A guide to financial risk and risk management

Home › Investments > Financial risk management

Whether you’re running a business or making an investment, financial risk is an inevitable consideration. From unpaid loans to unpredictable market shifts, some risks can be anticipated and managed, while others are harder to control. In this guide, we’ll take a look at the meaning of financial risk and explore ways these risks can be identified.

The information provided here is for informational and educational purposes only and does not constitute financial advice. Please consult with a licensed financial adviser or professional before making any financial decisions. Your financial situation is unique, and the information provided may not be suitable for your specific circumstances. We are not liable for any financial decisions or actions you take based on this information.

Financial risk is any kind of risk associated with financing an investment or business venture, and it can result in loss of capital for companies or individuals. An example of financial risk in a business context is when financial transactions involve loans or credit and there’s a chance the borrower might not repay what they owe.

Individuals accept some degree of financial risk when they make a decision to invest their money. The level of risk is usually fairly high, since there is every chance they lose some or all of what they invest due to forces outside their control, such as market fluctuations. This risk can be lessened to some extent by diversifying assets, but it never goes away completely.

Starting a business can be expensive, often requiring outside funding. This creates financial risks for the company, its investors, and its stakeholders. Secondly, keeping the business running is dependent on a consistent cash flow, which is the money coming in and going out to cover expenses. The common risk of a client paying late – particularly if the client brings in a big portion of a company’s revenue – can disrupt cash flow and make it hard for the company to meet its financial obligations.

Businesses will often carry out a financial risk assessment that helps them understand potential risks from different perspectives. They can then use these insights to guide their decisions, which reduces the likelihood of encountering financial problems.

Of course, not all financial risks are easy to assess or manage. Shifts in the markets tend to be unpredictable and beyond a company’s control. The impact here can sometimes be far-reaching.

Defining financial risk for individual investors is not always easy. Risks can arise due to poor decision-making and rushing into investment decisions without proper due diligence. However, some risk comes from factors outside an investor’s control. The financial crisis of 2008 is a prime example of an unforeseen risk, where the markets crashed, and many people lost money.

Investing is never without risk, but pursuing high-risk options that could result in losing money can exacerbate any existing financial risk. Speculative investments, as they’re known in financial circles, are those that have a very uncertain outcome. Investors stand to either make a lot of money or lose a lot, often based on guesswork or unpredictable market conditions.

Financial risks can arise in many different situations. Depending on the particular company, the list of risks may be much longer, but the following are the main types of risks in finance.

Companies and investors can make financial losses due to changes in overall market conditions.

Market risk is further broken down into the following:

• Interest rate risk – Any changes to interest rates can have an effect on a bank’s profits. If, for example, a bank offers a fixed mortgage at a low interest rate and then rates rise, the bank effectively loses money, whereas the borrower benefits. Investors can also be affected, as these shifts impact the value of bonds. If interest rates rise, older bonds with lower interest payments become less attractive, causing their prices to drop. Investors might then have to accept lower returns or even face losses on them.

• Equity risk – Stock prices can rise or fall unexpectedly due to market volatility, and these price swings are often influenced by investor sentiment (whether they’re optimistic or pessimistic about the market). Similarly, commodities like crude oil, gold, or agricultural products – often considered a type of alternative investment – are traded on the market much like stocks, making them subject to the same ups and downs. When investors take on equity risk, they’re hoping for returns that are higher than what they’d get from a safer investment.
• Currency risk – Companies and investors doing business in foreign markets can potentially lose money due to changing exchange rates between different currencies. Exporting or importing goods can become more expensive, which, in turn, makes transactions less profitable. When the euro weakens against the dollar, for example, it becomes cheaper to buy items from Europe, while goods leaving the U.S. become more expensive.

It’s never guaranteed that a borrower will repay a loan, and the lender can make losses as a result. Not only do they end up losing money, they may have to fork out more money to collect the debt owed to them. Because this is a recognised risk in finance, financial institutions like banks and lenders often use credit risk management strategies to assess the risk beforehand. The goal is to prevent losses or, at the very least, keep them to a minimum.

With investing, money is usually tied up for long periods of time, meaning a company or investor cannot easily sell up and convert the asset to cash if they urgently need the money. For example, a company might need some cash to pay off its debts, but is forced to default instead.

When markets are volatile, the lack of liquidity becomes more of an issue. In this instance, an investor might be keen to quickly offload their assets to keep any further losses at bay. But because other investors have the same idea, the investor often cannot sell their assets quickly enough to stem the financial losses.

Losses can be caused by problems within a business’s operations. A company can have poor management or experience technical failures or even criminal activities like fraud. But they also face external financial risks such as legal disputes. The effects of operational risks can potentially be quite hard to recover from, leaving a lasting impact on the satisfaction of customers or a company’s reputation.

Businesses and investors can encounter these risks at any time. That’s why there is a whole field of professionals, including risk managers, dedicated to identifying financial risk. The standard approach is to firstly conduct a financial risk assessment and then come up with a risk management plan of action. That way, the company is aware of the risks beforehand, and is best placed to manage them should they become an issue.

As part of this process, companies identify anything that could threaten their financial stability or cash flow, whether from internal issues like inefficient operations or external factors like market fluctuations. Depending on their particular area of operations, they might conduct industry research to define financial risks affecting other similar businesses.

Investors often use financial ratios to evaluate how much risk they are taking on by investing in a particular company. An example is the debt-to-equity ratio, which compares how much a company owes to what it owns, and therefore shows how reliant it is on borrowing to finance its activities. Likewise, financial institutions check credit scores to measure an individual’s or company’s creditworthiness, which influences how much interest they will charge.

Alongside understanding the meaning of financial risk and its potential impact, steps can be taken to reduce potential losses before making risky transactions or investments. This is part of financial risk management. While it’s impossible to eliminate risk completely, there are several ways to neutralise it.

1. Diversification: This is particularly relevant for market risk. Diversification is where investments are made across a variety of assets – such as stocks, bonds, index funds, and property – to avoid putting all your money in one area, and reduce the impact if one investment performs badly.

2. Insurance: Having the right amount of insurance is another way to protect against unexpected events, such as property damage, which could otherwise lead to significant financial loss.

3. Multiple income streams: If you have more than one source of income, you are better protected if one stream dries up. Whether it’s a second job, rental income, or investments, having variety in your income can reduce overall financial risk.

4. Emergency funds or cash reserves: Having some cash set aside for emergencies can lessen the impact of liquidity risk. For individual investors, an emergency fund would help cover any unexpected personal expenses. Companies could maintain a cash reserve or liquidity buffer to handle unexpected business costs or economic downturns. 

5. Hedging: This is where an investment is made to offset potential losses in another. For example, if you own a stock, you could buy an option that lets you sell that stock at a set price in the future. This way, if the stock’s price drops, the option helps protect your investment. Hedging can be fairly expensive, and is typically used for specific concerns like currency risk or market risk.

For someone looking to put their money to work and get a good return on their savings, investing isn’t the only option. Those keen to avoid financial risk might explore savings accounts, which are considered low risk in that there’s virtually no chance a saver will lose their money. And, if you’re happy to put your cash away for a set time, you can take advantage of some of the higher rates offered on fixed term deposits. 

Plus, at Raisin Bank, eligible deposits made into our savings accounts are protected up to €100,000 per person and financial institution as part of the EU-wide Deposit Guarantee Scheme. This means that, if anything happens to your chosen bank, your funds are safe.

It’s free to register, and once you’ve been approved, you just need to select the account that’s right for you, and watch your savings grow!