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 in a trade or investment. Therefore, risk is not the actual loss, but what can ultimately be lost.
In other words, many financial services or transactions contain an inherent risk of loss, and this is what we call financial risk. In a broad sense, the concept can be applied to a range of scenarios such as financial markets, business administration and governance.
The process of assessing financial risks and dealing with them is often called risk management. But before diving into risk management, it is important to have a basic knowledge of financial risks and their many types.
There are several ways to classify and define financial risks. Well-known examples include investment risk, operational risk, compliance risk, and systemic risk.
Types of financial risk
As already mentioned, there are different ways of classifying 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 implies, investment risks are associated with investment and trading activity. There are many forms of investment risk, but most of them are related to fluctuations in market prices. We can consider market risk, liquidity risk and credit risk as part of the investment risk pool.
Market risk
Market risk is the risk associated with fluctuations in the price of an asset. For example, if Alice buys Bitcoin, she will be exposed to market risk because volatility can cause the price to fall.
Market risk management begins with considering how much Alice stands to lose if the price of Bitcoin moves against her position. The next step is to create a strategy that will determine how Alice should act in response to market movements.
As a rule, investors face both direct and indirect market risks. Direct market risk is associated with losses that a trader may suffer as a result of an unfavorable change in the price of an asset. The previous example illustrates direct market risk (Alice bought Bitcoin before the price dropped).
On the other hand, collateral market risk refers to an asset that has a secondary or additional (ie less obvious) risk. In stock markets, interest rate risk often has an adverse effect on the stock price, making it a collateral risk.
For example, if Bob buys shares in a company, his assets may be indirectly affected by fluctuations in interest rates. It will be harder for the company to grow or remain profitable due to rising interest rates. In addition, higher rates encourage other investors to sell their shares. They often do this to use the money to pay off their debts, which are now more expensive.
However, it is worth noting that interest rates affect financial markets directly and indirectly. While rates indirectly affect stocks, they directly affect bonds and other fixed income securities. Thus, depending on the asset, interest rate risk can be seen as direct or collateral risk.
Liquidity risk
Liquidity risk is the risk that investors and traders will not be able to quickly buy or sell a certain asset without a sudden change in its price.
For example, imagine that Alice bought 1000 units of cryptocurrency for $10 each. Let's say the price remains stable for several months and the cryptocurrency is still trading around the $10 mark.
In a liquid market with high volumes, Alice can quickly sell her coins for $10,000 because there are enough buyers willing to pay $10 for each unit. But if the market is illiquid, there will be only a few buyers willing to pay $10 for each share. Thus, Alice will likely have to sell a large number of her coins at a much lower price.
Credit risk
Credit risk is the risk that the creditor will lose money due to the default of the counterparty. For example, if Bob borrows money from Alice, she faces credit risk. In other words, there is a probability that Bob will not pay Alice, and we call this probability credit risk. If Bob defaults, Alice loses money.
More broadly, an economic crisis can occur if a country's credit risk rises to unreasonable levels. The biggest financial crisis in the last 90 years was caused in part by an increase in global credit risk.
At that time, American banks made millions of offset agreements with hundreds of counterparties. When Lehman Brothers defaulted, credit risk quickly spread around the world, triggering a financial crisis that eventually led to the Great Recession.
Operational risk
Operational risk is the risk of financial loss caused by failures in internal processes, systems or procedures. These failures are often caused by accidental human error or intentional fraudulent activity.
To reduce operational risks, every company should conduct periodic security audits, as well as implement robust procedures and effective internal management.
There have been numerous cases of mismanaged employees making unauthorized transactions with their company's funds. This type of activity is often referred to as illegal trading, and it has led to huge financial losses around the world, especially in the banking sector.
Operational disruptions can also be caused by external events that adversely affect the company's operations, such as earthquakes, thunderstorms and other natural disasters.
Compliance department
Compliance risk is related to the losses that can occur when a company or institution fails to comply with the laws and regulations of its respective jurisdiction. To avoid such risks, many companies apply special procedures such as Anti-Money Laundering (AML) and Know Your Customer (KYC).
If a service provider or company does not comply, they can be shut down or face serious sanctions. Many investment firms and banks have faced lawsuits and sanctions for non-compliance (such as operating without a valid license). Insider trading and corruption are also common examples of compliance risks.
Systemic risk
Systemic risk refers to the possibility that a certain event will cause an adverse effect in a certain market or industry. For example, the collapse of Lehman Brothers in 2008 triggered a major financial crisis in the United States, which subsequently affected many other countries.
Systemic risks are indicated by a strong correlation between companies in the same industry. If the firm Lehman Brothers was not so closely connected with the entire American financial system, its bankruptcy would have had much smaller consequences.
An easy way to remember the concept of systemic risk is to imagine a domino effect where one piece falls first, causing the others to fall.
Notably, the precious metals industry has seen significant growth since the 2008 financial crisis. Thus, diversification is one way to reduce systemic risk.
Systemic risk or systematic risk
Systemic risk should not be confused with systematic or aggregate risk. Systematic risk is more difficult to define and it belongs to a wider spectrum of risks – not only financial.
Systematic risks can be associated with a number of economic and socio-political factors, such as inflation, interest rates, wars, natural disasters and major changes in government policy.
In essence, systematic risk is associated with events that affect a country or society in several areas. This can include the fields of agriculture, construction, mining, manufacturing, finance and more. Thus, while systematic risk can be reduced by pooling low-correlated assets, systematic risk cannot be reduced by portfolio diversification.
Final thoughts
We have discussed some of the many types of financial risks, including investment, operational, compliance and systemic risks. In the investment risk group, we introduced the concepts of market risk, liquidity risk and credit risk.
When it comes to financial markets, it is almost impossible to completely avoid risk. The best thing a trader or investor can do is somehow mitigate or control these risks. Therefore, understanding some of the main types of financial risks is a good first step towards creating an effective risk management strategy.