Glossary term
Financial Risk
Subject: Risk Management, Risk Fundamentals and Frameworks
Financial risk is the possibility of losing money or value through the way an organisation lends, invests, trades or funds itself. Credit, market and liquidity risk are its main forms.
Explanation
Banks and insurers are the obvious holders, yet any business has it: a manufacturer borrows in foreign currency, holds customer receivables and depends on bank credit lines. Credit risk is a counterparty failing to pay. Market risk is loss from moves in interest rates, exchange rates, commodity prices or share values. Liquidity risk is being unable to meet payments when due, or only at heavy cost. Some lists add interest rate risk in the banking book and funding risk. Financial risk is separate from operational, strategic and compliance risk, although one event, such as a fraud, can set off several at once. Measures include exposure limits, value at risk, stress tests and liquidity ratios. Treatment tools include hedging, collateral, diversification and buffers of cash or capital. Solvency questions, from a lender's covenant review to a supervisor's capital test, start from these exposures.
Example
A software firm invoices overseas clients in a foreign currency on 90-day terms and funds a new office with a floating-rate loan. A late payer creates credit risk, a currency move cuts the value of receipts, and a rate rise lifts interest cost. The finance team sets client limits, hedges part of the currency exposure and fixes the rate on half the loan.
Not to be confused with
- Operational Risk
- Operational risk comes from failed processes, people, systems or outside events; financial risk comes from funding, lending, investing and trading positions.