Types of Financial Risks

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.

1. 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.
2. 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.
3. 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.

           

           

           

           

Responsibilites of Risk Management

Risk Management Responsibilities

The board has overall responsibility for the management of risk as an essential part of its corporate governance responsibilities. Responsibilities below the board level will depend on the extent of delegation to the managers and whether there is a separate risk management function. Everyone who works for the organization has responsibilities for risk management, not just risk specialist whose role I shall discuss below.

The board

            The board of directors has very important role in managing the risk in an organization. The board is accountable for identifying risk management strategy and looking risks as part of its responsibility for the organization’s overall strategy and its responsibilities to shareholders and other stakeholders. It is also responsible for setting appropriate policies on internal controls and trying assurance that the internal control system is functioning effectively. It should also communicate the organization’s strategy to employees.

The Chief Executive

            The chief executive responsibility for ownership of risk management and internal control system is an important part into an organization. The CEO must consider specifically the risk and control environment by focusing amongst other things on how his or her example promotes a good culture. The chief executive should also monitor other directors and senior staff, particularly those whose actions can put the company at significant risk.

Risk Management Committee

            Board of directors needs to consider whether there should be separate board committee, with accountability for supervising and monitoring risk management and identification. If the board doesn’t have a separate committee, under the United Kingdom Combined Code the audit committee will be accountable for risk management.

Risk Management Group

            A risk management group, staffed by senior managers, may be responsible for building on the overall strategy and framework prescribed by the board. This group will add additional detail and will prescribe methods of risk management that operating units will employ. The risk management group will concentrate on risk responses and will also monitor risk management to see that the strategies and policies are operating effectively. The risk management group must report to the board and in turn will receive reports from line managers and employees.

Internal and External Audit

            Risk is integral to work of external and internal audit, both in the terms of influencing how much work they do and also what work they actually do. The external auditors must be concerned with the risks that affect most on the figures shown in the financial accounts. While internal auditor’s role is more flexible, and their approach will depend on whether they focus on the controls that are being operated or the process of overall risk management.

Line Managers

The Turnbull report of United Kingdom pushes the role of management in implementing wide policies on risk and control, involving evaluating and identifying the risk and operating and designing a proper system of internal control. Any risk that fall under the areas of managers should be in their knowledge. The performance indicators they use should assist them to monitor significant financial and business activities and identify when intervention is needed. Line manager should be involved in communicating the policies of risk management system in order to set a good example. Line managers should also be responsible for preparing reports that will be considered by the senior manager and board.

Risk Faced by Organizations

Risk Faced by Organizations

            Risk can be classified in numerous ways, including legal, financial, IT, fraud, operational and reputation. There are number of diverse risks that organizations are faced today specifically those organizations operating in international and commercial activities. The nature of different risks has been discussed in detail below;

1 – Legal and Political Risks

            Breaches of regulations, legislation or codes of conduct may have serious results for an entity. These risks include financial and other fines (even involving the entity shutdown) by having to spend resources and money in fighting against the litigation and saving the reputation. Thereby important areas include environmental legislation, health and safety, trade disruption, data protection, consumer protection and employment issues.   

            The codes of good governance are especially important instances of best practices and businesses must think about the risks of breaching provisions relating to objectivity and integrity and also control over the organization.

            While the political risks are those risks that may influence the position of an organization by a political action. This type of risk related to country risk, the risk connected with undertaking some transactions, or having assets in any specific country.

2 – Financial Risks

            Financial risk is that type of risk through which any organization may not able to run as a going concern entity. These risks include the risks relating to the structure of finance the organization has, we can say that the risk linked to the capital structure i.e. debt and equity, also whether an entity has enough long term capital base for the amount of trading the business doing. In order to control this type of risks organizations must use some strategies to limit risk of fraud and misuse of financial resources. However the long term involves the risk of currency rate, risk of interest rate also the risk of market. While short term risks involve liquidity risk and credit risk.

3 – Technological Risk

            Technological risks include three types of risks;

       I.      Physical Damage Risks: In physical risks fire is the most dangerous hazard that may damage the computer systems because everyone knows the destruction of data is more costly than the destruction of hardware. Moreover, water is another hazard when it is related to technological matters. In some areas of the this world the natural risk of flooding may cause serious damages, for instance if the basements in such floody areas are the main sites of large computer installation the business can loose all the hardware as well as the soft data. So business must not consider the basements for computer installation. Similarly rains, winds, and storms can cause substantial damage to buildings. Electrical and lightening storms can play havoc with power supplies causing power failures coupled with power surges as services are restored.

    II.      Data and System Integrity Risks: These risks may be particularly significant because of the nature of computer operations. The risks involve human error such entering incorrect transactions, failing to correct errors, processing the wrong files and failing to follow the stated security measures. In this way possible technical errors include malfunctioning software or hardware and supporting equipment such as communication equipment, normal and emergency power supplies and air conditioning units.

 III.      Fraud Risks: Computer fraud generally includes the theft of founds by misusing the computer system. Input fraud is happened where data input is falsified; good instances are putting a non-existent employee on the salary file or a non-existent supplier on the purchase file. With the fraud of processing, a programmer or someone else who has broken into this part of the system may alter a program. And the output fraud includes documents being tampered with and control totals being altered or stolen. Checks are the most common document to be stolen, but other documents may be stolen to hide the other frauds.

4 – Health and Safety Risks

            In any business health and safety risks involve loss of employees’ time because of injury and the risks of having to pay compensation or legal cost because of breaches. Health and safety risks can arise from:

• Lack of health and safety policy due to increased legislation in this area this becoming less likely
• Lack of emergency procedures because it is considered less likely
• Failure to deal with the hazards often due to a failure to implement policies such as inspection of electrical equipment, labeling of hazards and training
• Poor employee welfare is not just threats to health such as poor working environment or excessive exposure to VDUs, but also threats to quality from tired staff making mistakes
• Generally poor health and safety culture

5 – Environmental Risks

            Environmental risk is the risk of loss to the business arising out of the environmental effects of its operations. This risk is mostly higher with those businesses operating in farming, agriculture, transportation and chemical industry. These industries have the greatest direct effects on the environment and so face the most significant risks. However other factors may be significant. In the same way business located in such areas that are near to river may face increased risks of causing pollution. An important element of environmental risk is likely to be waste management, especially is waste materials are toxic.

Business Risks

Business Risks

Generally every business has two types of risks;

1. Strategic Risks: Strategic risks are risks that relate to the fundamental decisions that the directors take about the future of the organization.
2. Operational Risks: Operational risks relate to matters that can go wrong on a day-to-day basis while the organization is carrying out its business.

There are many different types of risks faced by commercial organizations, particularly those with international activities. 

1 - Strategic Risks

Strategic risk is the potential volatility of profits caused by the nature and type of the business operations. The most significant risks are focused on the strategy the organization adopts including concentration of resources, mergers and acquisitions and exit strategies. As organization also needs to guard against the risks that business processes and operations are not aligned to strategic goals, or are disrupted by events that are not generated by business activities.

1.1  – Business and non-business strategic risks

A useful classification of strategic risks is the division between business and non-business risks.

·         Business Risks: Business risks are threats to profits, the magnitude of which depends on the decisions the organization makes about the products and services it supplies. An obvious example of business risk would be threats of long-term product obsolescence. Changes in technology would also have long term impacts of they changed the production process; the significance of these changes would depend on how important technology was in the production processes. Long-term macroeconomic changes, for example a worsening of a country’s exchange rate, would also be a business risk.

·         Non-business Risks: Non-business risks are threats to profits that are not influenced by the products or services the organization supplies. Example of non-business risks arising from the long-term sources of finance chosen and risks from a collapse in trade because of an adverse event, an accident or natural disaster.

1.2 - Factors influencing strategic risks

            Factors that determine the level of strategic risks will include:

·         The types of industries/markets within which the business operates

·         The state of the economy

·         The actions of competitors and the possibility of mergers and acquisitions

·         The stage in a product’s life cycle, higher risks in the introductory and declining stages

·         The dependence upon inputs with fluctuating prices, eg wheat, oil, etc

·         The level of operating gearing – the proportion of fixed costs to total costs

·         The flexibility of production processes to adapt to different specifications or products

·         The organization’s research and development capacity and ability to innovate

·         The significance of new technology

There may be little management can do about some of these risks, they are inherent in business activity. However, strategies such as diversification can contribute substantially to the reduction of many business risks.

2 – Operational Risk

Operational or process risk is the risk of loss from a failure of internal business and control processes. Operational risks include;

• Losses from internal control system or audit inadequacies
• Non-compliance with regulations or internal procedures
• Information technology failures
• Human error
• Loss of key-person risk
• Fraud
• Business interruptions

Difference between Strategic and Operational Risks

            The main difference between strategic and operational risks is that strategic risks relate to the organization’s longer term place in, and relations with, the outside environment. Although some of them relate to internal functions, they are internal functions or aspects internal functions that have a key bearing on the organization’s situation in relation to its environment. Operational risks are what could go wrong on day to day basis, and are not generally very relevant to the key strategic decisions that affect a business, although some (for example a major disaster) can have a major impact on the business’s future.