Financial Risk

• Financial risk is a loosely defined term denoting the risk in undertaking any financial transaction where the other party may not be able to meet is obligation. To a bank, financial risk is the possibility of default. For an investor, financial risk is the possibility of losing all of his investment. Financial risk is ubiquitous since individuals, businesses and governments enter into financial transactions every day. The degree of financial risk varies based on circumstance. For instance, a credit card lender faces financial risk by issuing a credit card with a $3,000 limit. Likewise, bond investors face financial risk when they purchase government bonds.
  
  

Maximum Financial Risk

• In theory, the maximum financial risk for a lender or investor is the point at which the borrower can no longer make his next scheduled debt payment. If it is a loan, the lender loses the entire principal balance plus interest if the borrower defaults. If it is an investment such as a stock, the investor could potentially lose his entire capital, which is his point of maximum financial risk.
  
  

Measurement of Financial Risk

• Measuring financial risk varies by transaction and instrument. Typically, lenders want to know whether or not a borrower has the financial capacity to service the debt. Commonly used debt ratios include debt-to-income and debt-to-equity. Some industries, such as commercial real estate, use specific metrics to determine a borrower's financial risk, such as the debt service coverage ratio. A borrower faces greater financial risk as he takes on additional risk. Another lender will most likely deny the borrower's loan application. Technically, a stock has the potential to decline to zero, placing an investor at risk of losing his entire investment. Banks and governments employ personnel who specialize in risk management for the purpose of minimizing risk.
  
  

Consequence

• A borrower labeled as a financial risk faces a tough hurdle of obtaining credit. For an individual, this means no access to funds to finance a home or car, or difficulty obtaining a credit card. For a business, it means limited or no access to the capital markets. Likewise, governments face the same issue. Credit rating agencies provide other lenders information on borrowers via a credit score, which other lenders use as a measure for financial risk. Rating agencies such as Standard & Poor's not only issue credit ratings on publicly traded companies but also governments.