What is financial risk?
In short, financial risk is the risk of losing money or valuable assets. In the context of financial markets, we may define risk as the amount of money one can lose when trading or investing. So, the risk is not the actual loss, but what can be eventually lost.
Put in another way, many financial services or transactions contain an inherent risk of loss, and this is what we call financial risk. Broadly speaking, the concept may be applied to a range of scenarios, such as financial markets, business administration, and governing bodies.
The process of assessing and dealing with financial risks is often referred to as risk management. But, before diving into risk management, it's important to have a basic knowledge of financial risk and its many types.
There are multiple ways of classifying and defining financial risks. Notable examples include investment risk, operational risk, compliance risk, and systemic risk.
Types of financial risk
As mentioned, there are various ways of categorizing financial risks, and their definitions may differ significantly depending on the context. This article gives a brief overview of investment, operational, compliance, and systemic risks.
As the name suggests, investment risks are the ones related to investing and trading activities. There are multiple forms of investment risks, but most of them are related to fluctuating market prices. We may consider market, liquidity, and credit risks as part of the investment risk group.
Market risk is the risk associated with the fluctuating price of an asset. For instance, if Alice buys Bitcoin, she will be subject to market risk because volatility may cause the price to drop.
Market risk management starts by considering how much Alice might lose if the price of Bitcoin moves against her positions. The next step is to create a strategy, which will define how Alice should act in response to the market movements.
Typically, investors face both direct and indirect market risks. Direct market risk relates to the loss a trader might experience from an adverse change the price of an asset. The previous example illustrates a direct market risk (Alice purchased Bitcoin before a price drop).
On the other hand, indirect market risk relates to an asset that has a secondary or ancillary risk (i.e., less evident). In stock markets, interest rate risk often affects the price of stocks indirectly, which makes it an indirect risk.
For example, if Bob buys shares of a company, his holdings may be indirectly influenced by fluctuating interest rates. The company will find it harder to grow or remain profitable due to rising interest rates. Other than that, higher rates encourage other investors to sell their shares. They often do so to use the money to pay their debts, which are now more costly to maintain.
It's worth noting, though, that interest rates impact financial markets both directly or indirectly. While the rates affect stocks indirectly, they cause a direct impact on bonds and other fixed-income securities. So, depending on the asset, interest rate risk may be considered a direct or indirect risk.
Liquidity risk is the risk of investors and traders being unable to quickly buy or sell a certain asset without a drastic change in their price.
For example, imagine that Alice bought 1,000 units of a cryptocurrency for $10 each. Let's suppose the price remains stable after a few months, and the cryptocurrency is still trading around the $10 mark.
In a high-volume, liquid market, Alice can quickly sell her $10,000 bag because there are enough buyers willing to pay $10 for each unit. But, if the market is illiquid, there would be only a few buyers willing to pay $10 for each unit. So, Alice would probably have to sell a good amount of her coins for a much lower price.
Credit risk is the risk of a lender losing money due to counterparty default. For instance, if Bob borrows money from Alice, she is facing a credit risk. In other words, there is a possibility that Bob won't pay Alice, and this possibility is what we call credit risk. If Bob defaults, Alice loses money.
From a broader perspective, an economic crisis may occur if a nation's credit risk expands to unreasonable levels. The worst financial crisis of the last 90 years occurred in part due to a global credit risk expansion.
Back then, US banks had millions of offsetting transactions with hundreds of counterparties. When Lehman Brothers defaulted, the credit risk expanded rapidly around the globe, creating a financial crisis that led to the Great Recession.
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 mistakes or by intentional fraudulent activities.
To mitigate operational risks, every company should perform periodic security audits, along with the adoption of robust procedures and effective internal management.
There were numerous incidents of poorly managed employees who managed to perform unauthorized trades with their company's funds. This kind of activity is often referred to as rogue trading, and it caused huge financial losses worldwide - especially within the banking industry.
Operational failures may also be caused by external events that indirectly affects the operations of a company, such as earthquakes, thunderstorms, and other natural disasters.
Compliance risk relates to losses that may arise when a company or institution fails to follow the laws and regulations of their respective jurisdictions. To avoid such risks, many companies adopt specific procedures, such as Anti-money laundering (AML) and Know Your Customer (KYC).
If a service provider or company fails to be compliant, they may be shut down or face serious penalties. Many investment firms and banks faced lawsuits and sanctions due to compliance failures (e.g., operating without a valid license). Insider trading and corruption are also common examples of compliance risks.
Systemic risk relates to the possibility of a certain event triggering an adverse effect in a certain market or industry. For example, the Lehman Brothers collapse in 2008 triggered a serious financial crisis in the US, which ended up affecting many other countries.
Systemic risks are evidenced by the strong correlation between companies that are part of the same industry. If the Lehman Brothers firm weren't so deeply involved with the whole 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 one piece falls first, causing other pieces to fall.
Notably, the precious metal industry experienced significant growth after the 2008 Financial Crisis. So, diversification is one way of mitigating systemic risk.
Systemic vs. systematic risk
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 only financial.
Systematic risks can be related to a number of economic and sociopolitical factors, such as inflation, interest rates, wars, natural disasters, and major governmental policy changes.
Essentially, systematic risk relates to events that impact a country or society in multiple fields. This may include the industries of agriculture, construction, mining, manufacturing, finance, and more. So while systemic risk can be mitigated by combining low-correlated assets, systematic risk can't be mitigated by portfolio diversification.
Here we discussed some of the many kinds of financial risk, including investment, operational, compliance, and systemic risks. Within the investment risk group, we presented the concepts of market risk, liquidity risk, and credit risk.
When it comes to financial markets, it is virtually impossible to avoid risks completely. The best thing a trader or investor can do is to mitigate or control these risks somehow. So, understanding some of the main types of financial risk is a good first step towards the creation of an effective risk management strategy.