Content
What is financial risk?
Types of financial risks
Investment risk
Market risk
Liquidity risk
Credit risk
Operational risk
Compliance risk
Systemic risk
Systemic vs. systemic risk systematic
Final considerations
What is financial risk?
In short, financial risk is the risk of losing money or valuable assets. In the context of financial markets, we can define risk as the amount of money that can be lost when trading or investing. Therefore, the risk is not the actual loss, but rather what could eventually be lost.
In other words, many financial services or transactions contain an inherent risk of loss and this is what we call financial risk. Broadly speaking, the concept can be applied to a range of contexts, such as financial markets, business administration and government organizations.
The process of evaluating and addressing financial risks is often called risk management. But before diving into risk management, it's important to have a basic understanding of financial risk and its various types.
There are several ways to classify and define financial risks. Some examples include investment risk, operational risk, compliance risk and systemic risk.
Types of financial risks
As mentioned, there are several ways to categorize financial risks and their definitions can differ significantly depending on the context. This article provides a brief overview of investment, operational, compliance and systemic risks.
Investment risk
As the name suggests, investment risks are those related to investing and trading activities. There are several forms of investment risk, but most are related to fluctuations in market prices. We can consider market, liquidity and credit risks as part of the group of investment risks.
Market risk
Market risk is the risk associated with the fluctuating price of an asset. For example, if Alice buys Bitcoin, she will be subject to market risk because volatility can cause the price to drop.
Market risk management starts by considering how much Alice could lose if the price of Bitcoin moves against her positions. The next step is to create a strategy to define how Alice should act in response to market movements.
Typically, investors face direct and indirect market risks. Direct market risk is related to the loss that a trader may suffer from an adverse change in the price of an asset. The previous example illustrates a direct market risk (Alice bought Bitcoin before a price drop).
On the other hand, indirect market risk refers to an asset that presents a secondary (i.e. less evident) risk. In stock markets, interest rate risk often indirectly affects stock prices, making it an indirect risk.
For example, if Bob buys shares in a company, his holdings may be indirectly influenced by fluctuating interest rates. The company will have a harder time growing or remaining profitable due to rising interest rates. Additionally, higher rates encourage other investors to sell their shares. They often do this to use the money to pay off their debts.
It is worth noting, however, that interest rates impact financial markets, directly or indirectly. While rates affect stocks indirectly, they have a direct impact on bonds and other fixed income assets. Therefore, depending on the asset, interest rate risk can be considered a direct or indirect risk.
Liquidity risk
Liquidity risk is the risk of investors and traders being unable to quickly buy or sell a given asset without suffering a drastic change in price.
For example, suppose Alice purchased 1,000 units of a cryptocurrency for $10 each. Let's assume the price remains stable and after a few months, the cryptocurrency is still trading around the value of $10.
In a high-volume liquid market, Alice can quickly sell her $10,000 worth because there are enough buyers willing to pay $10 for each unit. But if the market is not liquid enough, there would be few buyers willing to pay $10 for each share. So, Alice would probably have to sell a good amount of her coins for a much lower price.
Credit risk
Credit risk is the risk that a lender will lose money due to a counterparty's default. For example, if Bob borrows money from Alice, she will be facing a credit risk. In other words, there is a possibility that Bob will not pay Alice. This possibility is what we call credit risk. If Bob doesn't pay, Alice loses money.
From a broader perspective, an economic crisis can occur if a country's credit risk expands to unmanageable levels. The worst financial crisis in the last 90 years occurred, in part, due to a global expansion in credit risk.
At that time, American banks had millions of clearing transactions with hundreds of counterparties. When Lehman Brothers defaulted, credit risk expanded rapidly across the world, creating a financial crisis that led to the Great Recession.
Operational risk
Operational risk is the risk of financial losses caused by failures in internal processes, systems or procedures. These failures are often caused by accidental human error or intentional fraudulent activity.
To mitigate operational risks, every company must conduct periodic security audits, along with adopting sound procedures and effective internal management.
There have been numerous cases of poorly managed employees who were able to, without authorization, use company funds for personal business. This type of activity is often called rogue trading and has caused huge financial losses around the world - especially in the banking sector.
Operational failures can also be caused by external events that indirectly affect a company's operations, such as earthquakes, storms and other natural disasters.
Compliance risk
Compliance risk refers to losses that may arise when a company or institution does not follow the laws and regulations of their respective jurisdictions. To avoid these risks, many companies adopt specific procedures, such as Anti-money laundering (AML) and Know Your Customer (KYC).
If a company is not in compliance, it could be shut down or face serious penalties. Many investment firms and banks have faced action due to compliance failures (e.g. operating without a valid license). Insider trading and corruption are also common examples of compliance risks.
Systemic risk
Systemic risk is related to the possibility of a certain event triggering an adverse effect on a market or sector. For example, the collapse of Lehman Brothers in 2008 triggered a serious financial crisis in the USA, which ended up affecting many other countries.
Systemic risks are evidenced by the strong correlation between companies that are part of the same sector. If Lehman Brothers were not so deeply involved in the entire American financial system, its bankruptcy would be much less impactful.
An easy way to remember the concept of systemic risk is to imagine a domino effect, where the fall of the first piece causes other pieces to fall.
The precious metals industry experienced significant growth following the 2008 Financial Crisis. Therefore, diversification is one way to mitigate systemic risk.
Systemic vs. systemic risk systematic
Systemic risk should not be confused with systematic or aggregate risk. The latter is harder to define and refers to a wider range of risks – not just financial ones.
Systematic risks can be related to various economic and sociopolitical factors, such as inflation, interest rates, wars, natural disasters and changes in government policies.
Essentially, systematic risk refers to events that impact a country or society across multiple sectors. This can include the agriculture, construction, mining, manufacturing, finance sectors and more. Therefore, although systemic risk can be mitigated by combining assets with low correlation, systematic risk cannot be mitigated by portfolio diversification.
Final considerations
We discuss some of the many types of financial risk, including investment, operational, compliance, and systemic risks. Within the investment risk group, we present the concepts of market risk, liquidity risk and credit risk.
When it comes to financial markets, it is practically impossible to completely avoid risks. The best thing a trader or investor can do is mitigate or control these risks in some way. Therefore, understanding some of the main types of financial risk is a good first step towards creating an effective risk management strategy.