Definition of 'Financial Risk'

The possibility that shareholders 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 will be repaid before its 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.

Investopedia Says
Investopedia explains 'Financial Risk'

Investors can use a number of financial risk ratios to assess an investment's prospects. For example, the
debt-to-capital ratio measures the proportion of debt used, given the total capital structure of the
company. A high proportion of debt indicates a risky investment. Another ratio, the capital expenditure
ratio, divides cash flow from operations by capital expenditures to see how much money a company will
have left to keep the business running after it services its debt.
Financial risk is an umbrella term for multiple types of risk associated with financing, including financial
transactions that include company loans in risk of default.[1][2][3] Risk is a term often used to imply
downside risk, meaning the uncertainty of a return and the potential for financial loss.[4][5] In addition
to financial risks, there are five broad categories of investment risks known as five risks.[6]

A science has evolved around managing market and financial risk under the general title of modern
portfolio theory initiated by Dr. Harry Markowitz in 1952 with his article, "Portfolio Selection".[7] In
modern portfolio theory, the variance (or standard deviation) of a portfolio is used as the definition of
risk.

Types of risk
Asset-backed risk

Risk that the changes in one or more assets that support an asset-backed security will significantly
impact the value of the supported security. Risks include interest rate, term modification, and
prepayment risk.
Credit risk
Main article: Credit risk

Credit risk, also called default risk, is the risk associated with a borrower going into default (not making
payments as promised). Investor losses include lost principal and interest, decreased cash flow, and
increased collection costs. An investor can also assume credit risk through direct or indirect use of
leverage. For example, an investor may purchase an investment using margin. Or an investment may
directly or indirectly use or rely on repo, forward commitment, or derivative instruments.
Foreign investment risk

Risk of rapid and extreme changes in value due to: smaller markets; differing accounting, reporting, or
auditing standards; nationalization, expropriation or confiscatory taxation; economic conflict; or political
or diplomatic changes. Valuation, liquidity, and regulatory issues may also add to foreign investment
risk.
Liquidity risk
Main article: Liquidity risk
See also: Liquidity

This is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a
loss (or make the required profit). There are two types of liquidity risk:

Asset liquidity - An asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of
market risk. This can be accounted for by:
Widening bid-offer spread
Making explicit liquidity reserves
Lengthening holding period for VaR calculations
Funding liquidity - Risk that liabilities:

Cannot be met when they fall due

Can only be met at an uneconomic price
Can be name-specific or systemic

Market risk
Main article: Market risk

The four standard market risk factors are equity risk, interest rate risk, currency risk, and commodity
risk:

Equity risk is the risk that stock prices in general (not related to a particular company or industry) or
the implied volatility will change.
Interest rate risk is the risk that interest rates or the implied volatility will change.
Currency risk is the risk that foreign exchange rates or the implied volatility will change, which affects,
for example, the value of an asset held in that currency.
Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) or implied volatility will
change.

Operational risk
Main article: Operational risk
Other risks

Reputational risk
Legal risk
IT risk

Model risk

Main article: Model risk

Diversification
Main article: Diversification (finance)

Financial risk, market risk, and even inflation risk, can at least partially be moderated by forms of
diversification.

The returns from different assets are highly unlikely to be perfectly correlated and the correlation may
sometimes be negative. For instance, an increase in the price of oil will often favour a company that
produces it,[8] but negatively impact the business of a firm such an airline whose variable costs are
heavily based upon fuel.[9] However, share prices are driven by many factors, such as the general health
of the economy which will increase the correlation and reduce the benefit of diversification. If one
constructs a portfolio by including a wide variety of equities, it will tend to exhibit the same risk and
return characteristics as the market as a whole, which many investors see as an attractive prospect, so
that index funds have been developed that invest in equities in proportion to the weighting they have in
some well known index such as the FTSE.

However, history shows that even over substantial periods of time there is a wide range of returns that
an index fund may experience; so an index fund by itself is not "fully diversified". Greater diversification
can be obtained by diversifying across asset classes; for instance a portfolio of many bonds and many
equities can be constructed in order to further narrow the dispersion of possible portfolio outcomes.

A key issue in diversification is the correlation between assets, the benefits increasing with lower
correlation. However this is not an observable quantity, since the future return on any asset can never
be known with complete certainty. This was a serious issue in the Late-2000s recession when assets that
had previously had small or even negative correlations[10] suddenly starting moving in the same
direction causing severe financial stress to market participants who had believed that their
diversification would protect them against any plausible market conditions, including funds that had
been explicitly set up to avoid being affected in this way [11]

Diversification has costs. Correlations must be identified and understood, and since they are not
constant it may be necessary to rebalance the portfolio which incurs transaction costs due to buying and
selling assets. There is also the risk that as an investor or fund manager diversifies their ability to

monitor and understand the assets may decline leading to the possibility of losses due to poor decisions
or unforeseen correlations.
Hedging

Hedging is a method for reducing risk where a combination of assets are selected to offset the
movements of each other. For instance when investing in a stock it is possible to buy an option to sell
that stock at a defined price at some point in the future. The combined portfolio of stock and option is
now much less likely to move below a given value. As in diversification there is a cost, this time in buying
the option for which there is a premium.
Financial / Credit risk related acronyms

ACPM Active credit portfolio management

EAD Exposure at default

EL Expected loss

ERM Enterprise risk management

LGD Loss given default

PD Probability of default

KMV quantitative credit analysis solution developed by credit rating agency Moody's

VaR value at risk, a common methodology for measuring risk due to market movements