Contents

• What are financial risks?

• Types of financial risks

  • Investment risk

    • Market risk

    • Liquidity risk

    • Credit risk

  • Operational risk

  • Compliance risk

  • Systemic risk

    • Systemic risk vs. systematic

• Final thoughts

What are financial risks?

Financial risks, briefly explained, are those that refer to the possibility of losing money or valuable assets. In the context of financial markets, we can define risk as the amount of money one can lose when trading or investing. Therefore, risk is not the actual loss, but rather what can be lost.

In other words, many financial services or transactions carry an inherent risk of loss, and this is what we call financial risk. In general terms, the concept can be applied to various scenarios, such as financial markets, business administration and government bodies.

The process of assessing and addressing financial risks is often called risk management. Now, before delving into risk management, it is important to have a basic knowledge of financial risk and its various types.

There are multiple ways to classify and define financial risks. Some of the most notable examples are investment risk, operational risk, compliance risk and systemic risk.

Types of financial risks

As we have already mentioned, there are several ways to categorize 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 suggests, investment risks are those related to investment and trading activities. There are multiple forms of investment risks, but most of them are related to fluctuating market prices. Market, liquidity and credit risks can be considered part of the group of investment risks.

Market risk

Market risk is the risk associated with the fluctuating price of an asset. For example, if Alice buys Bitcoin, she will be subject to market risk because volatility can cause the price to drop.

The starting point of market risk management is the estimation of the amount of money that Alice can lose, in the event that the price of Bitcoin moves against her positions. The next step is to develop a strategy that defines how Alice will act in response to market movements.

Investors typically face both direct and indirect market risks. Direct market risks refer to the losses that a trader may experience as a result of an adverse change in the price of an asset. The previous example illustrates a direct market risk (Alice bought Bitcoin before a price drop).

On the other hand, indirect market risk relates to an asset that has a secondary or auxiliary (that is, less obvious) risk. In stock markets, interest rate risk often affects stock prices indirectly, making 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 more difficult to grow or remain profitable due to rising interest rates. Aside from that, 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 to maintain.

However, it is worth noting that interest rates impact financial markets both directly and 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 direct or indirect 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 drastic change in its price.

For example, imagine that Alice bought 1,000 units of a cryptocurrency for $10 each. 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 will only be a few buyers willing to pay $10 for each share. Then Alice would probably have to sell a good amount of her coins at a much lower price.

Credit risk

Credit risk is the risk that a lender will lose money due to a counterparty's default. For example, if Bob borrows money from Alice, she faces a credit risk. In other words, there is a possibility that Bob will not pay Alice, and this possibility is what we call credit risk. If Bob doesn't pay, Alice loses money.

From a broader perspective, an economic crisis can occur if a nation's credit risk expands to unreasonable levels. The worst financial crisis in 90 years occurred in part due to a global expansion of credit risk.

Back then, American banks had millions of offsetting transactions with hundreds of counterparties. When Lehman Brothers defaulted, credit risk expanded rapidly around the world, creating a financial crisis that 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 activities.

To mitigate operational risks, every company must conduct regular security audits, along with adopting robust procedures and effective internal management.

There were numerous incidents of mismanaged employees managing to conduct unauthorized transactions with their company funds. This type of activity is often known as rogue trading, and caused huge financial losses around the world, especially within the banking industry.

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

Compliance risk

Compliance risk relates to the losses that may arise when a company or institution fails to comply with 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 does not comply, it may be shut down or face serious penalties. Many investment firms and banks faced lawsuits and penalties due to compliance failures (for example, operating without a valid license). Insider trading and corruption are also common examples of compliance risks.

Systemic risk

Systemic risk relates to the possibility that a certain event triggers an adverse effect in a certain market or industry. For example, the collapse of Lehman Brothers in 2008 triggered a serious financial crisis in the United States, 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 Lehman Brothers were not so deeply involved with the entire American financial system, its bankruptcy would be much less shocking.

An easy way to remember the concept of systemic risk is to imagine a domino effect, in which one piece falls first and causes other pieces to fall.

Notably, the precious metals industry saw significant growth after the 2008 financial crisis. Therefore, diversification is a way to mitigate systemic risk.

Systemic risk vs. Systematic

Systemic risk should not be confused with systematic or aggregate risk. The latter is more difficult to define and refers to a broader range of risks, not just financial ones.

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

Essentially, systematic risk relates to events that impact a country or society in multiple fields. This can include the industries of agriculture, construction, mining, manufacturing, finance, and more. While systemic risk can be mitigated by combining assets with low correlation, systematic risk cannot be mitigated by portfolio diversification.

In conclusion

Here we discuss some of the many types of financial risk, including investment, operational, compliance and systemic risks. Within the investment risk group, we present 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 mitigate or control these risks in some way. Therefore, understanding some of the main types of financial risk is a good first step towards creating an effective risk management strategy.