What is a financial instrument?

Financial risk represents the possibility of losing money or valuable assets. In financial markets, this is the amount of money you can lose when trading or investing. So the risk is not the actual loss, but what can be lost.

Simply put, many financial services or transactions carry an inherent risk of loss. This is what we call financial risk. Generally speaking, the concept can be applied to various scenarios, such as financial markets, business and regulatory bodies.

The process of assessing and addressing financial risks is often referred to as risk management. But, before diving into risk management, it is important to have a basic understanding of financial risk and its many types.

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

Types of financial risks

As we 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 relate to fluctuating market prices. We can consider market, liquidity and credit risks as part of the investment risk group.

Market risk

Market risk is the risk associated with fluctuation in the price of an asset. For example, if Alice buys Bitcoin, she will be subject to market risk, as volatility can cause the price to fall.

Managing market risk starts by thinking about how much Alice could lose if the price of bitcoin moved against her positions. The next step is to create a strategy, which will define how Alice should act in response to market movements.

In general, investors face direct and indirect market risks. Direct market risk relates to the loss that a trader may incur due to an unfavorable change in the price of an asset. The previous example illustrates direct market risk (Alice bought bitcoins before a price drop).

In contrast, indirect market risk refers to an asset presenting a secondary or auxiliary (i.e. 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 positions may be indirectly influenced by changes in interest rates. The company will have difficulty growing or remaining profitable due to rising interest rates. Additionally, 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 should be noted that interest rates have a direct or indirect impact on financial markets. While rates indirectly affect stocks, they have a direct impact on bonds and other fixed-income securities. Thus, 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 quickly buy or sell a certain asset without a drastic change in price.

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

In a high-volume liquid market, Alice can quickly sell her $10,000 in assets because there are enough buyers willing to pay $10 for each unit. However, if the market is illiquid, only a few buyers would be willing to pay $10 for each share. So Alice would probably have to sell a good amount of her assets for a much lower price.

Credit risk

Credit risk is the risk that a lender will lose money due to a counterparty default. 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, and this possibility is what we call credit risk. If Bob defaults, 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 because of a global expansion of credit risk.

At the time, U.S. banks had millions of clearing transactions with hundreds of counterparties. When Lehman Brothers defaulted, credit risk quickly spread around the world, creating a financial crisis that led to the Great Recession.

Operational risk

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 errors or intentional fraudulent activity.

To mitigate operational risks, every company should conduct periodic security audits, and adopt robust procedures and effective internal management.

There have been numerous cases of mismanaged employees who managed to make unauthorized transactions with their company funds. This type of activity, often called “rogue trading,” has led to huge financial losses around the world, particularly in the banking sector.

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

Compliance risk

Compliance risk relates to losses that can arise when a company or institution fails to comply with the laws and regulations of their respective jurisdictions. To avoid these risks, many companies adopt specific procedures, such as anti-money laundering (AML) and Know Your Customer (KYC).

If a service provider or company is not compliant, they may be shut down or face serious penalties. Many investment firms and banks have faced prosecution 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

Systemic risk concerns the possibility that a certain event triggers a negative effect on a certain market or sector. For example, Lehman Brothers collapsed in 2008, leading to a serious financial crisis in the United States, which affected many other countries.

Systemic risks are demonstrated by the high correlation between companies in the same industry. If Lehman Brothers was not so deeply involved in the entire American financial system, its bankruptcy would have had less impact.

A simple way to remember the concept of systemic risk is to imagine a domino effect, where one piece falls first, causing other pieces to fall.

In particular, the precious metal industry saw significant growth after the 2008 financial crisis. Diversification is therefore a way to mitigate systemic risk.

Systemic risk vs. systematic risk

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

Systematic risks can be linked to a number of economic and socio-political factors, such as inflation, interest rates, wars, natural disasters and major changes in government policy.

Essentially, systematic risk refers to events that affect a country or company in multiple areas. These could include agriculture, construction, mining, manufacturing, finance, etc. Thus, while systemic risk can be mitigated by combining weakly correlated assets, systematic risk cannot be mitigated by portfolio diversification.

To conclude

We have presented here some types of financial risks, including investment, operational, compliance and systemic risks. Within the investment risk group, we introduced the concepts of market risk, liquidity and credit risk.

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