Financial risk is an important concept to understand in the world of finance and investing. In a nutshell, it is the risk of losing money or valuable assets when trading or investing. Risk management is the process of assessing and dealing with risks and it is important to be aware of different types of financial risks. This article provides a brief overview of different types of financial risk and their respective impacts on markets.
Investment risk is the set of risks associated with investing and trading. Market, liquidity and credit risks all fall under the umbrella of investment risk. Market risk is the risk of an adverse change in an asset’s price and is directly linked to the trading and buying of certain assets. For example, if Alice buys Bitcoin and the price falls, Alice faces direct market risk. On the other hand, indirect market risk relates to when an asset has an ancillary risk, such as when interest rates changes cause stock prices to decline.
Liquidity risk is the risk of being unable to quickly buy or sell a certain asset without drastically changing its price. In the example of Alice buying her cryptocurrency, if the market is illiquid, Alice will likely have to sell much of her coins for a lower price.
Credit risk is the risk of a lender losing money due to a counterparty’s default. Bob borrowing money from Alice is an example of when Alice faces credit risk as there is a possibility that Bob won’t pay her back. A nation facing an economic crisis due to a global credit risk expansion is an additional example of credit risk.
Operational risk is the risk of financial losses caused by the failure of internal processes, systems and procedures. These failures may be caused by unintentional human mistakes or intentional fraudulent activities and require proper security audits to mitigate.
Compliance risk is the risk of losses due to a company failing to adhere to laws and regulations. Companies must maintain specific procedures such as Anti-money laundering and Know Your Customer to avoid such risks. Insider trading and corruption are also forms of compliance risk.
Systemic risk is the risk of an event triggering an adverse effect in an entire market or sector. The Lehman Brothers collapse in 2008 was an example of systemic risk that led to the Great Recession. Systemic risk can be mitigated by diversifying assets, while systematic risk can be caused by a number of economic and sociopolitical factors, and is not limited to financial ones.
No investor can completely avoid risk when dealing with financial markets, but understanding the different types of financial risk is important for developing an effective risk management process. Risk management starts with understanding the types of risk, and devising strategies to mitigate the effects of them.
