Financial risk and its types

November 1, 2020

Financial risk can be defined as a scenario where it is likely to risk losing money on an investment or business plan. Financial risk can manifest in multiple ways – from consumers who fail to pay for their orders, vendors who refuse to ship inventory, and even from the company's poor strategic plan.

Financial risk and it's type
The Financial Risk can affect us in many respects, Source: Pixel

This risk can affect us in many respects, and information about it can be valuable to achieve the financial goal. On the other hand, it is almost impossible to eradicate financial risk. However, having an idea will help minimize its impact.

Consider these financial risks before making any financial decisions.

Market risk

Market risk is a volatile risk, resulting from the shifts in market prices. The value of an investment can significantly decrease due to Market risk. Market risk (systematic risk) unavoidable by diversification, but it can be hedged against in some respects.

Financial risk
The risk arising due to movement in stock price, interest rates natural disasters, and terrorist attacks, Source: Pixel

Market risk can mainly be classified as Directional Risk and Non-Directional Risk. Directional risk arises due to movement in stock price, interest rates, and more. Likewise, Non-Directional may arise due to many reasons including natural disasters, terrorist attacks, and more.

Credit risk

Credit risk is insecurity related to an external entity's inability to uphold a contract. This form of risk occurs when one fails to satisfy his responsibilities to his counterparties. Traditionally, this risk can be relatable to the condition where the lender may not receive the owed principal and interest.

credit risk is the type of financial risk
Credit risk refers to the external entity's inability to uphold a contract, source: pixel

Credit risk can be categorized as Sovereign Risk and Settlement Risk. Sovereign risk typically results from tough foreign exchange strategies. Settlement risk, on the other hand, occurs when one party makes a claim and the other party declines to meet its obligations.

Operational risk

The type of financial risk, Operational risk relates to institutional uncertainties rather than market or credit risk.

The operational risk may also be defined as the unsystematic risk that is unique to a specific company or sector. Being specific, this kind of risk emerges from institutional errors, such as mismanagement or technological errors.

On the other hand, Operational risk can be categorized into Fraud Risk and Model Risk. Particularly, Fraud risk occurs due to loss of control, and Model risk occurs due to inappropriate implementation of the model.

Liquidity risk

Liquidity risk is the part of financial risk where a person or organization may be unable to execute transactions. In other words, it is a type of risk that a corporation or a bank will not be able to satisfy short-term financial requirements.

Liquidity risk can be divided into Asset Liquidity Risk and Funding Liquidity Risk. Asset Liquidity risk arises either because of inadequate customers or because of inadequate sellers to sell orders and purchase orders. Whereas Funding Liquidity Risk may occur due to the organization's inability to pay its debts.

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