In short, financial risk is the probability of a partial or complete loss of monetary assets. But if we consider this problem in the context of markets, then the definition changes a bit. Therefore, financial risk is also the amount of funds that can be lost in various trading operations and processes. So it is not a percentage probability, not a guaranteed actual loss but a theoretical amount that could be lost.
This term can be applied to many areas related to management and distribution of finances, including the work of governing bodies, administration of business processes, and trading in financial markets. Of course, if there are risks, then there are opportunities to reduce them. This set of methods is called “risk management”. But before you understand it in more detail, you need to understand what exactly you have to face. Nevertheless, financial risks are also different.
The following large categories are distinguished:
- Investment
- Operating
- Compliant (compliance risks)
- Systemic
- Systematic
Let’s consider them in more detail.
Investment risks
Directly related to investing financial resources. They are divided into market, liquid and credit, but almost always depend on the general price fluctuation in the respective market.
Market. Risk of losing money due to price fluctuations in financial markets. A situation that traders face daily. A simple example. A certain Sam analyses the exchange rate of Bitcoin and sees that it is increasing. In the hope of going a bull, he buys a certain amount of tokens, however, instead of the expected rise, a fall is observed. Sam loses money by incorrectly calculating market financial risk. If he can act quickly, he can still manage to sell his assets until they have fallen completely. However, traders will not rush to buy tokens at the price set by Sam — they also calculate financial risks and wait for the price to become minimal. This is the simplest example of direct market financial risk and the interactions based on it.
There is also indirect market risk. Most often, it is associated with interest rates. Simply put, it is extremely difficult to ensure high absolute profit with rising interest rates. Together with them, not only debts and other payments rise but also the chance that investors will begin to sell their shares increases, which can lead to a natural fall in their value. Therefore, many companies deliberately inhibit the rise of interest rates to make it easier to stay afloat.
It is also worth considering that the interest rate can affect the state of finance both indirectly and directly. At high rates, for example, direct profits from bonds and fixed income securities increase.
Liquid. The risk that traders will not be able to sell or buy assets both at the set price and without risk of causing a sharp decrease in this very price.
The first case is quite simple: if the market is not sufficiently liquid, then the trader will either have to wait for a suitable opportunity (for a long time, which also leads to loss of funds) or reduce the rate.
The second case is a little more complicated: it all depends on the supply/demand balance. With an insufficient number of traders providing demand, the bid price automatically rises. And vice versa. This is especially noticeable when working with rare and expensive securities.
In any case, the trader will lose money due to liquidity risks, not to mention the “lost profit”.
Credit. The risk of loss of funds in case the debtor refuses to fulfil credit obligations. The problem is that in a huge number of cases, the lender does not have quick and effective mechanisms to enforce debt collection. And the debtor, in turn, may simply not have the necessary funds.
And if such a situation is repeated more than once, it will lead to a serious increase in the country’s credit risk, which in turn can end in a financial crisis. It is this reason that led to the Great Recession. Simply put, when everybody owes everyone, it is extremely difficult to effectively use the available cash. Financial markets around the world are experiencing echoes of this phenomenon even now. And a repeat of the situation looks extremely likely in the future.
Operating
Risks arising from a malfunction in the processes of conducting financial transactions. Both mechanical and human-induced. Or, which is also quite often, from employee fraud. It also includes difficulties in operational processes caused by external factors — natural disasters.
Mechanical operational risks are reduced through regular information security audits and audits at all levels of control. In addition, they are positively affected by the effective internal management of the company.
The human factor is more difficult to fight. Even a seemingly “harmless” unauthorized trade, in which employees use customer funds in account turnover, is all the same a fraud involving serious financial losses. However, this is a fairly common scenario in the banking industry.
Compliance risk
Different countries have different laws, rules and standards. Therefore, companies operating at international levels regularly face inconsistencies between their standards and local ones. Which is fraught with a heavy fine at best and a temporary or permanent suspension of activity at worst. Compliance risks are precisely those losses arising because of such a situation.
In addition, direct legal sanctions are possible if a certain company is caught in money laundering or corruption scandals, which is also fraught with fines and “freezing” of assets. It also includes the targeted “leak” of various insider information.
These risks are very large, therefore, there are special ways to deal with them, for example, targeted anti-money laundering (AML) and “Know your customer” (KYC). Compliance risks are especially interesting in the context of decentralised systems. On the one hand, corruption is extremely difficult there and there is no insider information, but on the other hand, licences to such companies are extremely rare, and they almost never correspond to local jurisdiction.
Systemic
The risk that one particular event will lead to the collapse of the entire system. Simply put, a crumbling house of cards with one card removed. Or “domino effect”. In relation to financial markets, a large-scale financial crisis due to the bankruptcy of a large company.
A case in point is the 2008 crisis caused by the collapse of Lehman Brothers closely associated with other major US financial companies. With its bankruptcy, other companies began to have problems, which led to a global collapse in the securities market. Moreover, not only in the USA. But at the same time, it also led to a sharp strengthening of the precious metals market since diversification of funds is one of the most effective ways to avoid systemic risk.
Fortunately, this scenario, especially on this scale, is quite rare.
Systematic
This type of risk is somewhat reminiscent of a system one, but much more complex since it is not tied to the economy alone. If systemic risks consider problems associated with individual financial organisations, then systematic risks generally deal with everything that can somehow affect the stability of the financial system. Inflation, wars, natural disasters, political crises are the very events that are almost impossible to predict, but which directly affect various aspects of human life.
Perhaps one of the most difficult risks to forecast. As for the confrontation, the diversification of assets already mentioned helps significantly reduce personal losses.
Conclusion
Unfortunately, it is impossible to completely avoid financial risks. However, experienced traders and investors can not only predict and forecast them but also benefit from them. This is called an “effective risk management strategy”. Which is impossible without a good understanding of what can be encountered in the financial markets.