Financial risk is the possibility that shareholders or other financial stakeholders will lose money when they invest in a company that has debt if the company’s cash flow proves inadequate to meet its financial obligations. When a company uses debt financing, its creditors are repaid before shareholders if the company becomes insolvent.
Financial risk also refers to the possibility of a corporation or government defaulting on its bonds, which would cause those bondholders to lose money.
Types of Financial Risks
This type of risk arises out of operational failures such as mismanagement or technical failures. Operational risk can be classified into Fraud Risk and Model Risk. Fraud risk arises due to lack of controls and Model risk arises due to incorrect model application.
This type of financial risk arises out of legal constraints such as lawsuits. Whenever a company needs to face financial loses out of legal proceedings, it is legal risk
This type of risk arises when one fails to fulfill their obligations towards their counter parties. Credit risk can be classified into Sovereign Risk and Settlement Risk. Sovereign risk usually arises due to difficult foreign exchange policies. Settlement risk on the other hand arises when one party makes the payment while the other party fails to fulfill the obligations.
This type of risk arises out of inability to execute transactions. Liquidity risk can be classified into Asset Liquidity Risk and Funding Liquidity Risk. Asset Liquidity risk arises due to either insufficient buyers or insufficient sellers against sell orders and buy orders respectively.
This type of risk arises due to movement in prices of financial instrument. Market risk can be classified as Directional Risk and Non – Directional Risk. Directional risk is caused due to movement in stock price, interest rates and more. Non- Directional risk on the other hand can be volatility risks.