Understanding Financial Risk

Basics

Financial risk refers to the possibility of losing money or valuable assets. This type of risk can be present in various scenarios, including financial markets, business administration, and governing bodies. When trading or investing, risk refers to the potential amount of money that can be lost rather than the actual loss itself.

Financial risk is inherent in many financial services or transactions, making risk management a crucial aspect of finance. Understanding the different types of financial risk is a fundamental step in managing them. Investment risk, operational risk, compliance risk, and systemic risk are among the notable examples of financial risks.

Risk management involves assessing and addressing financial risks to mitigate potential losses. Before delving into risk management, it is essential to have a solid grasp of financial risk and its various forms.

Types of Financial Risk

Financial risk can be divided into four types: investment, operational, compliance, and systemic risks. 

Investment Risk

The group of risks associated with investment and trading activities is called investment risks. Fluctuations in market prices are the main cause of these risks. Market, liquidity, and credit risks are all part of the investment risk category.

Market Risk

Market risk is one of the types of investment risks that refers to the risk related to fluctuating asset prices. This means that if Alice buys Bitcoin, she will be exposed to market risk as the price of Bitcoin may change and cause her to lose money. To manage market risk, Alice must first determine how much she could potentially lose if the price of Bitcoin moves against her position. After this, she must develop a strategy outlining her response to the market movements.

Investors typically face both direct and indirect market risks. Direct market risk refers to the loss a trader may experience from a change in an asset's price. For example, Alice purchasing Bitcoin before a price drop is a direct market risk. 

Indirect market risk, on the other hand, is related to an asset that has a less obvious risk. In stock markets, interest rate risk is an example of an indirect market risk that can affect stock prices indirectly. For instance, if Bob purchases shares of a company, his holdings may be indirectly impacted by fluctuating interest rates. High-interest rates make it difficult for companies to grow or remain profitable, leading to investors selling their shares. Interest rates can have a direct impact on bonds and other fixed-income securities, making interest rate risk a direct or indirect risk depending on the asset.

Liquidity Risk

Liquidity risk is the inability to quickly buy or sell a certain asset without a drastic price change. When the market is illiquid, it becomes challenging to sell an asset for its fair value. To illustrate this, let's take the example of Alice, who purchased 1,000 units of cryptocurrency for $10 each. The price of the cryptocurrency remains stable for a few months. In a high-volume, liquid market, Alice can easily sell her cryptocurrency for $10 per unit, but if the market is illiquid, she may have to sell her coins for a much lower price due to the lack of buyers willing to pay the market value.

Credit Risk

Credit risk is the danger of a creditor losing money due to a borrower's default. Alice faces credit risk when she lends money to Bob. If Bob fails to repay Alice, she incurs a loss. Credit risk can lead to an economic crisis if it grows excessively. The worst financial crisis in the past 90 years was partly caused by a global expansion of credit risk. At that time, US banks had millions of counterparty transactions. When Lehman Brothers defaulted, credit risk spread rapidly worldwide, causing the Great Recession.

Operational Risk

The possibility of suffering financial losses due to internal system or procedural errors is known as operational risk. Such failures may occur as a result of accidental human errors or fraudulent activities. To reduce the likelihood of operational risks, organizations should carry out regular security audits and adopt robust procedures coupled with effective internal management. 

Many financial losses were recorded globally in the banking industry, resulting from rogue trading by poorly managed employees who executed unauthorized trades with their company's funds. Operational failures may also arise from external events that may indirectly impact a company's operations, including natural disasters like earthquakes and thunderstorms.

Compliance Risk

The risk of non-compliance with laws and regulations is known as compliance risk. To avoid this risk, many companies adopt procedures such as Anti-money laundering (AML) and Know Your Customer (KYC). Companies that fail to comply with regulations may face serious penalties, including being shut down. Investment firms and banks have faced legal action and sanctions due to compliance failures, such as operating without a valid license. Compliance risk may also arise from insider trading and corruption.

Systemic Risk

Systemic risk refers to a market or industry's exposure to adverse events that could trigger a collapse. The impact of these events is often felt across multiple sectors, causing significant financial damage. For instance, the bankruptcy of Lehman Brothers in 2008 triggered a severe economic crisis in the US, which then spread globally. 

The severity of systemic risk is correlated with the interdependence of companies in an industry. Lehman Brothers bankruptcy was particularly devastating due to its deep involvement with the American financial system. 

An effective way to conceptualize systemic risk is to imagine a domino effect, where the failure of one company causes others to fall. Following the 2008 financial crisis, the precious metal industry experienced substantial growth. Diversification is one effective method of mitigating systemic risk.

Systemic vs. Systematic Risk

Portfolio diversification cannot help mitigate systematic risk, unlike systemic risk. Systematic risk is a broader type of risk that can come from non-financial factors like war, inflation, interest rates, natural disasters, and government policy changes. It can impact various industries, including finance, agriculture, mining, manufacturing, and construction. In contrast, systemic risk is the risk that a specific event will trigger negative effects in a particular market or industry. For instance, the bankruptcy of Lehman Brothers in 2008 triggered a financial crisis in the United States that impacted many other countries. While systemic risk can be reduced by combining low-correlated assets, systematic risk cannot be mitigated through portfolio diversification.

Conclusion

One of the primary steps toward creating an effective risk management strategy in financial markets is understanding the various kinds of financial risks and how to protect the portfolio from them. However, it is essential to understand that it is nearly impossible to eliminate risks completely in financial markets. Therefore, the best approach for a trader or investor is to find ways to mitigate or control these risks.