What are financial risks?

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 a person can lose when trading or investing. So, the risk is not the actual loss, but what we stand to lose in the end.

In other words, many financial services or transactions involve the risk of natural loss, which we call financial risk. In general, the concept can be applied to a range of scenarios, such as financial markets, business management and administrative bodies.

The process of assessing and dealing with financial risks is often referred to as risk management. But before delving into the knowledge of risk management, it is important to have a basic knowledge of financial risks and their many types.

There are multiple ways to classify and define financial risk. Prominent examples include investment risk, operational risk, compliance risk, and systemic risk.


Types of financial risks

As mentioned, there are different ways of classifying financial risks, and their definitions may vary significantly depending on the context. This article provides a brief overview of investment risk, operational risk, compliance risk and systemic risk.


Investment risks

As the name indicates, investment risk is the risk related to investing and trading activities. There are many forms of investment risk, but most of them are related to the volatility of market prices. We may consider market, liquidity and credit risks as part of the investment risk group.


Market risk

Market risk is the risk associated with the volatility of an asset's price. For example, if Alice buys bitcoins, she will be exposed to market risk because volatility could cause the price to fall.

Market risk management begins by considering how much Alice could lose if the price of Bitcoin moved in the opposite direction to her trade. The next step is to create a strategy that specifies how Alice will behave in response to market movements.

Typically, investors face direct and indirect market risks. Direct market risk relates to the loss that a trader may experience from a negative change in the price of an asset. The previous example illustrates immediate market risk (Alice bought bitcoins before the price dropped).

Indirect market risk, on the other hand, relates to an asset that carries secondary or additional (i.e. less obvious) risks. In equity markets, interest rate risk often affects the stock price indirectly, making it an indirect risk.

For example, if Bob buys shares in a company, his holdings may be indirectly affected by fluctuating interest rates. The company will find it more difficult to grow or maintain its profits due to higher interest rates. Otherwise, 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 if they remain.

However, it should be noted that interest rates affect financial markets directly or indirectly. While rates affect stocks indirectly, they cause a direct impact on bonds and other fixed-income securities. So, depending on the asset, interest rate risk can be considered a direct or indirect risk.


Liquidity risk

Liquidity risk is the risk that investors and traders will not be able to buy or sell an asset quickly without a radical change in its price.

For example, imagine that Alice bought 1,000 units of cryptocurrency for $10 each. Let's assume that the price remains stable after a few months, and the cryptocurrency is still trading around the $10 mark.

In a highly liquid market, Alice can sell her $10,000 bag quickly because there are enough buyers willing to pay $10 per unit. But if the market is not liquid enough, there will be only a few buyers willing to pay $10 per share. Therefore, Alice would likely sell a good amount of her coins at a much lower price.


Credit risk

Credit risk is the possibility that a lender will lose money because a counterparty fails to pay its debts. For example, if Bob borrows money from Alice, she faces credit risk. In other words, there is a possibility that Bob will not pay Alice what he owes, and this possibility is what we call credit risk. If Bob defaults, Alice will lose her money.

From a broader perspective, an economic crisis may occur if a country's credit risk expands to unreasonable levels. The worst financial crisis of the past 90 years was due in part to the expansion of global credit risks.

At the time, US banks had millions of clearing transactions with hundreds of counterparties. When Lehman Brothers defaulted, credit risks expanded rapidly around the world, causing a financial crisis that led to the Great Recession.


Operational risks

Operational risk is the risk of financial loss resulting from failures in internal processes, systems or procedures. These failures are often the result of accidental human errors or intentional fraudulent activities.

To mitigate operational risks, every company must conduct periodic security audits, as well as adopt strict procedures and effective internal management.

There have been many incidents of mismanagement of employees who were able to make unauthorized trades using the funds of the companies they work for. This type of activity is often referred to as rogue trading, and has caused huge financial losses around the world, particularly in the banking industry.

Operational failures may also be caused by external events that indirectly affect a company's operations, such as earthquakes, thunderstorms, and other natural disasters.


Compliance risks

Compliance risk relates to losses that may arise when a company or organization fails to follow the laws and regulations of their respective jurisdictions. To avoid such risks, many companies adopt specific measures, such as anti-money laundering (AML) and identity authentication (KYC).

If the service provider or company fails to comply, it may be closed down or may face severe penalties. Many investment firms and banks have faced lawsuits and penalties for failure to comply (for example, operating without a valid license). Insider trading and corruption are common examples of compliance risks.


Systemic risk

Systematic risk relates to the potential for a particular event to cause a negative impact on a particular market or industry. For example, the collapse of Lehman Brothers in 2008 led to a serious financial crisis in the United States, which ended up affecting many other countries.

Systemic risk manifests itself through strong correlation between companies that are part of the same industry. If Lehman Brothers were not so heavily involved in the entire US financial system, its bankruptcy would have much less impact.

An easy way to remember the concept of systemic risk is to imagine a domino effect, where one piece falls first, causing others to fall.

It is worth noting that the precious metals industry witnessed significant growth after the financial crisis in 2008. Therefore, asset allocation is one way to mitigate systemic risk.


Systematic risk versus systemic risk

Systemic risk should not be confused with systematic or aggregate risk. These latter risks are more difficult to quantify and refer to a broader range of risks, not just financial risks.

Systematic risks can be related to a number of economic, social and political factors, such as inflation, interest rates, wars, natural disasters and major changes in government policies.

Essentially, systemic risks relate to events that affect a country or society in multiple areas. This may include the agriculture, construction, mining, manufacturing, finance and other industries. So, while systematic risk can be mitigated by combining low-correlated assets, systematic risk cannot be mitigated by spreading assets across portfolios.


Concluding thoughts

Here we have discussed some of the many types of financial risk, which include investment risk, operational risk, compliance risk and systemic risk. Within the investment risk group, we introduced the concepts of market risk, liquidity risk and credit risk.

When it comes to the financial markets, it is almost impossible to avoid risk completely. The best thing a trader or investor can do is mitigate or control these risks in some way. So, understanding some of the main types of financial risks is a good first step towards developing an effective risk management strategy.