Financial risk is the existence of a probability of losing money by shareholders who invest in a corporation that does not have adequate cash flows to finance all its obligations. In a case in which a corporation relies on debt financing when the company becomes insolvent, the creditors will be paid the money that they owe before the shareholders of the company get any payments. Financial risk can also be defined as the probability of a government or company defaulting on its bonds resulting in the loss of money by the holders of the bonds.
The Business Dictionary describes a liquidity risk as a probability of a loss that would result from a situation where the cash and cash equivalents that are available in a corporation are not enough to meet the demands of borrowers and depositors. The situation would also be a result of getting amounts less than the fair values of illiquid assets when the assets are sold or the impossibility of selling illiquid assets at the time that is desired because of no buyers with interest in the asset. The quantification of the liquidity risk is the difference between the fair value of the asset and the actual amount it is sold at.
An example of a liquidity risk would be a million-dollar home that attracts no buyers. The home may be of a high value and would be sold for high amounts in better market conditions with better demand, but due to the underlying conditions in the market at the time, it may not be attractive to customers. However, the owner of the home may be in urgent need of cash, and, hence, he/she will sell the home in an illiquid market at an amount that would result in a loss. This is the liquidity risk of owning the asset (the home).
This is a probability that the issuer of a bond will default in making the principal repayment or coupon repayments to the holders of the bonds. This may be due to challenges in the cash flow, a rise in the interest rates, or changes in the marketplace with adverse effects on the issuer. In an instance of a foreign bond, this may also be contributed to the regulatory practices of the foreign government, its stability, and sociopolitical situations.
This is a probable risk of getting losses due to fluctuations in the foreign exchange rates in investments that are traded in foreign currency or in a situation where the investor has exposure to the foreign currency. This is usually a risk facing holders of foreign bonds since the payments of the principal, and interest amounts are done in a foreign currency. An example would be a Canadian company, let’s take, for example, ABC Incorporation, paying interests and principal in Canadian dollars at a rate of 5%. If at the purchase time, the exchange rate is 1 US dollar for 1 Canadian dollar, then the 5% coupon payment will be 50 Canadian dollars, also similar to 50 US dollars. If in a period of one year the currencies fluctuate and the exchange rate moves to 1 US dollar for 0.85 Canadian dollars, the amount gotten from the coupon payment would still be 50 Canadian dollars but less in the US dollar currency (being only US$42.50).
It is also known as market risk, volatility, or undiversifiable risk and is a risk that the whole market or market segment has the potential to face. It is a risk that is not predictable, and its complete avoidance is also impossible. The usage of diversification cannot help to mitigate it. The mitigation is only possible through using the right strategy in the allocation of assets or through hedging. A good example of systematic risk is the Great Recession. This market-wide economic event affected all the parties who had invested in 2008 irrespective of the types of securities held by each one of them.