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Identifying and Managing Financial Risk

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Last editedJun 20212 min read

In business, no venture is completely risk-free. Sinking your cash into new projects or investments comes with an array of financial and non-financial risks. From market fluctuations to loss of income, it’s important to recognise potential pitfalls in advance so you can formulate a risk management strategy. We’ll discuss the main types of financial risk below, along with a few tools to help you manage them.

What is financial risk?

To begin with, it’s helpful to take a closer look at the question of what is financial risk, and how does it compare to non-financial risk? Financial risk refers to the possibility of losing money. It applies not only to businesses, but also to government bodies and individuals. In short, any time you invest money, there’s an inherent risk that you might lose it.

Types of financial risk

Financial risk is quite broad. Within this category, there are several types of risk to be aware of. Some will apply more to investors, while others apply to business owners or personal finance.

1. Market risk

When you invest in any asset or financial instrument, its prices will fluctuate according to market conditions. For example, whether you purchase shares in a company or invest in Bitcoin, the prices will change from minute to minute. Factors like market volatility could cause the price to drop, which is its inherent risk.

2. Liquidity risk

A second type of financial risk tied to investment is liquidity risk. For example, if investors are unable to quickly buy or sell securities without a big change in price, this would make it difficult to complete the transaction. Causes of liquidity risk could include an insufficient number of buyers or sellers for the asset. If you can’t find a buyer, you will have to hold onto the asset or risk losing money.

3. Credit risk

A third type of financial risk relates to credit and the risk of default. If your business provides a loan to another party, there is inherent risk that the borrower will be unable to make repayments. Some credit risk can also relate to currency exchanges, in which you might lose money due to unfavourable exchange rates or policies making it difficult to make a full repayment.

4. Operational risk

While the types of financial risk above relate to investments, another example would be operational risks that arise due to things like technical failures. This can also be classed as a business risk, but when a business’s systems break down due to human error or fraud, you might lose both money and assets.

Any business runs the risk of legal entanglement, which can be costly both in terms of time and money. For this reason, lawsuits are categorised as a financial risk. Not only do you run the risk of losing money in a settlement, but you’ll also have to think about legal fees.

Financial risk management strategies

Now that we’ve identified the main types of financial risk, it’s time to turn to perhaps the more important question: how can you manage it? Fortunately, there are several financial risk management tools at your disposal.

The primary strategies to manage risk include hedging and analysis. Before you jump ahead into a new investment, it’s important to weigh your options carefully with a full analysis of the figures:

  • Quantitative analysis looks at a company’s historical performance, helping you predict the likely rate of return.

  • Technical analysis is used to weigh different securities using historical returns, share prices, trade volume, and other fiscal data.

  • Fundamental analysis assigns value to any security by looking at a combination of assets and earnings.

  • Hedging techniques reduce exposure to risk when investing in any security.

The bottom line

Unfortunately, some types of financial risk – like market volatility and natural disasters – can be difficult if not impossible to fully plan for. But while it’s impossible to predict the future, evaluating all options carefully helps you mitigate risk.

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