Financial Risk

There is no shortage of definitions for risk. We often refer to risk as the uncertainty regarding what may happen in the future. Risk is often viewed as something that is negative, such as a danger, a hazard, or a loss.

In the corporate world, accepting risks is necessary to obtain a competitive advantage and generate a profit. Introducing a new product or expanding production facilities involves both return and risk. When a company is exposed to an event that can cause a shortfall in a targeted financial measure or value, this is financial risk. The financial measure or value could be earnings per share, return on equity, or cash flows, to name some of the important ones. Financial risks include market risk, credit risk, market liquidity risk, operational risk, and legal risk.

Type of Financial Risk

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.

Credit Risk

A credit risk happens when there is a chance that the loan borrower might skip, delay or default on his/her obligation to the bank or financial institution that has lent the money.

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.

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.

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