Financial risk is the potential losses incurred by an investor when investing in a business that uses borrowed money. When a firm uses a large amount of debt, it incurs a significant interest expense and obligation to repay principal that makes it more likely to have financial difficulties if its sales decline. There are several types of financial risk, which include the following:
- Credit risk. That a customer or borrower will default on a receivable or loan.
- Currency risk. That losses will be incurred on foreign currency holdings when exchange rates fluctuate.
- Equity risk. That losses will be incurred on equity holdings when the shares of stock in a business exhibit rapid price changes.
- Liquidity risk. That losses will be incurred when market conditions are highly volatile.
Financial risk can be mitigated through the use of diversified holdings and hedging strategies.