What is financial risk?

In simple terms, financial risk is the possibility of losing money or assets. In financial markets, we can define risk as the potential loss of money that one might incur when trading or investing. Therefore, risk is not the actual loss, but the possibility of loss.

In other words, the risk of loss is an inherent attribute of many financial services or transactions, which is called "financial risk". Broadly speaking, this concept applies to various scenarios such as financial markets, corporate management and government agencies.

The process of assessing and dealing with financial risks is often referred to as “risk management.” However, before implementing risk management, it is important to have a basic understanding of financial risks and their specific types.

There are many ways to categorize and define financial risk. Common types include investment risk, operational risk, compliance risk, and systemic risk.


Types of financial risk

As mentioned above, there are many ways to categorize financial risk, and the definitions can vary greatly depending on the specific circumstances. This article will briefly introduce investment, operational, compliance and systemic risks.


investment risk

As the name suggests, investment risk is the risk associated with investment and trading activities. Investment risk comes in various forms, most of which are related to market price fluctuations. We can consider market risk, liquidity risk and lending risk as a type of investment risk.


Market Risk

Market risk is usually associated with asset price volatility. For example, if Alice buys Bitcoin, she will be exposed to market risk because the volatility of Bitcoin may cause the price to fall.

She first needs to think about market risk management—how much money she will lose if the price of Bitcoin moves against her position. The next step is to create a strategy and plan operations during market fluctuations.

Generally speaking, investors face both direct and indirect market risks. Direct market risk is related to asset prices, and falling prices may cause investors to suffer losses. The example above introduces direct market risk (Alice buys Bitcoin before the price falls).

On the other hand, indirect market risk usually refers to secondary or additional risk of an asset (that is, more obscure). In the stock market, interest rate risk usually has an indirect impact on stock prices, so it is an indirect risk.

For example, if Bob buys stock in a company, fluctuations in interest rates can indirectly affect his holdings. As interest rates rise, it becomes harder for the company to continue growing or remaining profitable. In addition, high interest rates can cause other investors to continue selling their shares. The funds from these sales are generally used to pay down debt, making it more expensive to maintain the debt.

It is important to note that interest rates can affect financial markets directly or indirectly. While interest rates can only indirectly affect stock prices, they can directly affect bonds and other fixed-income securities. Therefore, whether interest rate risk is a direct or indirect risk depends on the asset class.


Liquidity Risk

Liquidity risk refers to the inability of investors and traders to quickly buy and sell assets within a stable price range.

For example, Alice buys 1,000 cryptocurrencies at $10 each. Assuming the price remains stable after a few months, the price of the coin is still hovering around $10.

If the market is liquid and there are many buyers willing to buy at $10, Alice can quickly sell her current holdings (worth $10,000). If the market is illiquid, then there are only a few buyers willing to buy at $10. Therefore, Alice may have to sell her cryptocurrency holdings for less than $10.


Lending Risks

Lending risk refers to the risk that a lender will suffer a loss due to the default of the counterparty. For example, if Bob borrows money from Alice, Alice will be exposed to lending risk. In other words, Bob may not be able to return the funds to Alice, which is called lending risk. If Bob defaults, Alice will suffer a loss.

From a macro perspective, if a country's lending risk rises abnormally, it is likely to trigger an economic crisis. The most serious financial crisis in the past 90 years was the result of the intensification of global credit risk.

At that time, major US banks established millions of loan transactions with hundreds of counterparties. After Lehman Brothers defaulted, credit risks quickly spread around the world, and the financial crisis triggered another "Great Depression".


Operational risks

Operational risk is the risk of financial loss resulting from problems with internal processes, systems or procedures. These problems often result from human error or fraud.

In order to reduce operational risks, each company should conduct regular safety audits and implement safe, reliable and effective internal management procedures.

It is not uncommon for rogue employees to illegally embezzle public funds without authorization. This activity, often referred to as “rogue trading,” has caused huge financial losses around the world, especially in the banking industry.

Operational risks can also arise from external events that indirectly affect a company's operations, such as earthquakes, thunderstorms, and other natural disasters.


Compliance Risk

Compliance risk refers to a company or institution violating the laws and regulations of a jurisdiction, which ultimately results in losses. To avoid such risks, many companies adopt specific processes such as Anti-Money Laundering (AML) and Know Your Customer (KYC).

If the relevant regulatory policies are violated, the service provider or company is likely to be ordered to shut down or severely punished. Many investment companies and banks fail to meet the compliance requirements of the regulatory authorities (such as operating without a license) and eventually face lawsuits and sanctions. Insider trading and corruption are also typical examples of compliance risks.


Systemic Risk

Systemic risk is related to the negative impact of certain events in a specific market or industry. For example, the collapse of Lehman Brothers in 2008 led to a severe financial crisis in the United States, which eventually spread to many countries and regions.

The close correlation between companies in the same industry confirms systemic risks. Had Lehman not been so closely tied to the U.S. financial system, the impact of the bankruptcy might have been significantly reduced.

To make it easier to understand, we can imagine the concept of systemic risk as a domino effect. When one domino falls, it will cause a chain reaction, causing all other dominoes to fall one after another.

It is worth noting that the precious metals industry grew significantly after the 2008 financial crisis. Therefore, asset allocation diversification is one of the ways to mitigate systemic risks.


Systematic risk vs. market risk

Systemic risk should not be confused with market risk or aggregate risk, which are more difficult to define and have a broader scope than just financial risk.

Market risks may be associated with many economic and socio-political factors, such as inflation, interest rates, war, natural disasters, and significant changes in government policies.

In essence, systemic risk involves events that affect the development of a country or society in many areas. Agriculture, construction, mining, manufacturing, finance and other industries will face shocks. Therefore, building a diversified investment portfolio cannot alleviate systemic risk. Diversifying weakly correlated assets is the right approach.


Summarize

In this article, we have explored various financial risks, including investment, operational, compliance and systemic risks. Regarding investment risks, we have introduced the concepts of market risk, liquidity risk and lending risk in detail.

It is almost impossible to completely avoid risks in the financial market. Traders or investors can only find reasonable solutions to reduce or control risks. Therefore, understanding the main types of financial risks is the first priority in developing an effective risk management strategy.