8 TYPES OF RISK IN FINANCE

Risk is defined as a situation in which the future outcome is unknown and the likelihood of that outcome can be calculated or estimated.

Simply put, risk is a situation in which the probability of future occurrence can be estimated.

Risk is sometimes defined as the probability that the actual result will differ from the expected result.

Risk can be distinguished from uncertainty. Uncertainty is a situation in which the future outcome is unknown and the likelihood cannot be determined.

To put it in another way, uncertainty is a situation in which the probability of a future occurrence cannot be determined

Types of risks in finance

1. Financial risk: This arises as a result of a change in the capital structure of an organisation

The capital structure of a business is the composition of shareholder funds and borrowed funds that are used in financing the assets and activities of the business.

Financial risk also refers to the risk that shareholders face when investing in a financially leveraged company. That is a company that is heavily reliant on debt financing.

One way of measuring financial risk is through the debt-to-equity ratio. A very high debt-to-equity ratio is considered a sign of financial risk by investors because it indicates that a company is funding a significant part of its operation through debt.

2. Operational risk: This arises from the business process of an organisation.

Operational risk may arise from a breakdown in the internal procedures, personnel, policies or system.

Mismanagement and technical breakdowns can also cause operational risk.

Operational risk may also result from the misuse of company assets, profit defects or mismanagement of a company's equipment.

3. Political risk: This risk arises due to changes in government policies.

Such changes may impact investors negatively, especially if a change in political conditions causes a related change in the monetary policy of the government.

Political risk can also refer to the possibility that a business would suffer a loss as a result of political instability in the country in which it operates.

It is the possibility that political decisions, events, or conditions will significantly affect the profitability of a business actor or the expected value of a given economic action.

4. Interest rate risk: This refers to the possibility of investment losses as a result of interest rate fluctuations over time

Interest rate risk is most commonly connected with debt securities, which have a fixed interest rate and hence lose value if the interest rate rises.

5. Business risk: This is associated with a company's ability to make adequate sales and earn adequate profit.

It is the possibility that a company will be exposed to factors, such as competition, change in consumer preference, that will lower its profit or caused it to fail.

In essence, business risk is anything that can cause business failure or impede the ability of a company to achieve its financial goals.

6. Liquidity risk: This occurs when a company's ability to execute transactions is hampered by a lack of liquidity.

It is the possibility that a company may not able to meet short term obligations when they fall due.

One way of determining the liquidity risk is through the current ratio. A current ratio lesser than 0.5 is generally regarded as a sign of liquidity risk.

7. Credit risk: This is the possibility that a counterparty in a financial transaction will default on his debts or would renege on his financial obligations.

It is the possibility that a lender may experience interruptions in cash flow if the borrowers do not pay the interest or principal of a loan.

8. Economic risk: This refers to the possibility that changes in macroeconomic variables or business cycles will affect investments or the operation of a company.

Such macroeconomics variables that can constitute economic risk include unemployment rate, fiscal policy, exchange rate and monetary policy.

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