10 Types Of Risks In Finance And Tips For Mitigating Impact

Updated 30 September 2022

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With every investment, there is a possibility of success or failure. In finance, various types of risk can affect the outcome of investments. Learning about the various types of risks in finance and how they materialise can help you foresee challenges before making crucial financial decisions. In this article, we examine the definition of risks in finance and discuss ten different types you may encounter as a business professional.

10 Types Of Risks In Finance

In finance, there are many types of risks that you can address before making a significant investment. When a company makes a financial decision, such as opening a new branch in a major city or forming a co-branding partnership, it accepts the possibility that its efforts could be unsuccessful, which means it may spend more money making the effort than it gained throughout its course. Risk management is a collection of techniques and practices that business leaders can adopt to safeguard their firms from experiencing severe financial losses.

Financial risks can manifest in a variety of ways, depending on the activities, scale of operations and the industry of the company. These are 10 types of financial risks that business enterprises may encounter:

1. Speculative risk

When investors make financial decisions too soon, they expose themselves to speculative risk. They may have a limited understanding of the chances of their investments succeeding. They may also not have adequately examined the market value of their assets, or they may have invested too much of their financial resources at once, putting them at risk of losing a large sum of money. To reduce speculative risk, you can stay updated about market movements and trends that may affect the success of an investment. You can identify potential challenges and make informed decisions about how to best use the funds you already have.

2. Business risk

Business risk refers to the chance that a company may not generate enough income to fund its operations. When a business first starts operations, it often requires financial resources to fund projects that could generate more revenue, pay employees and get exposure. Professionals may face business risk because they recognise that their efforts may not result in increased revenue, which means they risk losing the money they invested in starting a business.

Consider making strategic financial decisions to manage business risk. You can start with minor projects to test how successful they are before investing larger portions of your funds. When you start out, it may also be beneficial to hire a few employees to save money on salaries and minimise the number of people that the business risk affects. You can also avail insurance, which allows you to transfer your risk to insurance companies for a modest fee, especially when compared to the potential expense of risk that you otherwise leave unaddressed.

3. Longevity risk

Longevity risk pertains to retired or nearly retired individuals who have earned wealth throughout their lives. It arises when people's retirement funds are insufficient to support their lifestyles after they retire from their jobs. A teacher, for example, retires at the age of 63 after three decades of service in education. They may rely on the money they have saved during their career because they might not have a stable income from their full-time job, but they face a longevity risk because their retirement fund is not as large as they had expected.

You can mitigate longevity risk to some extent by modifying underlying investments, asset allocation and the amount of income you collect as pension each month or year. Professionals can limit their longevity risk by prioritising contributions to their savings accounts to plan for the post-career phase of their lives. As an employee, you can create a budget that transfers money from your salary to a retirement account that you can only access during an emergency, allowing you to save as much as possible.

4. Idiosyncratic risk

A risk that is idiosyncratic, or unsystematic, is a risk that is specific to a company or industry. A problem that develops internally or in the field can result in a financial loss for a company. Thousands of museums, for example, may close for the foreseeable future to safeguard patrons and personnel during a public health crisis, preventing visitors from appreciating artefacts in person. The decision costs the museum sector money because their operations rely on entrance fees from visitors, and their issues are unique to their field.

To mitigate the adverse effects of idiosyncratic risk, business leaders can diversify their assets and focus on generating multiple streams of income. Although some of their investments may not succeed, they can be confident in their backup plans. In the same example above, despite the situation's negative impact on the museum industry, museums may continue to accept donations from patrons to pay employees and maintain the quality of their exhibits until it is safe to reopen physically.

5. Currency risk

Currency risk may be a concern for professionals who invest in stock from other countries. The value of a currency might alter due to market fluctuations. For instance, if you have a large sum of money in Euros through a stock transaction, but you live in the United States, if the value of the Euro decreases compared to US dollars, then you may lose money. Even if you have a lot of wealth or currency in a particular geo-political area, the value of your money in another country's market may not be the same.

If you are looking for a country to invest in, look for one that has an in-demand, stable currency. These currencies may be competent when compared to your domestic currency. The investment could be worth more in your home currency if the foreign currency continues to rise in value. Monitor the fluctuation of currency value with the tender you own to avoid currency risk. Compare the value of tender between both countries before making a foreign investment and make stock purchases accordingly.

6. Political risk

Political risks can affect foreign investments. It usually presents itself during a large-scale financial arrangement involving several countries. A change in government in one country, which may involve the election of a new leader, can affect the trajectory of business relations with other countries. Receiving countries may suffer financial losses because of this risk. It may be beneficial to monitor activity in the nations that enter the trade to reduce the consequences of political risk. You can spot possible pitfalls in your contract and make changes before political situations can have a negative impact on your investment.

7. Inflation risk

Inflation risk occurs when the number of goods you can buy with your money diminishes as inflation rises. For instance, if you have ₹700 to spend, you could buy ten products with ₹700 before inflation. Even though you are buying the same products with the same amount of money, you may only be able to buy four products after inflation. Consider investing in share prices to protect your finances from inflation. Share prices can rise along with inflation, allowing you to maintain your purchasing power.

8. Concentration risk

Concentration risk occurs when you spend your financial resources on a single sector of investments. When you invest in many sources, such as in different companies' stocks or in multiple foreign countries, the concentration risk dilutes because of the likelihood of the investment falling short. To aid in minimising concentration risk, you can, as an investor, remain updated about events that can affect the success of your financial decisions, such as changes in governmental regulations, rising interest rates and currency values.

9. Management risk

Management risks are related to decisions that organisational leaders make with a company's financial resources. Mismanagement of funds might involve developing an unproductive budget or allocating too much money to one area, leaving little money for other activities. Hiring managers can employ managers with expertise in finance and money management to mitigate this risk. You can also encourage leaders to work together to make educated decisions about where to invest funds, so that they protect the interests of the company and its employees.

Implementing policies that promote accountability for financial decisions made on behalf of the company could also be beneficial. For example, an employee handbook could indicate that managers can spend only a particular amount of money per quarter, which could help save money for the rest of the year and mitigate unexpected expenses. Employing a financial consultant can assist a management team in learning how to manage money and set financial objectives.

10. Interest rate risk

Bond investments can face interest rate risk. The risk arises when the interest rate fluctuates, causing the bond's value to drop. Investors can assess interest rates and estimate rises to limit the effects of interest rate risk, allowing them to make more educated decisions about which bonds they can invest in. They can also buy interest rate products like forward rate agreements and futures contracts to minimise the risk of losing money on bond transactions.