What is financial risk?

In short, financial risk is the risk of losing money or valuable assets. In the context of financial markets, risk is the risk of loss when trading or investing. So the risk is not the actual loss, but the amount of money that could be lost.

In other words, many financial services or transactions are inherently risky, this is known as financial risk. More broadly, the concept can be applied to a variety of contexts, such as in financial markets, business administration, and regulatory agencies.

The process of assessing and handling financial risks is often called risk management. However, before delving into risk management, we need to have basic knowledge about financial risk and different types of financial risk.

There are many different ways to classify and define financial risk. Financial risks can be classified including investment risks, operational risks, legal risks and system-wide risks.


Types of financial risks

As mentioned, there are many different ways to classify financial risk, and financial risk can be defined in different ways depending on the context. This article provides a brief overview of types of financial risks including investment risks, operational risks, legal risks and system-wide risks.


Investment risks

Investment risks are risks related to investment and trading activities. There are many different types of investment risks, but most of them are related to fluctuations in market prices. Market risk, liquidity risk and credit risk can be considered in the investment risk group.


Market risks

Market risk is the risk associated with fluctuations in the price of an asset. For example, when Alice buys Bitcoin, she is exposed to market risk because market fluctuations can cause the price to drop.

We can manage market risk by considering how much money Alice could lose if the price of Bitcoin moves against her. As a next step, we need to devise a strategy to determine how Alice should act in response to market fluctuations.

Typically, investors face both direct and indirect market risks. Direct market risk is the risk of loss due to an unfavorable change in the price of an asset. The previous example is an example of direct market risk (Bitcoin price fell after Alice bought it).

On the other hand, indirect market risk is a risk caused by a secondary or ancillary factor (i.e. a less obvious risk). In the stock market, interest rates often indirectly affect stock prices, so it is an indirect risk.

For example, if Bob buys stock in a company, fluctuations in interest rates could indirectly impact the value of his shares. It will be difficult for the company to grow or maintain profits due to rising interest rates. In addition, when interest rates are higher, investors also tend to sell their stocks. They often do this to have money to pay off debt because debts then cost more to maintain.

However, it is worth noting that interest rates impact financial markets in both ways, directly or indirectly. While interest rates affect stocks indirectly, they have a direct impact on bonds and other fixed income securities. So, depending on the asset, interest rate risk can be considered a direct or indirect risk.


Payment risk

Liquidity risk is the risk that investors and traders cannot buy or sell an asset immediately without changing its price.

For example, imagine that Alice bought 1,000 cryptocurrency coins at $10 each. Let's say the price remains stable after a few months and the cryptocurrency is still trading around the $10 mark.

If in a large and liquid market, Alice could quickly sell her 10,000 coins because there would be enough buyers willing to pay $10 per coin. However, if the market has low liquidity, there will only be a few buyers willing to pay $10 per coin. So it's possible that Alice will have to sell a large amount of cryptocurrency at a much lower price.


Credit risk

Credit risk is the risk that occurs to lenders when their counterparties default. For example, if Bob borrows money from Alice and Alice is facing credit risk. In other words, there is a possibility that Bob will not be able to repay Alice, and this is what we call credit risk. If Bob defaults, Alice will lose money.

On a macro scale, a country can face an economic crisis if its credit risks occur on a large scale. The worst financial crisis in the past 90 years occurred partly due to credit risks spreading globally.

At that time, American banks had millions of clearing transactions with hundreds of their counterparties. When Lehman Brothers defaulted, credit risk spread rapidly across the globe, creating a financial crisis that led to the Great Depression.


Risks during operations

Operational risk is the risk of financial loss due to failure in internal processes, systems or procedures. These failures often occur as a result of unintended human errors or intentional fraudulent activities.

To minimize operational risk, every company should perform regular security audits, along with adopting robust processes and effective internal management.

There have been many cases of company employees making illegal transactions with company money. This activity is commonly known as spoof trading, and it causes huge financial losses worldwide - especially in the banking industry.

External events also lead to operational inefficiencies that indirectly affect a company's operations, such as earthquake events, hurricanes, and other natural disasters.


Legal risk refers to the losses that can arise when a company or organization fails to comply with the laws and regulations in their jurisdiction. To avoid such risks, many companies apply specific processes, such as Legal Risk (AML) and Know Your Customer (KYC) processes.

If a service provider or company does not comply with the law, they can be shut down or face serious penalties. Many investment firms and banks have faced lawsuits and sanctions for not complying with the law (for example, operating without a valid license). Insider trading and corruption are also common examples of legal risks.


Risks throughout the system

System-wide risk refers to an event that could lead to the collapse of a market or industry. For example, the collapse of Lehman Brothers in 2008 caused a severe financial crisis in the United States, which ultimately affected many other countries.

Systemwide risks demonstrate the strong correlation between companies within the same industry. If Lehman Brothers did not play such an important role in the overall US financial system, its bankruptcy would probably have less impact.

An easy way to remember the concept of system-wide risk is to relate it to the domino effect, in which a falling card takes all the other cards with it.

Notably, the precious metals industry grew significantly after the 2008 Financial Crisis. Therefore, diversification is one way to reduce system-wide risk.


System-wide risks and systemic risks

Systemic risk is different from systemic risk or aggregate risk. The second type of risk is more difficult to define and includes many other types of risks, in addition to financial risks.

Systemic risks can be related to a number of economic and sociopolitical factors, such as inflation, interest rates, war, natural disasters, and major changes in government policy.

Essentially, systemic risks involve events that impact a country or society across multiple sectors. This can include the industries of agriculture, construction, mining, manufacturing, finance, and more. So, while system-wide risk can be mitigated by investing in many low-correlation assets, systemic risk cannot be mitigated by portfolio diversification. private.


summary

In this article we discussed several types of financial risk, including investment risk, operational risk, compliance risk and system-wide risk. In the investment risk group, we have presented the concepts of market risk, liquidity risk and credit risk.

Risk is inevitable and unavoidable in the financial market. The best thing a trader or investor can do is to minimize or control these risks in some way. Therefore, understanding the basic types of financial risks is the first and important step to having an effective risk management strategy.