Financial risk

In business mangers—both financial and non-financial professionals make decisions everyday that involve financial risks. Managing financial risks help you to make sound decisions and protect the financial health of your organization. Managing financial risks also encourages investors to have confidence in your organization.

TYPES OF FINANCIAL RISK

There are four common types of investment risks including default, inflation, maturity and inflation risks.

Idle money or money that is not invested tends to lose value because of inflation (the overall general upward price movement of goods and services in an economy).To avoid this loss of value, individuals and organizations generally invest cash that they do not immediately need. In doing so, they hope to recover both the initial investment and a fair return. But investments are generally associated with some level of risk and examples are listed below.

• General economic conditions such as recessions and depressions
• National and international political events, such as elections, political revolutions and terrorism
• Industry trends such as growth of computer use
• Organizational characteristics such as weak third quarter performance

Default risk: Investments made in startup companies typically represent a default risk (if the start-up defaults, the investor can lose the entire investment).In contrast investments made in stable established organizations, such as the U.S government, represent little risk of default.

Default risk assesses the likelihood that the organization in which you have invested will fail to pay interest or principal promptly when it is due. In memorable terms, default risk alerts you to the profitability that the company in which you have invested is likely to default on its obligations. While most investments are subject to some default risk, the level of default risk varies.

Inflation risk: Investing in shorter term investments can minimize inflation risk. The shorter term investments stand a better chance of retaining their value in comparison to longer term investments where yearly inflation rates take their toll in devaluing the initial investment. It reduces the buying power.

Inflation risk addresses the likelihood that the predictable overall economic rise in prices for goods and services will cause the investment to lose some of its buying power. By devaluing the initial investment, over time, inflation results in the investor losing an increasing number of cents on every dollar. Inflation affects the entire economy, and inflation risk applies equally to all investments. The significance of inflation risk, however, is a threshold that all organizations must determine for themselves—there is no predefined range.

Maturity risk: Maturity risk can be represented as an investor presented with a more profitable investment opportunity, however the investors cash is tied up in their current investment (as the investor waits for the investment to mature).

Maturity risk addresses the gamble taken when investors tie up their cash in investments that require an investment period. Similar to inflation risk, maturity risk is dependent on time. When money is tied up in long term investments, it cannot be used for other perhaps more profitable, purposes. Similar to inflation risk, maturity risk increase in direct proportion to the length of the investment period.

Liquidity risk: Liquidity risk can be represented as an investor who is in urgent need of some cash back from their investment before it matures. The degree of liquidity risk can be assessed by how readily the investment can be converted back into cash. The easier it is, the lower the liquidity risk.

Liquidity is the degree to which an investment can be bought or sold on the market. Liquidity risk is an indication that an investment cannot be bought or sold readily.

Investments made in startup companies typically represent a default risk, while the 1% initial investment value loss ,over time is representative of an inflation risk.Likewise,the inability to readily convert the investment back into cash before it matures ,to replace the broken machinery, represents the liquidity risk. And finally the investor unable to free his or her funds from their current investment,(to invest in the better, more profitable investment opportunity) is representative of a maturity risk.

The types of risk are not the only factors that financial managers must consider when they review investment alternatives. They must also take into account general economic conditions, other opportunities, management philosophy, and the levels of risk. However, analyzing potential business investments to determine which types of financial risk they represent is an important part of financial decision making.