When we speak of "risks" we think of the possibility of undesired events occurring. But part of the risks in the financial markets occur due to events to which no probability is associated. Assigning a probability to all events that can alter the profits of companies is called "Risk Analysis". Financially, "Risk" can be defined as the probability that the prices of the assets held in a portfolio will move adversely in the face of changes in the macroeconomic variables that determine them. Therefore, any future distribution of profits is of interest, thus associating a probability to each possible value that profits may reach, in order to characterize the risk profile represented by each feasible scenario.
The profitability of companies is directly or indirectly linked to the prices of financial assets; the very survival of companies depends on movements in these markets. For this reason, it has become increasingly important to be able to anticipate possible variations in interest rates, stock market prices and exchange rates, among other variables. There would be no financial decision to make if the changes in these variables could be accurately determined. To the extent that one is faced with the uncertainty of the future of these variables, it is necessary to consider the different possible courses of action and the consequences that each of them has if different scenarios arise.
For this reason, risk analysis is closely related to the portfolio decision making process, in fact in the financial area they are studied in parallel.
Financial Risk
For de la Fuente & de la Vega (2003), financial risks are the risks associated with the nature of financial operations and are those that are the first to be considered when talking about risk management, such as the credit risk of debtors or the market risk of the financial investment portfolio.
The operations most susceptible to risk are:
- Investments: they focus on the difficulty of estimating the future profitability of a project, which can lead to significant deviations from the expected return.
- Financing: the most common is the cost of accessing financing, meeting contractual obligations or, more seriously, not being able to repay the loan due to excessive indebtedness.
- Commercial activity: delays in collections, possible insolvency of customers or lack of foresight to ensure sufficient liquidity.
Types of risk
A. Credit Risk
These are perhaps the most important because they affect the main asset: the loan account. A liberal credit approval policy generated by excessive levels of liquidity and high collection costs, or by a relaxation of the requirement to evaluate customers subject to credit, causes a high level of delinquency.
This is why we must be careful with the saying "in good times bad loans are made".
B. Market Risks
This occurs due to unforeseen variations in the prices of trading instruments. Every day many companies are closed and others are successful. It is the entrepreneurial and management skills that will allow to see the future and choose successful products to maintain customer loyalty, preserve image and confidence.
C. Interest Rate Risk
It is produced by the mismatch in the amount and maturity of assets, liabilities and off-balance sheet items. Generally when credit is obtained at variable rates. In certain markets, the demand for money can affect interest rates, which can reach levels similar to those of the debt crisis due to changes in the international economy.
D. Liquidity Risk
It is produced as a consequence of continuous portfolio losses, which deteriorates the working capital. A disproportionate growth of liabilities can also lead to the risk of loss of liquidity.
E. Foreign Exchange Risk
Originated by fluctuations in the value of currencies. The economies of developing countries such as ours are not free from a growing trade or balance of payments gap. The normal consequence is the devaluation of the exchange rate, which will affect by raising the value of credits granted in dollars, which may be unpayable by debtors if their economic activity generates income in local currency. To protect against this risk, it is necessary to select the portfolio of borrowers by placing loans in foreign currency only to those who operate in this currency, and to assume a mismatch rule between the amount borrowed and the amount placed (an amount borrowed equals the amount placed in foreign currency).
F. Insufficiency Risk
The risk of capital insufficiency is defined as the risk that the Institutions do not have the adequate capital size for the level of their operations corrected for their credit risk.
G. Indebtedness and Liability Structure Risk
It is defined as not having adequate sources of resources for the type of assets indicated by the corporate objectives. This includes not being able to maintain adequate liquidity levels and resources at the lowest possible cost.
H. Operational Management Risk
Operating risk is understood as the possibility of occurrence of financial losses due to deficiencies or failures in internal processes, information technology, people or adverse external events.
It is the risk that other expenses necessary for the institution's operational management, such as personnel and general expenses, cannot be adequately covered by the resulting financial margin. Good management of operating risk indicates that they are performing efficiently.
I. Legal Risk
This can occur as a result of legal changes or changes in a country's regulations, which can put an institution at a disadvantage compared to others. Abrupt changes in legislation can cause confusion, loss of confidence and possible panic.
J. Sovereign Risk
Refers to the possibility of non-compliance with obligations on the part of the state.
K. Systemic Risk
Refers to the country's financial system as a whole in the face of internal or external shocks, such as the impact of the Asian or Russian crisis or the El Niño phenomenon, which cause market volatility and fragility of the financial system.
Financial Risk Prevention and Control Models
When evaluating the variables at play in social and economic systems that have an impact on financial risk, a series of mathematical, logical and empirical models are used that must be taken into account when analyzing these variables.
Financial risks cannot be eliminated; however, they can be minimized, so there are several ways to manage financial risks, which can be applied individually or in combination, according to the type of investment involved, such as:
Hold. Maintain the investment until maturity without any protection against the risk of a fall in its value.
Avoid. Not to invest in any particular instrument because it is considered outside the established risk tolerance parameters. Maintain a level of indebtedness at the margin of its possibilities, avoiding increasing or exceeding the debt capacity.
Transfer. Sale of financial positions that one is no longer willing to assume their potential risks. Risk transfer mechanisms include foreign exchange hedges, insurance, guarantees, futures contracts, etc. An example is when life insurance is purchased, since paying a premium transfers the financial consequences that your family will suffer if the person dies.
Reduce. Invest in risk-free instruments that guarantee a safe return, such as government securities. Another example is the establishment of marketing plans that ensure a set level of sales, the objective being to reduce the degree of exposure to risk.
Reserves. These are the cash surpluses that will be used to face any loss originated when making an investment; these reserves can be obtained from profits of previous periods.
Diversify. This refers to the allocation of the investment among various financial assets to reduce risk, without forgoing similar profitability. From the above it is determined that, to the extent that a greater amount is invested in higher risk instruments, the potential to obtain a profit increases, but also the possibility of obtaining losses and volatility (a security is called volatile when its price varies in relation to market variation).