Risk is a term often used in the financial world, but what is risk and why does it matter? This guide will tell you the basics of what you need to know.
What is Financial Risk?
Risk is the term used to describe the dangers a financial institution faces. It is generally associated with financing and monetary transactions. Normally it is used when a company does not have adequate amounts of cash to meet its financial obligations. Risk is taken on by shareholders when a business issues debt, and when the uncertainty of a return and the potential for financial loss is a possibility.
Types of Financial Risk
There are a number of different types of financial risk, which we have detailed below.
Credit risk – also called default risk – is linked to a borrower defaulting on his promised payments. An investor can lose interest payments and suffer from a decreased cash flow. They may also have to pay more in collection costs.
Liquidity risk is when an asset cannot be traded fast enough in the financial markets to prevent a loss or to generate a profit. Asset liquidity is when an asset cannot be sold due to a lack of market demand or liquidity in a market.
An asset’s value may change for the worse thanks to a range of market factors; this is what is known as market risk. The four main market risk factors are interest rates, foreign exchange rates, commodity prices and stock prices.
Foreign Investment Risk
Foreign investment risk is caused by any extreme changes in value to markets abroad. Political and economic conflict, tax hikes and nationalization of assets all contribute to this risk. Liquidity and regulatory issues can also increase foreign investment risk.
Hedging is a method used to reduce risk where a combination of assets are chosen to offset the movements of each other. It is used as a sort of shield against risk. For example, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters.