Understanding Financial Risk Management - SmartAsset

Financial risk, which is the probability of financial loss, can arise in numerous business and investment scenarios. For instance, a business can’t launch a product or service without taking on risk. However, risk also opens up opportunities in other areas of a given space. In portfolio management, there’s usually a direct correlation between risk and rewards.

Consider working with a financial advisor as you gauge your own risk tolerance and the risks of specific financial moves.

The Basics of Financial Risk Management

Financial risk management is not necessarily avoiding all risk. Rather, it involves assessing risk in any proposed investment or business venture and weighing it against the prospects that a proposal will succeed. It often entails employing hedging and other strategies to help lessen the effect of risk and maximize the value of the firm to the stakeholders.

For instance, financial risk facing a business arises because of a company’s various financial transactions. Examples include sales and purchases, investments, debt financing, energy, the actions of management and the stakeholders and much more.

Generally speaking, financial risk can be classified into six types. These include interest rate risk, market risk, credit risk, foreign exchange risk, commodity risk and liquidity risk.

Interest Rate Risk

Interest rate changes, and the resultant interest rate risk, can greatly affect companies. If a company borrows money and the loan has an adjustable interest rate while interest rates are low, their interest payments will ramp up if the Federal Reserve raises interest rates. If interest rates are high and drop, even a company with a fixed interest rate loan may be at a competitive disadvantage. Higher interest rates make it more difficult to borrow money. In the case of a company holding bonds, the value of the underlying investment is lower as interest rates go higher.

Financial risk managers help mitigate these risks using a variety of hedging strategies. Smoothing is one hedging strategy. Companies that borrow from commercial banks can spread out the loan into disbursements with both variable and fixed interest rates. If interest rates drop, the fixed-rate loans are affected. If they rise, only the variable rate loans are affected.

Derivative securities are usually employed to manage interest rate risk (as well as to manage foreign exchange rate risk and commodity risk). Matching is another strategy financial risk managers can use. If a company borrows from a bank and has a given interest rate on their loan, they can also deposit with the same bank at a similar interest rate and, thus, hedge part of their risk.

Interest rate swaps are particularly effective in hedging against interest rate risk in the bond market. A company can use a derivative security to convert variable-rate obligations into fixed-rate obligations.

Market Risk

Market risk includes the risk associated with changes in the marketplace in which a company competes. This is sometimes also called systematic risk.

A premier example of market risk has happened gradually in the energy sector of the U.S. economy. The companies that mine fossil fuels and use fossil fuels to generate energy have seen the introduction of green energy firms into their marketplace. Even though the fossil fuel industry still dominates in this sector, they see their market share falling away due to hybrid and electric cars, wind power, solar power and a general movement toward cleaner energy. They have to find a new way to compete.

Usually, that involves a change in their business model and finding a way to offer their products with value-added that persuade customers to frequent their businesses. If they don’t change, they will eventually fall by the wayside with shrinking profit margins. That is happening in the case of coal mining and coal-fired plants.

If companies engage in financial risk management as their marketplace experiences change, they will be in a better position. Some traditional auto manufacturers are venturing into electric and hybrid vehicles, for example.

Credit Risk

Credit risk refers to the possibility that a business firm will default, or fail to pay, its obligations. Banks and other lending institutions bear credit risk when lending to businesses. Businesses bear credit risk when allowing customers to pay on credit.

The best way to avoid credit risk is diversification. If a lending business has a wide variety of customers and loans of different interest rates and maturities, that mitigates some of the loss if a customer defaults. Using collateral and compensating balances to secure a loan is often effective.

Lenders can also use credit default swaps to manage credit risk. Credit derivatives are agreements between the creditor and debtor allowing a large part of the risk to be transferred to a third party as in the case of collateralized debt obligations.

Foreign Exchange Risk

Foreign exchange rate risk is the possibility exchange rates will change before a transaction is complete. Companies with foreign exchange risk sometimes hedge against changes in exchange rates using currency swap forward contracts as a part of their financial risk management. They are derivative securities that allow the company to lock in exchange rates for a given period of time. A simple, non-derivative strategy is to simply invoice and deal in U.S. dollars only.

Commodity Risk

An example of hedging against the changing price of a product is visible in the farming industry. Farmers operate on a razor-thin profit margin. If a farmer’s product is going to be ready to go to market in three months, the farmer knows from their production costs what he needs to make on each unit of the product. The farmer is worried about the price of the product in three months declining due to unforeseen circumstances, like the weather.

That farmer can sell a futures contract on the product which will lock in the future selling price. This also works if the price goes above the farmer’s expected price. The downside, in this case, is that the farmer will not reap the benefit of the increased price.

Liquidity Risk

Liquidity refers to the ease with which a business can convert its assets to cash. If a business is either seasonal or cyclical, it may face more liquidity risk than businesses with more sales. Seasonal or cyclical firms typically face significantly more liquidity risk since the business could have no cash flow to pay the bills.

Financial risk management looks toward metrics like the firm’s free cash flow to monitor liquidity risk at any given time. The quick ratio and the inventory turnover ratios can be useful. also, the price-to-cash ratio helps indicate how much liquidity risk is affecting firm value.

Bottom Line

Financial risk management serves to minimize risk for a business. Companies are subject to many different types of risk. Using derivative instruments to quantitatively manage risk is one strategy. Other strategies come from the specific type of risk and may be particular to each type of risk. There are also hedging strategies that can be effective with most types of risk.

Risk Management Tips

A potential course of action when attempting to assess the risk of a specific move, whether in business or investing, is to consult a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
The risk of inflation is a type of risk you may face on an individual level. SmartAsset’s free inflation calculator helps you determine what inflation does to your purchasing power.