Financial risk is an inherent part of investing, running, or even managing personal finances involves bearing financial risk. Be it saving for retirement or investing in stocks, or running a company, knowledge of the various kinds of financial risks can protect the wealth and ensure financial well-being in the long term. Financial risk is actually a type of risk that arises when money is lost due to changes in markets, credit defaults, or operational problems.
1.Market Risk
The Volatility in Investment Markets
Market risk is systematically otherwise referred as the risk which generates with fluctuations of financial markets. These fluctuations can result in an economic downfall, increase or decrease in interest rates, political instability, and global events.
These risk factors usually cannot be avoided and have an impact on every asset such as stocks, bonds, and commodities. However, investors can reduce this type of market risk by diversifying their portfolios.
Types of Market Risk
Equity Risk The risk of fluctuation in stock prices.
Interest Rate Risk The risk of changes in interest rates affecting the prices of bonds.
Currency Risk The risk of changes in the rates of exchange having an impact on international investments.
Case Study The Financial Crisis of 2008
The 2008 global financial crisis is a most vivid example of market risk. During this period, the stock markets in most regions went bust, and the prices of virtually all assets tumbled in unending economic darkness. The world-wide ripple effects cost investors trillions of dollars. Those investors whose portfolios were heavily skewed towards certain industries or sectors were the worst hit. In contrast, those investors who have diversified their investment could survive the disaster.
Methods to Reduce Market Risk
Diversification The risk exposure is somewhat reduced by the spreading of investment across asset classes.
Hedging In a way, if there is a possibility of declination of market prospects using options or futures, then an investor may hedge.
Long-term View One investment with a long-term perspective should be able to sift out short-term fluctuations in the market.
2. Credit Risk The Risk of Borrowers Defaulting
Credit risk refers to the risk in which a borrower might not pay back his debt obligations, and thus, there would be a loss in terms of finances that the lender must bear. This credit risk, however, has implications on bonds, loans, as well as any form where money is lent with an expectation of return. Credit risk is of paramount importance to banks, businesses, and even individual investors holding corporate or governmental bonds.
Types of Credit Risk
Default Risk It arises from the possibility that a borrower fails to fulfill his obligations, either by failing to repay the borrowed amount or by not adhering to the agreed-upon terms.
Concentration Risk Lending too much to one borrower or an industry.
Counterparty Risk The risk arises when a party to a financial contract fails to meet its obligation.
Case Study Lehman Brothers Bankruptcy
In 2008, it was one of the biggest investment banks in the world, Lehman Brothers that at last filed for bankruptcy due to subprime mortgage loans that they had invested in. Over here, the bank had undertaken tons of credit risks based on lousy credit profiles of various debtors. It could not go on with its business during a wave of default and thus witnessed one of the highest-profile bankruptcies in history.
How to Manage Credit Risk
Credit Analysis Proper credit checks on the borrower before lending.
Diversification Never lend too much to one entity or to a particular sector.
Use credit insurance products or financial instruments that promise protection for the risk of default by the borrowers.
3. Liquidity Risk The hassle of liquidating assets quickly
Liquidity risk is a phenomenon where there is an inability of a person or an institution to liquidate the funds quickly due to an important loss. Business works either for generating cash flow to execute its operations, or investors who may need the sale of assets to generate quick access to funds. In such a case, illiquid assets-real estate, or certain stocks-within such portfolios are hard or time-consuming to be sold quickly at acceptable prices and, hence raise the risk of liquidity.
Types of liquidity risk
It is the risk that enterprise or person unable to raise enough money to pay short-term obligations because it does not have enough liquid assets.
Asset Liquidity Risk Asset liquidity risk simply means the risk of inability to sell assets within a short period at their market value.
Case Study The Real Estate Market in 2008
Liquidity risk also turned out to be a true concern of the financial crisis in 2008 in the real estate market. The rush for quick selling of houses resulted in a scare of few home buyers and thus pushed the prices down. Likewise, investors who invested in real estate-backed securities also faced liquidity problems as a result of an expressively dramatic value drop.
Management of Liquidity Risk
Maintain Cash Reserves Diversify your portfolio by holding a percentage in liquid assets, such as cash or cash equivalents, to be in a position to settle short-term obligations.
To ensure that they maintain adequate liquid assets, companies should always be monitoring their liquidity ratios, such as current ratio.
Overleveraging When there is too much borrowing, it is said that the company has overstretched its debt usage. There is a higher liquidity risk, mainly when changes are going on about market conditions.
4. Failure in Operations Running the Business
Operational risk refers to the possibility of loss through inadequate or failed internal processes, people, systems, or from external events. This could involve human errors, system failure, fraud, or natural disasters. Operational risk has the strongest impact on a firm; however, it may also touch an individual’s life through identity theft or personal fraud.
Categories of Operational Risk
Process Risk This is the likelihood of mistakes or inefficiencies in business processes.
System Risk Defaults in technology or information system.
Human Risk Mistakes or unethical conducts of employees.
External Risk Fraud committed by outsiders, natural disasters etc.
Case Study JPMorgan Chase’s “London Whale” Scandal
One trader, who came to be known as the “London Whale,” caused a $6.2 billion trading loss for JPMorgan Chase in 2012. Strong operational risk controls are important because the risk management systems of the bank failed to identify the risk taken by the trader. This scandal has led to financial losses and reputation losses for the bank.
How to Manage Operational Risk
Risk Management Systems Establish strong internal controls combined with the frequent auditing of business processes.
Training and Education Ensure that the employees working in the venture are skilled and aware of the dangers involving performing different activities.
Insurance Businesses can carry an insurance cover so that they get compensated in case there is a risk during operation, such as property damage or cyber attack.
5. Inflation Risk The Erosion of Purchasing Power
Increasing inflation rates can decrease the value of an investment. The higher the rate of inflation, the more the purchasing power of money diminishes-that is to say, the returns on investments may not keep pace with the higher cost of goods and services. Inflation risk is particularly threatening for long-term investors because it can drastically cut down the real value of returns received.
Types of Inflation Risk
Purchasing Power Risk This type of risk arises where the purchasing power of savings or investments is being eroded with inflation.
Interest Rate Risk There may be an upward pressure on interest rates because of inflation and, therefore, the effect to bond prices and costs of borrowing.
Case Study Zimbabwe Hyperinflation
Zimbabwe is a good example at the beginning of this millennium, it was exhibiting one of the worst cases of hyperinflation worldwide. An inflation rate of 89.7 sextillion percent per month was recorded at the peak. The local currency overnight became virtually worthless and nullified people’s savings. Therefore, an extreme case of inflation can destroy wealth if it goes unmanaged.
Managing Inflation Risk
Investment in Inflation-Protected Assets There are always some assets, such as Treasury Inflation-Protected Securities or real estate, that do well in inflation.
Make investments globally diversified Assets from inflationary economies with relatively stable inflation rates tend to reduce inflationary risk.
Monitor your Investment Returns Your investments need to produce returns that are higher than inflation so that your money’s purchasing power remains intact.
Conclusion Navigating Financial Risk for Long-term Success
Understanding and controlling financial risk are on top of the lists for individuals and businesses alike. Using appropriate strategies, one can control not just market risk, credit risk, and liquidity risk, but even operational risk and inflation risk. Diversification, proper analysis, and a long-term perspective are the core elements of managing financial risk.
The case studies of the 2008 financial crisis and Lehman Brothers bankruptcy, and Zimbabwe’s hyperinflation, are extreme examples of unmanaged financial risk. In this regard, it must be noted that proper risk management can take individuals and businesses through all these tough times to prosperity.
No doubt, we cannot eliminate financial risk entirely, but we can very well minimize it. Knowing the various forms of risk and how to nullify them puts you and your wealth in a much better position for future expansion.