The Fundamental Components of Financial Risk

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Financial risk is an important part of every business and without analyzing the financial risk it is impossible to succeed. Not only businesses, even individuals who make investments in stocks or put their savings in banks face financial risk. Although most individuals do not realize that they are facing financial risks at every point of their investment, the risk is always there.

In order to understand what financial risk is, it is important for you to know the basic components of financial risk. Here are they:

The Potential of Profit and the Risk Associated:

Without the potential of profits, it is impossible to predict future financial risks. There are numerous ways of estimating financial risk in regards to the profits. Out of all the best practices of analyzing financial risk, the one widely used is summarized as:

‘The amount of financial risk estimated by the company is directly proportional to the ups and downs of the investment.’

This means that the more the investment is, the higher the financial risk will be.

Risk in Association with the Debts:

The second most important component of financial risk is debts. The amount of debt a company assumes is directly associated with the size and capacity of the financial risk. This means that if a company invests $10,000 borrowed money in stocks and loses it completely, the company not only loses $10,000 but also the interest amount associated with it. Therefore, the company has to pay $10,000 along with the interest amount to the lender.

Risk, Alpha and Beta:

This part of financial risk is about the ‘Alpha’ and ‘Beta’ worth of the investment. Alpha is usually considered as the risk related to the riskiness of the investment in association to a broader index. Beta is described as the risk associated with the changes in the trends.

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