2 August 2023
Financial risk, in essence, is the chance of losing money or valued assets. Risk can be thought of as the potential financial loss that one faces when trading or investing in the world of financial markets. Therefore, the risk is what could ultimately be lost rather than the actual loss.
In other words, many financial services or transactions come with a built-in risk of loss, which is what we refer to as financial risk. The idea can, in general, be used to describe a variety of situations, including financial markets, company administration, and governmental bodies.
The term "risk management" is frequently used to describe the process of identifying and addressing financial hazards. However, it's crucial to have a fundamental understanding of financial risk and its various categories before getting into risk management.
Financial hazards can be categorized and defined in a variety of ways. Investment risk, operational risk, compliance risk, and systemic risk are illustrative instances.
Financial hazards can be categorized in a number of ways, and depending on the context, their meanings can vary greatly. An overview of systemic, operational, compliance, and investment risks is provided in this article.
Investment hazards are, as their name would imply, risks associated with investing and trading. Investment hazards come in many different forms, but the majority of them are linked to shifting market values. The collection of investment risks may include market, liquidity, and credit issues.
Market risk is the risk brought on by an asset's changing value. For example, if person A (let's call them "she") purchases Ethereum, she will be exposed to market risk because volatility could result in a decline in price.
How much person A might lose if the price of Ethereum swings against her position is the first step in market risk management. The next step is to design a strategy that would specify how person A should respond to changes in the market.
Investors frequently deal with both direct and indirect market concerns. The loss a trader can incur as a result of a negative change in the price of an asset is referred to as direct market risk. The prior illustration shows a direct market risk (person A bought Ethereum prior to a price decline).
The asset that is subject to indirect market risk, on the other hand, has a less obvious secondary or auxiliary risk. Interest rate risk is a type of indirect risk in the stock market since it frequently has an impact on stock price indirectly.
For instance, if person B (let's call them "he") purchases stock in a corporation, changing interest rates may have an indirect impact on his holdings. The corporation will have a harder time expanding or staying profitable if interest rates rise. In addition, higher rates entice additional investors to sell their shares. They frequently do this in order to pay off their obligations, which are now more expensive to keep current.
But it's important to remember that interest rates have an effect on the financial markets, either directly or indirectly. Rates have an indirect impact on stocks, but they have a direct effect on bonds and other fixed-income products. Thus, interest rate risk may be categorized as either a direct risk or an indirect risk depending on the asset.
The risk of investors and traders being unable to swiftly acquire or sell a certain asset without a significant change in its price is known as liquidity risk.
Imagine, for instance, that person A spent $100 on 1,000 units of a particular cryptocurrency. Let's say that after a few months, the price remains steady and the coin is still trading at about $10.
In a market with many consumers willing to part with $10 for each item, person A can easily sell her $10,000 bag. However, there would be a dearth of purchasers prepared to part with $10 for each unit if the market was illiquid. As a result, person A would likely need to sell a big portion of her coins for a significantly lower price.
Credit risk is the possibility that a lender will experience financial loss as a result of counterparty default. For instance, person A would be exposed to credit risk if person B borrowed money from her. In other words, there is a chance that person B won't pay person A, and this chance is what economists refer to as credit risk. person B must pay Person A if he defaults.
If a country's credit risk rises to unreasonably high levels, an economic catastrophe could result. Global credit risk expansion contributed to the occurrence of the worst financial catastrophe in the past 90 years.
At that time, US banks had hundreds of counterparties and millions of offsetting transactions. When Lehman Brothers went bankrupt, the credit risk quickly spread around the world, sparking a financial crisis that eventually resulted in the Great Recession.
Operational risk is the possibility of experiencing financial losses as a result of malfunctions in internal systems, processes, or practices. These errors are frequently the result of unintentional fraud or unintentional human error.
Every business should conduct recurring security audits, develop reliable procedures, and implement efficient internal management to reduce operational risks.
There were countless instances of poorly managed employees using their company's funds to conduct illicit trading. Rogue trading is a term used to describe this type of action, which led to significant financial losses across the globe, particularly in the banking sector.
External factors like earthquakes, thunderstorms, and other natural calamities that have an indirect impact on a company's operations can also contribute to operational failures.
Losses that could result from a business or institution disregarding local laws and regulations are referred to as compliance risks. Many businesses implement specialized practices, such as anti-money laundering (AML) and know-your-customer (KYC), to reduce the likelihood of such dangers.
A service provider or business that does not comply risk closure or harsh penalties. Due to compliance issues (such as operating without a proper license), numerous investment firms and banks were subject to litigation and sanctions. Corruption and insider trading are two other prevalent instances of compliance hazards.
Systemic risk refers to the potential for a certain incident to have a negative impact on a specific market or industry. For instance, the 2008 fall of Lehman Brothers in the US led to a severe financial crisis that spread to many other nations.
The high correlation between businesses in the same industry is proof of systemic dangers. The impact of Lehman Brothers' bankruptcy would be significantly less if the company weren't so intricately entwined with the whole American financial system.
Imagine a domino effect, where one component falls first, forcing other parts to fall, to help you recall the idea of systemic risk.
Notably, after the 2008 Financial Crisis, the precious metals industry saw tremendous growth. Therefore, diversity is a strategy for reducing systemic risk.
Systemic risk and systematic risk or aggregate risk are not the same thing. The latter is more difficult to quantify and includes hazards other than financial.
Numerous economic and sociopolitical variables, including inflation, interest rates, wars, natural disasters, and significant shifts in governmental policy, can be linked to systemic hazards.
In essence, systematic risk refers to situations that have an impact on a nation or society across a variety of spheres. A few examples of these are agriculture, building and construction, mining, manufacturing, banking, and other sectors. Therefore, portfolio diversification cannot reduce systematic risk, whereas systemic risk can be reduced by integrating low-correlated assets.
Here, we covered a few of the several types of financial risks, such as systemic, operational, and investment risks. We introduced the ideas of market risk, liquidity risk, and credit risk within the investment risk category.
Risks in the financial markets are so prevalent that they are practically impossible to totally avoid. The best course of action for a trader or investor is to reduce or manage these risks in some way. In order to develop a successful risk management strategy, it is wise to first grasp some of the basic categories of financial risk.