, forcing them into lower-paying debt securities or facing negative returns.

Asset-backed risk is the chance that asset-backed securities—pools of various types of loans—may become volatile if the underlying securities also change in value. Sub-categories of asset-backed risk involve the borrower paying off a debt early, thus ending the income stream from repayments and significant changes in interest rates.

How Financial Risks Impact Individuals

Individuals can face financial risk when they make poor decisions. This hazard can have wide-ranging causes from taking an unnecessary day off of work to investing in highly speculative investments. Every undertaking has exposure to pure risk—dangers that cannot be controlled, but some are done without fully realizing the consequences.

Liquidity risk comes in two flavors for investors to fear. The first involves securities and assets that cannot be purchased or sold quickly enough to cut losses in a volatile market. Known as market liquidity risk this is a situation where there are few buyers but many sellers. The second risk is funding or cash flow liquidity risk. Funding liquidity risk is the possibility that a corporation will not have the capital to pay its debt, forcing it to default, and harming stakeholders.

Speculative risk is one where a profit or gain has an uncertain chance of success. Perhaps the investor did not conduct proper research before investing, reached too far for gains, or invested too large of a portion of their net worth into a single investment.

Investors holding foreign currencies are exposed to currency risk because different factors, such as interest rate changes and monetary policy changes, can alter the calculated worth or the value of their money.Meanwhile, changes in prices because of market differences, political changes, natural calamities, diplomatic changes, or economic conflicts may cause volatile foreign investment conditions that may expose businesses and individuals to foreign investment risk.

Pros and Cons of Financial Risk

Financial risk, in itself, is not inherently good or bad but only exists to different degrees. Of course, "risk" by its very nature has a negative connotation, and financial risk is no exception. A risk can spread from one business to affect an entire sector, market, or even the world. Risk can stem from uncontrollable outside sources or forces, and it is often difficult to overcome.

While it isn't exactly a positive attribute, understanding the possibility of financial risk can lead to better, more informed business or investment decisions. Assessing the degree of financial risk associated with a security or asset helps determine or set that investment's value. Risk is the flip side of the reward.

One could argue that no progress or growth can occur, be it in a business or a portfolio, without assuming some risk. Finally, while financial risk usually cannot be controlled, exposure to it can be limited or managed.

Tools to Control Financial Risk

Luckily there are many tools available to individuals, businesses, and governments that allow them to calculate the amount of financial risk they are taking on.

The most common methods that investment professionals use to analyze risks associated with long-term investments—or the stock market as a whole—include:

• Fundamental analysis, the process of measuring a security's intrinsic value by evaluating all aspects of the underlying business including the firm's assets and its earnings.
• Technical analysis, the process of evaluating securities through statistics and looking at historical returns, trade volume, share prices, and other performance data.
• Quantitative analysis, the evaluation of the historical performance of a company using specific financial ratio calculations.

For example, when evaluating businesses, the debt-to-capital ratio measures the proportion of debt usedgiven the total capital structure of the company. A high proportion of debt indicates a risky investment. Another ratio, the capital expenditure ratio, divides cash flow from operations by capital expenditures to see how much money a company will have left to keep the business running after it services its debt.

In terms of action, professional money managers, traders, individual investors, and corporate investment officers use hedging techniques to reduce their exposure to various risks. Hedging against investment risk means strategically using instruments—such as options contracts—to offset the chance of any adverse price movements. In other words, you hedge one investment by making another.

Real-World Example of Financial Risk

Bloomberg and other financial commentators point to the June 2018 closure of retailer Toys "R" Us as proof of the immense financial risk associated with debt-heavy buyouts and capital structures, which inherentlyheightenthe risk for creditors and investors.

In September 2017, Toys "R'" Usannounced it hadvoluntarily filed for Chapter 11 bankruptcy. In a statement released alongside the announcement, the company's chair and CEO said the company was working with debtholders and other creditors to restructure the $5 billion of long-term debt on its balance sheet.

As reported in an article by CNN Money, much of this financial risk reportedly stemmed from a 2005 US $6.6billion leveraged buyout (LBO) of Toys "R" Us by mammoth investment firms Bain Capital, KKR & Co., and Vornado Realty Trust. The purchase, which took the company private, left it with $5.3 billion in debt secured by its assets and it never really recovered, saddled as it was by $400 million worth of interest payments annually.

The Morgan-led syndicate commitment didn't work. In March 2018, after a disappointing holiday season, Toys "R" Us announced that it would be liquidating all of its 735 U.S. locations to offset the strain of dwindling revenue and cash amid looming financial obligations. Reports at the time also noted that Toys "R" Us was having difficulty selling many of the properties, an example ofthe liquidity risk that can be associated with real estate.

In November 2018, the hedge funds and Toys "R" Us' debt holders Solus Alternative Asset Management and Angelo Gordon took control of the bankrupt company and talked about reviving the chain. In February 2019, The Associated Press reported that a new company staffed with ex-Toys "R" Us execs, Tru Kids Brands, would relaunch the brand with new stores later in the year.

In late 2019, Tru Kids Brands opened two new stores—one in Paramus, New Jersey, and the other in Houston, Texas. Most recently, Macy's has partnered with WHP Global to bring back the Toys "R" Us brand. In 2022, Macy's plans to roll out approximately 400 physical toy store storefronts within existing Macy's locations.

The Bottom Line

Financial risk naturally occurs across businesses, markets, governments, and individual finance. These entities trade the opportunity to make profits and yield gains for the chance that they may lose money or face detrimental circ*mstances. These entities can use fundamental, technical, and quantitative analysis to not only forecast risk but make plans to reduce or mitigate it.