What is financial risk and how to mitigate it?

Types of financial risk

Financial risks arise from different kinds of uncertainty. Although there are commonly recognized risk categories, no universal classification system applies to every company. Each company faces its own unique risks, so classifying them helps managers make informed, tailored decisions based on their specific environment.

Market risk

Market risk refers to potential losses caused by fluctuations in the price of securities, exchange rates, or interest rates. These changes can be driven by a range of factors, such as economic changes, geopolitical events, or shifts in investor sentiment. 

For example, during the 2008 financial crisis, global stock markets plummeted due to widespread economic uncertainty. As a result of the overall downturn in the market, investors holding stocks, regardless of individual company performance, saw a sharp decline in the value of their investments. 

Credit risk

Credit risk occurs when a borrower or counterparty fails to meet their obligations. While this type of risk primarily impacts fixed-income investors and financial institutions, it also impacts shareholders of companies with excessive leverage. If a company defaults on its loans or experiences financial distress, its share price could drop due to fears of bankruptcy, or a dividend cut. For bondholders, the expected loss from credit exposure relates to the amount lent, the borrower’s likelihood of default, and the collateral available in case of non-repayment. Bondholders can suffer if the issuing company faces financial difficulties, potentially losing interest or principal payments.

Liquidity risk

Liquidity risk arises when an asset cannot be quickly converted into cash without a substantial price reduction. This risk is more prevalent in markets or for assets with lower trading volumes. When markets are illiquid – either temporarily, such as during financial crises, or more structurally, such as in some emerging markets – the ability to trade assets is substantially reduced, which has a negative effect on these firms.

For example, suppose an investor holds shares in a small-cap company with low trading volume. If the market for these shares is slow, the investor might struggle to sell the shares quickly at the desired price. If the investor needs to sell these shares quickly, perhaps due to a sudden need for cash or because of declining confidence in the company, they may have to accept a much lower price than expected or be unable to sell the shares at all.

Operational risk

Operational risk is the potential for losses that are associated with inadequate or failed people, systems, and internal policies. Operational risks can also include external threats posed by events that affect a company’s operations but that are beyond its control. Examples include human errors, internal fraud, system malfunctions, and cyberattacks.

A financial services firm faces operational risk if an employee engages in unauthorized trading. This could involve an employee making risky investments beyond their authorized limits in hopes of generating higher returns. If these trades result in significant losses, the firm could suffer both financially and reputationally. In addition, regulatory penalties or legal actions could follow, further compounding the damage caused by the employee’s misconduct.

Legal risk

Legal risk, also known as compliance risk, involves potential losses stemming from legal disputes or problematic contractual agreements. Changes in the regulatory environment like new government legislation or litigation can also impact financial positions by increasing risk levels. 

Typically, the risk of non-compliance with laws and regulations is higher than non-compliance with internal policies and procedures because sanctions or penalties can be applied. These can affect both individuals and companies and can be significant and costly. Internal fraud and lawsuits are also examples of legal risk if they result in regulatory penalties, or other legal actions against the organization. 

Currency risk

Currency risk, sometimes called exchange rate risk or foreign exchange risk, arises from potential losses due to fluctuations in exchange rates between different currencies. In other words, it is the risk that the foreign currency depreciates against the home currency. Companies with international operations or those dealing in foreign currencies are particularly vulnerable.

For example, if a U.S. company has operations or generates revenue in Europe, and the euro weakens against the dollar, the company's converted revenue could decline, resulting in financial losses.

Managing financial risk

Effective risk management goes beyond measuring risk - it also requires implementing strategies to minimize potential losses. An effective risk management process provides a framework for identifying and privatizing risks. It is used to assess the likelihood and potential severity of adverse events and outcomes and can provide guidance about preventive or mitigating actions. 

Risk management is an iterative process that is frequently unplanned. It often evolves in response to a crisis, incorporating recent lessons learned and any new regulatory requirements that might follow in response to that crisis.

Here are some key practices investors use to manage risk:

Diversification

Diversification spreads investments across various assets, sectors, and geographies, reducing exposure to any single source of risk. A well-diversified portfolio is an important consideration for any investor as it helps smooth out returns and distribute risk. When investors spread their investments across different asset classes, they are less likely to experience market shocks that could impact all their investments simultaneously.

Hedging

Hedging involves using financial instruments, such as options and futures, to offset potential losses in a portfolio. While hedging can incur additional costs, it provides some protection against adverse price movements. For example, buying a put option on a stock can protect against a decline in its value, offering some security at a relatively low cost. 

Using a US dollar trading account

For Canadian investors trading US stocks, using a US dollar account avoids the risk of fluctuating exchange rates. A US dollar account allows investors to buy and sell assets in US dollars without having to consider the fluctuating exchange rate and associated commissions, which can be significant. As a result, they can minimize conversion fees and exchange currency when market conditions are more favourable.

Learning from past crises

The 2008 financial crisis underscored the importance of comprehensive risk management. The event involved a massive underestimation of risks associated with credit derivatives that quickly unfolded into widespread financial turmoil. 

Luckily, the trend was reversed with the reimposition of greater regulation, which in turn has led to stronger compliance and oversight. Nevertheless, analysts and self-directed investors should learn from these events by factoring in worst-case scenarios, ensuring their portfolios are prepared for future uncertainties.

Regular monitoring and adjustment

Continuous portfolio monitoring and periodic adjustments are crucial. As market conditions and personal circumstances change, reviewing and rebalancing your portfolio helps manage risk. 

One effective strategy for managing risk is the use of stop loss orders, which automatically sell an asset when it reaches a predetermined price, helping investors limit potential losses in volatile markets.

How to Place a Stop Loss Order

For self-directed investors, staying informed and vigilant is key.  Market conditions and global events may be continuously evolving, but it is important to remember that risk is an integral part of the investment journey. 

By recognizing the different types of risk, employing various risk measures, and implementing robust risk management strategies, investors can navigate the complexities of the financial markets with greater confidence. At NBDB, we are committed to providing the tools and insights needed to help our clients make informed investment decisions and manage their financial risks effectively.