What is financial risk and how can it be managed?

Financial risk is the chance that a financial decision or event may lead to unexpected losses. Some risks can be anticipated and managed, while others, such as sudden economic changes, are harder to predict. In this guide, we’ll take a look at what defines financial risk and explore ways these risks can be identified and managed.

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 refers to the possibility of losing money or being unable to meet financial obligations, and it can affect individuals, businesses, financial institutions, and governments in different ways.. For example, an investment might not deliver the expected returns due to a market downturn, while a company could experience cash flow problems if a client fails to pay an invoice. These events can’t always be prevented, but measures can be taken to try to control or manage financial risk.

From individuals following a monthly budget to large firms trading across the world – anyone using money or capital can be affected by financial risk. 

• Individual consumers might face job loss or debts that impact how much they are able to spend and save, including for longer-term goals like retirement.

• Businesses may struggle with cash flow or failing investments, affecting their profits and, in some cases, whether they survive.

• Investors may lose capital due to changes in the markets or poor company performance.

• Lenders and banks can face credit losses from borrowers failing to repay loans.

• Governments might face financial strain from economic downturns or from defaulting on debt, which can lead to tightened spending on public services and affect national budgets.

Individuals face different types of financial risk to large companies, and the effects can vary as well. 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 can be broken down into three main types:

• Interest rate risk – Changes to interest rates can affect a bank’s profits or an investor’s potential returns. 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 holding bonds can also be affected. Older bonds with lower interest payments may become less attractive, causing their prices to drop.

• Equity risk – Stock prices can rise or fall unexpectedly due to market volatility and investor sentiment. This includes investments in commodities like crude oil, gold, or agricultural products, which are considered a type of alternative investment and are traded on the market much like stocks. Investors might accept equity risk with the aim of higher returns, but there is also the chance of losing money.

• Currency risk – Companies and investors doing business in foreign markets can lose money when exchange rates change. When the euro weakens against the dollar, for example, it becomes cheaper to import 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. They may also have to spend more to collect the money owed to them. Because it’s a well-known risk in finance, banks and other lenders often assess credit risk before agreeing to lend. The goal is to prevent potential losses or keep them to a minimum.

With some types of investments (for example, property investing), money is tied up for long periods of time, meaning a company or investor cannot easily convert the asset to cash when it’s needed. For example, a company might need some cash to pay off debts, but it could be forced to default if it can’t access funds quickly enough.

For assets traded on the markets, liquidity risk can become more serious during volatile periods. . If many investors try to sell at the same time, it can be difficult to offload these assets quickly without making a loss.

Losses can be caused by problems within a business’s operations. A company can have poor management or experience technical failures or criminal activity like fraud. They also face operational risk from external events, such as legal disputes. These issues can be hard to recover from, and may have lasting effects on customer satisfaction or a company’s reputation.

This is a risk linked to the difficulty of determining an asset’s value, which could lead to it being incorrectly priced. This may be more likely to occur with complex or less commonly traded assets, where there isn’t much recent market activity to use as a guide, and estimates are used instead. This type of financial risk can result in unexpected losses if an asset cannot be sold for the price that an investor originally expected.

Models are often used to help organisations assess risk or simply support decision-making. However, they’re built on assumptions that don’t always materialise when market conditions change. This type of risk is most common in banks and larger organisations, but it can affect any situation where forecasts or projections are used.

When multiple financial risks happen at once, it’s not only businesses or investors that are affected, but the wider financial system as a whole. Problems in one area can quickly spread, creating knock-on effects elsewhere. The 2008 financial crisis shows how this can happen. Issues in parts of the banking system spread rapidly, causing widespread disruption and losses. The Central Bank of Ireland’s Financial Stability Review monitors asset prices, borrowing levels, and liquidity to assess how resilient the country’s financial system is to these kinds of risks.

Businesses and investors can encounter financial risks at any time – situations that could lead to financial loss if not properly managed. Professionals such as risk managers firstly identify potential threats, before assessing how likely they are to happen and their impact. They might conduct industry research to define financial risks affecting other similar businesses.

Investors and companies might use financial ratios to measure the level of risk. 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. Cash flow analysis involves examining a company’s balance sheet and revenue streams. Likewise, financial institutions check credit histories on the Central Credit Register to measure an individual’s creditworthiness, which influences how much interest they will charge on loans.

The process is roughly as follows:

1. Identify risks, looking for threats from within and outside the business.

2. Assess risks by working out how likely they are to happen and how big the impact could be, using both qualitative and quantitative measures.

3. Measure indicators, such as financial ratios, credit histories, and cash-flow trends.

4. Develop a financial risk management strategy to mitigate risk.

While financial risk can’t be removed entirely, businesses and investors can take steps to reduce potential losses. This is part of financial risk management, and the strategies involved can also be used by individuals to improve their financial literacy. Below are some of the most common approaches used to mitigate financial risk.

• 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. By avoiding putting money in one area, it can reduce the impact if one investment performs badly.

• Insurance: Insurance protects against unexpected events, such as property damage or liability claims, which could otherwise lead to significant financial loss.

• Multiple income streams: Having more than one income stream can reduce dependence on a single source of revenue. For individuals, this could be a second job, rental income, or investments. For businesses, it can lower overall exposure to financial risk.

• Emergency funds or cash reserves: Having some cash set aside for emergencies can lessen the impact of liquidity risk. Individuals can set up an emergency fund that would help cover any unexpected personal expenses. Companies could maintain a cash reserve or liquidity buffer to ensure operations continue when faced with unexpected business costs or economic downturns.

• Hedging: This is where an investment is made to offset potential losses in another investment. For example, investors might use options or futures to protect stock holdings, while businesses may hedge against currency or interest rate fluctuations. Hedging is a common risk management tool, though it can be expensive, and is typically used for specific concerns like currency risk or market risk.

For someone looking to minimise exposure to financial risk, savings accounts are generally considered low risk. The main risk with variable rate accounts is that the interest rate could go down while the account is open, and higher inflation might lower the purchasing power of cash savings as time goes on. 

Unlike market-linked investments, however, the balance in a savings account typically won’t fall. And because demand deposit accounts let you access funds when needed, some people prefer to use savings accounts for a stash of emergency cash.

With Raisin, you can easily diversify by combining flexible demand deposit accounts with fixed term offers from multiple partner banks, all managed through one secure platform. This lets you balance accessibility and long-term planning in a single place.

Plus, at Raisin, deposits of up to €100,000 per person, per bank are legally protected by the national deposit guarantee scheme of the country where the bank is headquartered.