Financial Dictionary -> Investing -> Risk

Risk or more specifically financial risk is the possibility of incurring loss with any type of financing. This term is used to denote the difference between actual and expected return. When the actual return is less than the expected, the investment incurs losses.

The goal in financing is to come up with an investment carrying a low level of risk, with the purpose of gaining profit or return. Investors such as financial institutions, businesses, and individuals should check the degree of risk that comes with any financial endeavor before proceeding with it. If the risk is too high (unjustified), the investor has to make sure there is a back-up plan for the particular investment, or financial losses are possible. One example of how financial institutions manage risk is the way banks grant secured loans and secured credit cards to high risk customers.

There are different types of risks related to financing. These include investments risk, business risk, liquidity risk, market risk, credit risk, and operational risk, among others. Let us take a look into some of the major risk types in order to get a better understanding of the term.

Investment Risk

With this category, risk will vary from one investment form to another. There are two basic types of investment: risky and risk-free. The latter category is secured by collateral of any form. However, the guarantee may not be fully secure, with that depending on the guarantor.

Risky investments are those relying on certain factors for realizing profit or loss. One such factor is the value of the currency. If the devaluation of a currency affects the value of an investment or asset, risk is quite high, especially if the currency is seen to be devaluating. Another factor is the liquidity of an investment. If the asset is not easily traded or sold on a financial market by the time it has to be sold, the investor runs the risk of losing money. Here, liquidity risk comes into play.

Business Risk

Companies also run the risk of bankruptcy if their cash flows cannot be used to finance all financial obligations. In addition, business risk is involved if a company seeks financing in the form of a loan but is unable to produce enough funds to pay it off.

Credit Risk

Credit risk refers to a situation in which a borrower does not meet his financial obligations as agreed, eventually defaulting on them. In this case, the investor or lender loses money. Since the government protects borrowers in case of bankruptcy, the lender has no choice but to accept the consequence of credit risk.

Apart from these categories, there are other risk types such as legal, reputational, and information technology risk. Legal risk refers to cases in which the counterparty is not legally able to conclude a contract. Regulatory risk is another form of legal risk whereby transactions are in conflict with a policy of regulatory agencies. Furthermore, legislative acts may change over the life span of a financial contract. Reputational risk, on the other hand, refers to the trustworthiness of a business entity. Damage to the company's reputation may result in decline of shareholder value or lost revenue. In any case, to avoid loss, it is a good idea to assess all risks involved in a potential financial endeavor before proceeding with investment.