What Is Financial Risk? Financial Risk Explained

The Oxford Dictionary defines risk as:

“A situation involving exposure to danger” and it goes on “The possibility that something unpleasant or unwelcome will happen.”

Thus we want to define what is dangerous and what is this unpleasant thing we want to avoid.

A first obstacle stands in the way of determining risk. In fact, each of us seems to have a different perception of what danger is.

For instance, you may be a firefighter that is so brave to jump into homes on fire and save people and still be very fearful when it comes to investing.

Aspect	Explanation
Definition	Financial Risk refers to the possibility of losing money or the uncertainty of financial returns in various financial transactions and investments. It encompasses several types of risk that individuals, businesses, and investors face when managing their finances and making financial decisions. Financial risk is a fundamental concept in the field of finance and is central to investment strategies, portfolio management, and risk assessment. Understanding and managing financial risk is crucial for achieving financial goals and minimizing potential losses.
Key Concepts	– Types of Financial Risk: Financial risk can be categorized into several types, including market risk, credit risk, liquidity risk, operational risk, and more. Each type represents a specific aspect of risk in financial activities. – Risk vs. Return: There is an inherent trade-off between risk and return in finance. Higher-risk investments have the potential for greater returns, but they also carry a higher risk of loss. – Diversification: Diversifying a portfolio by investing in different asset classes can help mitigate financial risk by spreading exposure. – Volatility: Volatility measures the degree of variation in the price of financial assets. High volatility indicates higher potential risk. – Risk Assessment Tools: Various tools and models, such as Value at Risk (VaR) and stress testing, are used to assess and measure financial risk. – Risk Management Strategies: Risk management strategies involve techniques like hedging, insurance, and risk avoidance to mitigate financial risk.
Types of Financial Risk	– Market Risk: Market risk encompasses the risk of financial losses due to changes in market conditions, including interest rate risk, currency risk, and market volatility. – Credit Risk: Credit risk refers to the risk of financial loss due to the default or non-payment of debt by borrowers or counterparties. – Liquidity Risk: Liquidity risk is the risk of not being able to buy or sell an asset quickly without affecting its price. – Operational Risk: Operational risk arises from internal processes, systems, and human errors within an organization. – Reputational Risk: Reputational risk is the risk of damage to an individual’s or organization’s reputation due to negative public perception. – Systemic Risk: Systemic risk is the risk that a financial crisis in one part of the system can lead to a broader financial meltdown.
Risk Measurement	– Value at Risk (VaR): VaR is a widely used risk measurement tool that estimates the maximum potential loss an investment portfolio could face over a specified time horizon and at a given confidence level. – Stress Testing: Stress testing involves simulating extreme adverse scenarios to assess how a portfolio or financial system would perform under severe stress conditions. – Beta Coefficient: Beta measures an asset’s sensitivity to market movements and is used to assess market risk.
Risk Management Strategies	– Diversification: Spreading investments across different asset classes, industries, and geographic regions can reduce risk. – Hedging: Hedging involves using financial instruments like options and futures to offset potential losses in other investments. – Insurance: Insurance policies can protect individuals and businesses against various types of financial risk, such as health insurance, life insurance, and property insurance. – Risk Avoidance: In some cases, individuals or organizations may choose to avoid certain financial activities or investments altogether to eliminate specific risks. – Risk Tolerance: Assessing one’s risk tolerance helps determine the level of risk an individual or organization is willing and able to take on.
Challenges in Financial Risk Management	– Data Quality: Accurate risk assessment requires reliable data, and data quality can be a challenge. – Regulatory Changes: Financial regulations and compliance requirements are subject to change, impacting risk management practices. – Complex Financial Products: The proliferation of complex financial products can make risk assessment and management more challenging. – Behavioral Biases: Behavioral biases, such as overconfidence and herding behavior, can lead to poor risk management decisions. – Black Swan Events: Extremely rare and unpredictable events, known as “black swan” events, can have a significant impact on financial markets and portfolios.

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How do we take investing decisions?

Investing in corporate finance lingo means:

“Buying assets that earn a return greater than the minimum acceptable hurdle rate” (A. Damodaran).

Also, A. Damodaran used an interesting definition. He starts from the Chinese characters that express the word “crisis” and goes on to derive the two main aspects to consider when undertaking an investment decision:

As you can see the word “crisis” is comprised of two characters and each one has its meaning. In fact, the first means danger and the second opportunity. Thus, let’s start with this definition.

Each time an investment decision has to be taken, the investor faces the danger (which in finance lingo is called risk) to lose the capital invested (or not generating enough returns), while he also put himself in the condition to be highly rewarded (in finance this reward is called return) for the undertaken risk.

To simplify we have to find the % return that would convince the investor to risk his own money. To find this % return we have to study and understand what is risk and how to assess it.

What Is a financial risk?

The Oxford Dictionary defines risk as:

“A situation involving exposure to danger” and it goes on “The possibility that something unpleasant or unwelcome will happen.”

Thus we want to define what is dangerous and what is this unpleasant thing we want to avoid.

A first obstacle stands in the way of defining risk. In fact, each of us seems to have a different perception of what danger is.

For instance, you may be a firefighter that is so brave to jump into homes on fire and save people and still be very fearful when it comes to investing!

Also, in the investing world, there is a term used by behavioral economists, which is “loss aversion.” In short, it seems that we perceive losses way more than we perceive gains.

This bias was first elaborated and verified by Amos Tversky and Daniel Kahneman. In other words, a 10$ gain is perceived more than twice less satisfactory of a loss of the same amount.

This seems to be a built-in bias. Thus, we can do our best to define risk, although our definition may not be perfect.

Since risk is different according to the perspective of the investor, A. Damodaran proposes a useful approach, which is that of the “marginal investor.”

In short, to define risk, you have to identify the marginal investor first. But who is this marginal investor?

Who is the marginal investor?

The marginal investor is the person or institution that at any time may hold the stocks of a company and therefore also influences its prices.

The next step is to identify the marginal investor. How? Well, we have to look at the ownership structure of our target company. For instance, let’s look at who the marginal investors are for Apple:

As you can see from the image provided by Morningstar.com Apple’s principal shareholders are Institutions and Mutual Funds.

In fact, insiders hold just a tiny part of Apple’s issued shares. Thus, we can easily assume that Apple’s marginal investors are well diversified.

That means that they will have a lower risk compared to a non-diversified investor. Why?

Let’s assume that you have all your capital invested in one company. What happens if that company goes bankrupt? You will lose all your wealth, wouldn’t you?

Conversely, if you have your eggs in different baskets if one basket falls you will still have the other eggs; If you are an individual, you can diversify your financial risk by investing in various stocks or for instance in a stock index.

What about businesses? How can a business diversify (thus reduce) its risk exposition? Let’s see the different components of risk.

Financial risk components

There are five components of risk:

Project specific
Competitive
Industry
International
Market

If you are familiar with businesses, you may already know that they face several risks. For instance, although opening a restaurant always seems a good business idea, think for a second how many risks it faces.

First, if you want to run a successful restaurant you have to experiment new dishes continually. Now some dishes will work out some will not.

Those that won’t work will also have a cost for you. We will call the risk of these dishes not working out project-specific risk. Second, you have to be better than the other dozens of restaurants in the neighborhood.

To do so, you will cut prices, or improve the quality of the product and so on. You won’t know if this will work out for sure. Thus, we will call this danger competitive risk.

Third, you have to be able to manage your budget, since the price of the ingredients for your recipes steadily increases. Also, you have to make sure the restaurant is always clean and that it is compliant with legal standards.

Thus, you have to follow periodically any regulation changes that may be in the industry. And also, update your system to make sure the restaurant is run efficiently.

All those things cost you money and can also endanger your business. Thus, we will call them industry risks.

Fourth, if you opened a restaurant in another state, you want also to understand the regulations in that state. Assuming that the country also has a different currency, this will can affect your revenues either positively but also negatively.

We will call this sort of danger international risk. And fifth, if an economic crisis strikes the restaurant will resent it. In fact, when economic conditions worsen people have less money to spend on their leisure activities.

Thus, the revenues will considerably slow down. We are going to call this danger market risk. In conclusion, so far we identified five components of risk:

Project specific
Competitive
Industry
International
Market

The next question is “Until which extent can we get rid of risk?”

What financial risks can be managed?

The primary objective of diversification is to reduce and manage risk. But the problem is that while some risk may be easily mitigated, others are not.

Perhaps, going back to the restaurant business, you may be able to diversify the project specific risk by trying out different dishes. For instance, you can play on the large numbers.

If you try out ten new dishes, the chances are that nine out of ten will not work out. But the successful plate will generate more than enough revenues to cover the expenses incurred in trying out the other dishes plus an additional reward for the undertaken risk.

Also, if a successful restaurant just opened in your neighborhood, you could either compete with it or become an ally. How? Well, you may buy part of the ownership.

This, in turn, will reduce the competitive risk. Huge corporations like Amazon, which bought Zappos, Facebook, which bought Instagram or Whatsapp and so on, use this same strategy. This is a way to diversify their business model.

Now there is also the strategic reason for doing so. Perhaps, Zappos can make Amazon more valuable, but these deals are also driven by the necessity for these businesses to reduce the competitive risk.

Further, once the money from the restaurant business flows in you may want to consider investing it in other ventures as well. I did not say restaurants on purpose.

In fact, if you keep investing in other restaurants, you may reduce your competitive risks, but this will not mitigate the industry risk. To diversify away this risk, you will invest in other industries.

For instance, with the cash flow from the restaurant, you can buy a piece of real estate and rent it out.

Since you opened your restaurant in another state with a different currency and interest rates; Assume that you have a restaurant in San Diego, CA and you just opened another in Rosarito, Mexico.

Although those restaurants are 50 minutes apart they are in different countries. In fact, in San Diego, you pay in dollars and Rosarito in pesos.

A dollar is worth several pesos. Also, according to the World Bank Landing Rates U.S. has a 3.3% lending rate, while Mexico shows a 4.9%.

Thus, you may want to borrow in U.S. dollars and finance the Mexico operations with that money, assuming they will accept dollars rather than pesos. In this way, you will diversify away part of your international risk!

A lot of hard work so far to take away some of the risk involved for being in business. Although you successfully managed to come so far, there is a form of risk that cannot be diversified.

This is the market risk. In short, if the whole world economy will suffer (think of the 2008 global crisis), there is nothing you can do about it. As they say “A trouble shared is a trouble halved.” Hopefully, you saved enough money for the rainy days and will survive.

In conclusion, we analyzed the five components of risk and saw how they could be diversified away. Though, there is a component (market risk) that is not diversifiable. Let me summarize what we saw in this table below:

How do you Measure financial Risk?

So far we got two central concepts down, about risk. First, a risk is not an absolute concept but it somewhat depends on how well diversified is the marginal investor.

Also, we may argue that with new developments in behavioral economics we now know that there are also certain aspects related to risk (such as loss aversion and other built-in biases) that make risk an even more complicated topic.

On the other hand, we are dealing with corporate finance; a world was shrewd financial managers assume that the marginal investors are rational. Thus, our second point is that marginal investors will tend to diversify their portfolios. Why?

Let me use an analogy here. I apologize in advance for using the Darwinian concept of evolution, but I believe it makes my point. In fact, natural selection works somewhere around these lines: nature has scarce resources (in most of the cases).

Thus the individuals living in the same environment will tend to compete against each other for survival and reproduction. This will bring to the creation of strategies by each competing in the same situation.

Eventually, nature will select the winning strategy and avoid the rest. In conclusion, these strategies will be passed on to progenies.

For instance, trees compete with each other for the sunlight. What is the best way to absorb sunlight? By being closer to the sun, thus by growing taller.

For such reason, they tend to grow taller and taller until a forest will be created. While at the beginning of the process, you could see short trees, now they were utterly swept out.

Thus, all the trees in the forest are tall, and they keep growing until they reach a limit to avoid losing their functionality (this is speculation). Eventually, all the trees in the forest will more or less have the same height. In short, there is a certain consistency.

If we go back to the financial world, we can use the same example. When all the marginal investors understand that the strategy to manage the risk is to diversify the portfolio, they all start to use diversification.

On the other hand, there is a point in which the marginal benefit of diversifying will be null. In fact, as we saw there is a component of risk (market risk or systematic risk) that cannot be diversified.

Consequently, if you hold ten stocks or one hundred, it does not make any difference. Instead, it just increases the cost associated with managing such a portfolio.

In conclusion, all the marginal investors will hold diversified portfolios, which will carry only systematic risk. Thus, this means that wherever we look in the markets, we will find diversified investors.

Conclusively, the simplest way to compute the risk of a security is to assess the systematic risk or that part of the risk that cannot be diversified away.

What Are The Different Types of Financial Risk?

As we saw, financial risk is an inevitable part of personal and business finance.

It is important to understand the different types of financial risk in order to make informed decisions when it comes to your finances.

Let’s see in detail all the types of financial risks to take into account.

Market Risk

Market risk is the risk of investments losing value due to changes in the overall market.

Examples of market risk include volatility of stocks and bonds, and currency fluctuations.

Volatility of stocks and bonds means that the prices of these investments can fluctuate significantly due to changes in the market, which can lead to losses for investors.

Currency fluctuations occur when the value of a currency changes due to changes in the market, which can also lead to losses for investors.

Credit Risk

Credit risk is the risk of a borrower or issuer of a financial instrument defaulting on their obligations, or filing for bankruptcy.

Defaulting on loans can occur if a borrower is unable to repay the loan, while bankruptcy occurs when a borrower is unable to repay their debts.

Operational Risk

Operational risk is the risk of losses due to human error, inefficient processes, or inadequate systems.

Human error can occur if an employee makes a mistake when processing a financial transaction, while inefficient processes can lead to errors and delays in processing transactions.

Inadequate systems can also lead to errors and delays in processing transactions.

Liquidity Risk

Liquidity risk is the risk of an investor being unable to sell their assets quickly in order to meet their financial obligations.

Examples of liquidity risk include difficulty selling assets and cash flow issues.

Difficulty selling assets can occur if the market is illiquid, or if there are few buyers for a particular asset.

Cash flow issues can occur if an investor does not have enough cash to meet their obligations.

Systemic Risk

Systemic risk is the risk of losses due to fluctuations in market conditions or contagion risk.

Fluctuations in market conditions can occur if there are changes in the overall market, which can lead to losses for investors.

Contagion risk occurs when a default in one sector of the market leads to losses in other sectors of the market.

Political Risk

Political risk is the risk of losses due to changes in tax laws or regulatory requirements.

Changes in tax laws can affect the amount of taxes an investor must pay, while changes in regulatory requirements can affect the ability of an investor to conduct certain activities.

Interest Rate Risk

Interest rate risk is the risk of losses due to rising or falling interest rates.

Rising interest rates can lead to increased borrowing costs, while falling interest rates can lead to decreased returns on investments.

Inflation Risk

Inflation risk is the risk of losses due to rising prices or decreasing purchasing power.

Rising prices can lead to increased costs for goods and services, while decreasing purchasing power can lead to decreased returns on investments.

Why is it Important to Manage Financial Risk?

Managing financial risk is essential in order to maintain a healthy financial position.

In order to do so, companies must identify and assess their financial risks, develop strategies to mitigate them, and monitor their performance.

Companies should consider using a variety of risk management tools such as hedging, diversification, and insurance to help manage their financial risks.

Proper risk management can help companies to protect their investments, maximize profits, and achieve their long-term business goals.

Key Highlights:

Definition of Risk: Risk is defined as a situation involving exposure to danger or the possibility of something unpleasant happening.
Perception of Danger: Each individual’s perception of danger varies, leading to different risk tolerance levels in different situations.
Investment Decision-Making: Investing involves risking capital to earn a return greater than the minimum acceptable hurdle rate.
Crisis Definition: A. Damodaran’s definition of crisis involves both danger and opportunity, reflecting the dual aspects of investment decisions.
Marginal Investor: The marginal investor is the one who influences a company’s stock prices and holds its shares. Their perspective helps define risk.
Diversification: Diversifying investments across various assets or industries helps reduce specific risks, making portfolios less vulnerable.
Components of Financial Risk: There are five components of financial risk: project-specific, competitive, industry, international, and market risks.
Risk Mitigation Strategies:
- Project-Specific: Experimentation and diversification of projects reduce project-specific risk.
- Competitive: Collaboration or strategic partnerships can reduce competitive risk.
- Industry: Staying updated with regulations and managing costs reduces industry risk.
- International: Using currency and interest rate strategies can mitigate international risk.
- Market: Market risk (systematic risk) is unavoidable and affects the entire economy.
Market Risk: Market risk is associated with overall market changes, including volatility of stocks, bonds, and currency fluctuations.
Credit Risk: Credit risk involves the potential of borrowers or issuers defaulting on their obligations.
Operational Risk: Operational risk is linked to human errors, inefficient processes, and inadequate systems.
Liquidity Risk: Liquidity risk arises when assets can’t be sold quickly, leading to financial obligations issues.
Systemic Risk: Systemic risk stems from market fluctuations and the potential for financial distress spreading across sectors.
Political Risk: Political risk pertains to losses due to changes in tax laws or regulatory requirements.
Interest Rate and Inflation Risk: Interest rate risk results from fluctuations in interest rates, while inflation risk is due to rising prices affecting purchasing power.
Importance of Risk Management: Proper risk management helps protect investments, maximize profits, and achieve long-term business goals.
Risk Management Strategies: Companies use tools like hedging, diversification, and insurance to manage financial risks effectively.