What is financial risk?

Simply put, financial risk is the possibility of losing money or assets. In financial markets, we can define risk as the loss of money that one can incur when trading or investing. Therefore, risk is not actual loss, but the possibility of loss.

In other words, the risk of loss is an inherent attribute of many financial services or transactions. This is the so-called "financial risk". Broadly speaking, this concept applies to various scenarios such as financial markets, corporate management, and government agencies.

The process of assessing and dealing with financial risks is often called "risk management." However, before implementing risk management, it is necessary to have a preliminary understanding of financial risks and their specific types.

There are many ways to classify and define financial risks. Common types include investment risk, operational risk, compliance risk and systemic risk.

Types of financial risks

As mentioned above, there are many ways to classify financial risks , definitions may vary significantly depending on the circumstances. This article will provide a brief introduction to investment, operations, compliance and systemic risks.

Investment risk

As the name suggests, investment risk is related to investment Risks associated with trading activities. Investment risks come in various forms, most of which are related to market price fluctuations. We can regard market risk, liquidity risk and lending risk as a type of investment risk.

Market risk

Market risk is usually related to asset price fluctuations Related. For example, if Alice purchases Bitcoin, she faces market risk because Bitcoin's volatility may cause the price to fall.

She first needs to consider market risk management—how much money she will lose if the price of Bitcoin goes against her position. The next step is to create a strategy to plan operations during periods of market volatility.

Generally speaking, investors face both direct and indirect market risks. Direct market risk is related to asset prices, and a decline in prices could cause investors to suffer losses. The example above describes direct market risk (Alice buys Bitcoin before the price drops).

Indirect market risk, on the other hand, usually refers to the secondary or subsidiary risk of an asset (that is, it is more obscure). In the stock market, interest rate risk often has an indirect impact on stock prices, so it is an indirect risk.

For example, if Bob buys stock in a company, interest rate fluctuations may indirectly affect his holdings. As interest rates rise, it will be difficult for the company to continue to grow or remain profitable. Additionally, interest rates that are too high cause other investors to keep selling their stocks. Funds from the sales are generally used to repay debt, increasing the cost of maintaining debt.

It should be noted that interest rates can directly or indirectly affect financial markets. While interest rates only affect stock prices indirectly, they directly affect bonds and other fixed-yielding securities. Therefore, whether interest rate risk is direct or indirect depends on the asset class.

Liquidity risk

Liquidity risk refers to investment Investors and traders are unable to quickly buy and sell assets within a stable price range.

For example, Alice buys 1,000 cryptocurrency at a unit price of $10. Assuming the price remains stable in a few months, the coin’s price is still hovering around $10.

If the market liquidity is high and a large number of buyers are willing to buy at a price of $10, Alice can quickly sell the assets currently held (worth $10,000). If the market is illiquid, then only a few buyers are willing to buy at $10. Therefore, Alice may have to sell her cryptocurrency holdings for less than $10.

Lending risk

Lending risk refers to the lender’s risk of The risk of loss due to default by a counterparty. For example, if Bob borrows money from Alice, Alice will face lending risk. In other words, Bob may not be able to return the funds to Alice, which is the so-called lending risk. If Bob defaults, Alice will suffer losses.

From a macro perspective, if a country's borrowing risk rises pathologically, it is likely to trigger an economic crisis. The most serious financial crisis in the past 90 years was the result of heightened global credit risks.

At that time, major U.S. banks established millions of lending transactions with hundreds of counterparties. After Lehman Brothers defaulted, credit risks spread rapidly around the world, and the financial crisis triggered another "Great Depression."

Operational risk

Operational risk refers to internal processes, Risk of financial loss due to system or procedural problems. Such problems often result from human error or fraud.  

In order to reduce operational risks, each company should conduct regular security audits and implement safe, reliable, and effective internal management procedures.

It is not uncommon for misbehaving employees to illegally embezzle public funds without authorization. This activity, often referred to as "rogue trading," has caused huge financial losses around the world, with the banking industry being the worst hit.

Operational risks may also arise from external events that indirectly affect the company's operations, such as earthquakes, thunderstorms and other natural disasters.

Compliance risk

Compliance risk refers to the company Or the institution violates the laws and regulatory measures of the jurisdiction, ultimately causing losses. To avoid such risks, many companies adopt specific processes such as anti-money laundering (AML) and identity verification (KYC).

If relevant regulatory policies are violated, the service provider or company is likely to be ordered to shut down or be severely punished. Many investment firms and banks fail to meet regulatory compliance requirements (such as operating without licenses and licenses) and end up facing lawsuits and sanctions. Insider trading and corruption are also classic examples of compliance risks.

Systemic risk

Systemic risk and certain Related to the negative impact a specific event has on a specific market or industry. For example, the collapse of Lehman Brothers in 2008 caused the United States to fall into a severe financial crisis, which eventually spread to many countries and regions.

The close relationship between companies in the same industry confirms systemic risks. Had Lehman not been so closely tied to the U.S. financial system, the impact of the bankruptcy might have been significantly reduced.

To facilitate understanding, we can imagine the concept of systemic risk as a domino effect. The fall of one domino will cause a chain reaction, driving all other dominoes to fall in sequence.

It is worth noting that the precious metals industry grew significantly after the 2008 financial crisis. Therefore, asset allocation diversification is one of the ways to mitigate systemic risks.

Comparison of systemic risk and market risk

Systemic risk should not be confused with market risk or aggregate risk. The latter is more difficult to define, involves a wider scope, and is not limited to financial risks.

Market risk can be related to many economic and sociopolitical factors, such as inflation, interest rates, war, natural disasters, and major changes in government policy.

In essence, systemic risks involve events that affect the development of a country or society in many areas. Industries such as agriculture, construction, mining, manufacturing, and finance will all face impacts. Therefore, constructing a diversified investment portfolio cannot mitigate systemic risks, and diversifying investments in weakly correlated assets is the correct approach.

Summary

In this article we have looked at a variety of financial risks, including Investment, operations, compliance and systemic risk. Regarding investment risks, we introduced the concepts of market risk, liquidity risk and lending risk in detail.

It is almost impossible to completely avoid risks in financial markets. Traders or investors can only find reasonable solutions to mitigate or control risks. Therefore, understanding the main types of financial risks is a top priority in developing an effective risk management strategy.