Understanding Financial Risk Plus Tools to Control It

What Is Financial Risk?

Financial risk is the possibility of losing money on an investment or a business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk.

Financial risk is a type of danger that can result in the loss of capital to interested parties. This can mean that governments are unable to control monetary policy and will default on bonds or other debt issues. Corporations also face the possibility of default on debt they undertake but they might also experience failure in an undertaking that causes a financial burden on the business.

Understanding Financial Risks for Businesses

Financial markets face risk due to various macroeconomic forces, changes to the market interest rate, and the possibility of default by sectors or large corporations. Individuals face financial risk when they make decisions that might jeopardize their incomes or ability to pay a debt they've assumed.

Financial risks are everywhere and they come in many shapes and sizes, affecting nearly everyone. Knowing the dangers and how to protect yourself won't eliminate the risk but it can mitigate the harm and reduce the chances of a negative outcome.

It's expensive to build a business from the ground up. The company might have to seek outside capital to grow and this need for funding creates a financial risk to both the business and to any investors or stakeholders invested in the company.

Credit risk, also known as default risk, is the danger associated with borrowing money. The borrower will likely default should they become unable to repay the loan. 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 the collection of debt.

It's referred to as a specific risk when only one or a handful of companies are struggling. 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 about collecting returns and the accompanying potential for monetary loss.

Businesses can experience operational risk when they have poor management or flawed financial reasoning. This is the risk of failing to succeed in its undertakings and it's based on internal factors.

How Governments Offset Financial Risk

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

Governments issue debt in the form of bonds and notes to fund wars, build bridges and other infrastructure, and pay for their general day-to-day operations. The U.S. government's debt is Treasury bonds. They're considered one of the safest investments in the world.

The list of governments that have defaulted on debt they've issued includes Russia, Argentina, Greece, and Venezuela. Sometimes these entities only delay debt payments or they pay less than the agreed-upon amount. It causes financial risk to investors and other stakeholders either way.

The Impact of Financial Risks on Markets

Several types of financial risk are tied to financial markets. Many circumstances can impact the financial market. It can impact the monetary well-being of the entire marketplace when a critical sector of the market struggles as was demonstrated during the 2007 to 2008 global financial crisis. Businesses closed during this time, investors lost fortunes, and governments were forced to rethink their monetary policies. Many other events also impact the market, however.

Volatility brings uncertainty about the fair value of market assets. It reflects the confidence of the stakeholders that market returns match the actual valuation of individual assets and the marketplace as a whole. Measured as implied volatility (IV) and represented by a percentage, this statistical value indicates the bullish or bearish view of investments: the market on the rise versus the market in decline. Volatility or equity risk can cause abrupt price swings in shares of stock. 

Defaults and changes in the market interest rate can also pose a financial risk. Defaults happen mainly in the debt or bond market as companies or other issuers fail to pay their debt obligations, harming investors. Changes in the market interest rate can push individual securities into being unprofitable for investors, forcing them into lower-paying debt securities or facing negative returns.

Asset-backed securities are pools of various types of loans. Asset-backed risk is the chance that these securities may become volatile if the underlying securities also change in value. Subcategories of asset-backed risk involve the borrower paying off a debt early and ending the income stream from repayments and significant changes in interest rates.

How Financial Risks Impact Individuals

Individuals can face financial risk when they make poor decisions. This hazard can have wide-ranging causes from taking an unnecessary day off from work to investing in highly speculative investments. Every undertaking has exposure to pure risk. Some dangers can't be controlled but some undertakings are committed without fully realizing the consequences.

Liquidity risk comes in two forms for investors to fear. The first involves securities and assets that can't be purchased or sold quickly enough to cut losses in a volatile market. This is known as market liquidity risk and it's a situation where there are few buyers but many sellers. Another risk is funding or cash flow liquidity risk. Funding liquidity risk is the possibility that a corporation won't have the capital to pay its debt, forcing it to default and harming stakeholders.

Speculative risk is one where a profit or gain has an uncertain chance of success. Perhaps the investor didn't conduct proper research before investing, reached too far for gains, or invested too large a portion of their net worth into a single investment.

Investors holding foreign currencies are exposed to currency risk because factors such as interest rate changes and monetary policy changes can alter the calculated worth or the value of their money. Changes in prices because of market differences, political changes, natural calamities, diplomatic changes, or economic conflicts can cause volatile foreign investment conditions that might expose businesses and individuals to foreign investment risk.

Pros and Cons of Financial Risk

Financial risk isn't inherently good or bad in itself but it exists to different degrees. "Risk" has a negative connotation by its very nature and financial risk is no exception. A risk can spread from one business to affect an entire sector, market, or even the world. Risk can stem from uncontrollable outside sources or forces and it's often difficult to overcome.

Understanding the possibility of financial risk can lead to better, more informed business or investment decisions. Assessing the degree of financial risk associated with a security or asset helps determine or set that investment's value. Risk is the flip side of the reward.

It can be argued that no progress or growth can occur in a business or a portfolio without assuming some degree of risk. Financial risk usually can't be controlled but exposure to it can be limited or managed.

Tools to Control Financial Risk

Many tools are available to individuals, businesses, and governments that allow them to calculate the amount of financial risk they're taking on. The most common methods that investment professionals use to analyze risks associated with long-term investments or the stock market as a whole include:

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

The debt-to-capital ratio measures the proportion of debt used given the total capital structure of the company when evaluating a business. A high proportion of debt indicates a risky investment.

The capital expenditure ratio divides cash flow from operations by capital expenditures to see how much money a company will have left to keep the business running after it services its debt.

Professional money managers, traders, individual investors, and corporate investment officers use hedging techniques to reduce their exposure to various risks. Hedging against investment risk means strategically using instruments such as options contracts to offset the chance of any adverse price movements. You hedge one investment by making another.

Real-World Example of Financial Risk

Bloomberg and other financial commentators point to the June 2018 closure of retailer Toys "R" Us as proof of the immense financial risk associated with debt-heavy buyouts and capital structures that inherently heighten the risk for creditors and investors.

Toys "R'" Us announced that it had voluntarily filed for Chapter 11 bankruptcy in September 2017. The company's chair and CEO said in a statement released with the announcement that the company was working with debtholders and other creditors to restructure the $5 billion of long-term debt on its balance sheet.

As reported in an article by CNN Money, much of this financial risk reportedly stemmed from a 2005 US $6.6 billion leveraged buyout (LBO) of Toys "R" Us by mammoth investment firms Bain Capital, KKR & Co., and Vornado Realty Trust. The purchase took the company private and left it with $5.3 billion in debt secured by its assets. It never really recovered, saddled as it was by $400 million worth of interest payments annually.

The Morgan-led syndicate commitment didn't work. Toys "R" Us announced in March 2018 after a disappointing holiday season that it would be liquidating all of its 735 U.S. locations to offset the strain of dwindling revenue and cash amid looming financial obligations. Reports also noted that Toys "R" Us was having difficulty selling many of the properties. This is an example of the liquidity risk that can be associated with real estate.

The hedge funds and Toys "R" Us debt holders Solus Alternative Asset Management and Angelo Gordon took control of the bankrupt company in November 2018 and talked about reviving the chain. The Associated Press reported in February 2019 that Tru Kids Brands, a new company staffed with ex-Toys "R" Us execs, would relaunch the brand with new stores later that year.

In late 2019, Tru Kids Brands opened two new stores in late 2019, one in Paramus, New Jersey, and the other in Houston, Texas. Macy's partnered with WHP Global to bring back the Toys "R" Us brand and announced in 2022 that it planned to bring Toys "R" Us to all its stores.

The Bottom Line

Financial risk naturally occurs across businesses, markets, governments, and individual finance. These entities trade the opportunity to make profits and yield gains for the chance that they may lose money or face detrimental circumstances. These entities can use fundamental, technical, and quantitative analysis to not only forecast risk but make plans to reduce or mitigate it.