MODULE 9

Financial Risk

is the risk that involves financial loss to firms. Financial risk generally arises due to instability and losses in the financial market caused by movements in stock prices, currencies, interest rates and more.

-Credit spread risk happen due to the fluctuations in the difference between investments' interest rates and the risk free return rate. -Default risk arising when the borrower is not able to make agreed payments. -Downgrade risk resulting from the downfall in the risk rating of an issuer.

three divisions of credit risk

Financial Risks for the Market

As demonstrated during the 2007-2008 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.

Financial Risks for Businesses

It is expensive to build a business from the ground up. At some point, in any company's life, they will 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.

-Financial risk generally relates to the odds of losing money. -The financial risk most commonly referred to is the possibility that a company's cash flow will prove inadequate to meet its obligations. -Financial risk can also apply to a government that defaults on its bonds. -Credit risk, liquidity risk, asset-backed risk, foreign investment risk, equity risk, and currency risk are all common forms of financial risk. -Investors can use a number of financial risk ratios to assess a company's prospects.

KEY TAKEAWAYS

Legal Risk

This type of financial risk arises out of legal constraints such as lawsuits. Whenever a company needs to face financial losses out of legal proceedings, it is a legal risk.

Liquidity Risk

This type of risk arises out of an inability to execute transactions. Liquidity risk can be classified into Asset Liquidity Risk and Funding Liquidity Risk. Asset Liquidity risk arises either due to insufficient buyers or insufficient sellers against sell orders and buys orders respectively.

Operational Risk

This type of risk arises out of operational failures such as mismanagement or technical failures. Operational risk can be classified into Fraud Risk and Model Risk. Fraud risk arises due to the lack of controls and Model risk arises due to incorrect model application.

Financial risk

is a type of danger that can result in the loss of capital to interested parties. Risk can be referred to like the chances of having an unexpected or negative outcome. Any action or activity that leads to loss of any type can be termed as risk. There are different types of risks that a firm might face and needs to overcome. Widely, risks can be classified into three types: Business Risk, Non-Business Risk, and Financial Risk.

Financial Risks for Governments

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

Non- Business Risk

These types of risks are not under the control of firms. Risks that arise out of political and economic imbalances can be termed as non-business risk.

Business Risk

These types of risks are taken by business enterprises themselves in order to maximize shareholder value and profits. As for example, Companies undertake high-cost risks in marketing to launch a new product in order to gain higher sales.

Market Risk

This type of risk arises due to the movement in prices of financial instrument. Market risk can be classified as Directional Risk and Non-Directional Risk. Directional risk is caused due to movement in stock price, interest rates and more. Non-Directional risk, on the other hand, can be volatility risks. There are several different risk factors that make up market risk. · Currency risk: The risk that exchange rates will go up or possibly down · Equity risk: The risk that share prices will go up or down · Inflation risk: the potential for inflation to increase the price of all goods and services such that it undermines the value of money · Commodity risk: the possibility of commodity prices such as metals change value dramatically · Interest rate risk: the risk that comes from an increase or decrease in interest rates

Credit Risk

This type of risk arises when one fails to fulfil their obligations towards their counterparties. Credit risk can be classified into Sovereign Risk and Settlement Risk. Sovereign risk usually arises due to difficult foreign exchange policies. Settlement risk, on the other hand, arises when one party makes the payment while the other party fails to fulfil the obligations. Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection.

Fundamental analysis is 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 is the process of evaluating securities through statistics and looks at historical returns, trade volume, share prices, and other performance data. Quantitative analysis is the evaluation of the historical performance of a company using specific financial ratio calculations.

Tools to Control Financial Risk

Credit risk - also known as default risk—is the danger associated with borrowing money. Should the borrower become unable to repay the loan, they will default. Investors affected by credit risk suffer from decreased income from loan repayments, as well as lost principal and interest. Creditors may also experience a rise in costs for collection of the debt. Specific risk - This danger, related to a company 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 of collecting returns and the accompanying potential for monetary loss. 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. Pure risk - dangers that cannot be controlled, but some are done without fully realizing the consequences. Liquidity risk - the ability of a firm, company, or even an individual to pay its debts without suffering catastrophic losses. Conversely, liquidity risk stems from the lack of marketability of an investment that can't be bought or sold quickly enough to prevent or minimize a loss. Speculative risk - is a category of risk that, when undertaken, results in an uncertain degree of gain or loss. All speculative risks are made as conscious choices and are not just a result of uncontrollable circumstances. Currency risk - commonly referred to as exchange-rate risk, arises from the change in price of one currency in relation to another. Investors or companies that have assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses.

Type of Risks

Market Risk, Credit Risk, Liquidity Risk, Operational Risk, and Legal Risk.

Types of Financial Risks

1. Business Risk 2. Non- Business Risk 3. Financial Risk

Types of Risks: