What is financial risk?
Financial risk can be described as the possibility of losing money or valuable assets. Financial markets can be described as the risk of losing money when investing or trading. The risk does not refer to actual losses but rather what could be lost.
Financial risk is the risk that many financial transactions or services will fail. The concept can be applied to many scenarios such as financial markets and business administration.
Risk management is the process of assessing and managing financial risks. However, you should have a basic understanding of the various types of financial risks before you dive into risk management.
There are many ways to categorize and define financial risk. Examples of prominent financial risks include operational risk, investment risk, compliance risk and systemic risk.
Different types of financial risk
There are many ways to categorize financial risks. Their definitions can be very different depending on context. This article will provide a brief overview on investment, compliance, and systemic risk.
Investment risks can be associated with trading and investment activities, as the name implies. Although there are many investment risks, most are related to fluctuations in market prices. As part of our investment risk group, we may also consider credit risk, liquidity risk, and market risk.
Market risk refers to the risk that an asset’s price will fluctuate. If Alice purchases Bitcoin, for example, it is exposed to market risk as volatility could cause its price to drop.
The first step in managing market risk is to consider how much Alice stands to lose if bitcoin prices rise against her position. Next, you need to develop a strategy to determine what Alice should do in response to market movements.
Investors are often exposed to both direct and indirect risks in the market. A trader could suffer losses due to an adverse change in an asset’s price. This is called direct market risk. Direct market risk is illustrated in the previous example (Alice purchased bitcoin before its price dropped).
On the other hand, indirect market risk refers to assets that have secondary or additional risk (i.e. less obvious). Stock markets are subject to indirect risks because interest rate risk can often affect the stock price, making it an indirect threat.
If Bob purchases shares in a company’s stock, interest rate fluctuations could indirectly affect his assets. Rising interest rates will make it harder for companies to grow and remain profitable. Higher rates also encourage investors to sell shares. This is often done to clear their debts which are more costly to keep.
It is important to note that interest rates have an indirect and direct impact on financial markets. While interest rates indirectly affect stocks, they also have an impact on bonds and fixed income securities. Depending on the asset, interest rates can be categorized as either direct or indirect risks.
Liquidity is the possibility that traders and investors will not be able quickly to buy or sell an asset, without dramatically changing its price.
Imagine Alice buying 1,000 bitcoins for $10 each. Imagine that the price of cryptocurrency will stabilize in the next few months and trades around $10.
Alice could sell her bag quickly for $10,000 in a liquid market if there were enough buyers willing to pay $10 per unit. If the market is not liquid, however, only a few buyers will pay $10 per share. Alice will likely have to sell many of her coins at much lower prices.
Credit risk refers to the possibility that a lender may lose money due a default by a counterparty. If Alice borrows money from Bob, for example, then she is subject to credit risk. This means that Bob may not pay Alice. We call this credit risk. Alice will lose money if Bob fails to fulfill his obligations.
A country’s credit risk increases to an unacceptable level could lead to an economic crisis. The rise in global credit risk has contributed to the worsening of the financial crisis.
The offsets that U.S. banks made with hundreds of counterparties were millions. Credit risk quickly grew around the globe after Lehman Brothers’ default, causing a financial crisis that led directly to the Great Recession.
Operational Risk is the possibility of financial loss due to failures in internal systems, processes or procedures. These failures can be caused by human error or intentional fraud.
Every company should conduct regular security audits to reduce operational risk.
In many cases, employees who are not properly managed have made unauthorised transactions with company funds. This activity is commonly known as fraud trading and has led to huge financial losses all over the globe, particularly in the banking sector.
External events can also cause disruptions that infringe on a company’s operations.
Compliance risk refers to the potential loss that could arise from a company/institution not complying with its local laws and regulations. Many companies use special procedures to avoid these risks. These include Anti-Money Laundering and Know Your Customer (KYC).
They could be closed down or subject to heavy fines if they fail to comply with the service provider. Non-compliance has led to many lawsuits against banks and investment firms. Compliance risks include insider trading and corruption.
Systemic risk refers to the possibility that an event could have a negative impact on a market or industry. The 2008 collapse of Lehman Brothers led to a severe financial crisis in America that ultimately affected many countries.
A strong correlation between companies within the same industry is a sign of systemic risk. Lehman Brothers’ involvement in the American financial system would have made its bankruptcy much less serious.
It is easy to visualize a domino effect where one component falls first and all the others fall.
The 2008 financial crisis saw significant growth in the precious metals sector. Diversification is one way of reducing systemic risk.
Systemic risk vs. systemic
It is important not to confuse systemic risk with cumulative or systematic risk. This latter term is harder to define and covers a wider range, not just financial.
A variety of socio-political and economic factors can lead to systemic risks, including inflation, interest rates and natural disasters.
Systematic risk refers to events that have a large impact on a country or society. This could include finance, agriculture, construction, mining and manufacturing. While systemic risk can sometimes be reduced by combining assets that have low correlation, systematic risks cannot be decreased by diversifying your portfolio.
We have covered a variety of financial risks including operational, compliance, and investment risks. We discussed the concepts of credit risk, liquidity risk, and market risk within the investment risk group.
Financial markets are not risk-free. These risks can be managed or reduced by traders and investors. Understanding the major financial risks is an important first step in creating a risk management strategy.