Financial risk definition

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What is Financial Risk?

Financial risk is the potential losses incurred by an investor when investing in a business that uses borrowed money. When a firm uses a large amount of debt, it incurs a significant interest expense and obligation to repay principal that makes it more likely to have financial difficulties if its cash flows decline. Or, if the entity is a government, it cannot raise sufficient cash from taxes to pay for its bond obligations.

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Corporate Finance

Types of Financial Risk

There are several types of financial risk, which include those noted below:

  • Credit risk. Credit risk is the possibility that a customer or borrower will default on a receivable or loan. Credit risk can be reduced by reviewing a prospective borrower’s creditworthiness. This examination includes a review of their existing debt load and cash flows.

  • Currency risk. Currency risk is the possibility that losses will be incurred on foreign currency holdings when exchange rates fluctuate. This risk can be eliminated by forcing counterparties to use the company’s reporting currency for all transactions, or by using hedging transactions.

  • Equity risk. Equity risk is the possibility that losses will be incurred on equity holdings when the shares of stock in a business exhibit rapid price changes.

  • Liquidity risk. Liquidity risk is the possibility that losses will be incurred when market conditions are highly volatile.

How to Mitigate Financial Risk

Financial risk can be mitigated through the use of diversified holdings and hedging strategies.