Types of Financial Risks
Currency Risk
The loss or gain possibility to the prospective changes in the exchange rates is called currency risk. The business is open to currency risk at the time dealing with foreign customer or supplier, if the invoice is in foreign currency. If the business needs to pay some foreign debts, changes in the exchange rates also established a risk at the time of settling final receivable or payable because of uncertainty in home currency rates. In the same way borrowing from or inverting in foreign country also carry a threat of currency risk. We can divide currency risk into three types, i.e.
- Translation Risk: A risk that arises at the time of changes in balance sheet figures because of retranslation at different exchange rates at the year end.
- Risk of Transaction: such risk that arises from exchange rates fluctuation between the time of entering into international transaction and the time of payment settlement.
- Economic Risk: If any business is operating into foreign country, it may have economic risk to maintain international competitiveness because the exchange rate can affects the import/export or more payments need to be made to foreign labor, etc.
From the above three types of currency risks, transaction risk is more critical to manage cash flows on day to day basis. However, there are many strategies to eliminate this risk, e.g. the use of hedging or derivation techniques can mitigate such type of critical risks.
Risk of Interest Rate
It is obvious that, like exchange rates, interest rates cannot be projected easily. The change in interest rates can create uncertainty to interest amount on debts is an entity has a large amount of changing interest rates. Similarly if a business enters into fixed interest rate debts, it may loose the benefit at the time when interest rates will fall.
Risk of Market
There are different definitions of market risk that you may encounter, however some of them are given below;
- Market risk can be defined as a risk of reduction in the value of asset due to market adverse movement. For instance the values of market bonds, loans, stocks, etc. can be changed due to uncertain trend into market that may influence business heavily.
- We can also define market risk as a risk that appears from any market in which an entity has been operating, this risk may be linked to input resources, output resource or financial resources.
However, market risk is ultimately connected to rate of interest or exchange rate at the time when derivatives are exercised to hedge or transfer these risks. It can be analyzed with other risks, for instance small price movement risk that can change the position of asset holders, and losses risks linked to changed in the asset’s maturity structure. This type of risk should be considered before entering into local and foreign markets for heavy investment.
Risk of Liquidity
When business faces the problem of mismatching of cash inflow with cash outflow, we can say that business is facing liquidity risk. Its means that an entity may be unable to pay its short term obligation with its current assets that may interrupt the daily operations. So in order to continue daily operations, business needs to borrow load even on high interest rates. There are many methods to measure such type of risk.
Risk of Credit
Credit risk is a risk to an entity that fails to collect from debtors on time. In this regard management of credit risk is significant for exporters. However, there are number of methods to avoid such types of risks, e.g. bills of exchange, documentary credits, export credit insurance, forfaiting, and factoring.
Risks of Financial Records and Reporting
The risk of material misstatement (intentionally) into published financial statements is also considered as financial risk. The main reason of this risk occurrence is such liabilities that are not recorded, accounting system breakdown and fallacious accounting records.
