Financial Risk Explained

Financial risk represents the possibility of losing your money or assets on investment, business deals, etc. In financial markets, especially the crypto market, which is our primary interest, the financial risk would translate to how much of your capital you could lose when trading or investing in cryptocurrencies.  The risk can be seen as a hypothetical danger of losing your money, however, not a guaranteed one. Not only does it mean a potential loss but it will also refer to potential profits. In other words, it is a two – edged sword that may endanger your capital or cause it to grow.  

On the flip side, financial risk can spread beyond financial markets into the global economy. It can be seen within different businesses and cause companies, banks, industries and even governments to default. You saw it in practice when the Lehman Brothers bank went bankrupt in 2008. There was also a risk of the automobile industry crashing due to indebtedness, however, the government was able to bail it out. Furthermore, in the past, countries like Argentina, Russia, and Lebanon failed to meet their debt obligations and defaulted

Financial risk can be both individual and collective. There are more types of financial risks, and we will cover those in the article. Further along, we are going to briefly mention how you can limit them, albeit not being able to avoid them altogether. 

What kinds of financial risks are there?

We want our focus to be on financial risk, and not business or non – business risks. There are quite a few categories that may fall under this definition. Yet, in practice, the most common categories are market risk, credit risk, liquidity risk, and operations risk. Those have some subcategories inside them, however, we will not go into depth about them. 

Market risk

Market risk is associated with risks that arise from price movements of a given financial instrument: stock, cryptocurrency, bond, commodity, etc. This means that fluctuations of prices in the assets are a market risk that you expose yourself to when buying or selling a particular asset. For example, you define that ether is in an uptrend, and therefore decide to buy ETH/USD pair. There is a market risk factor involved, as the instrument can be overpriced, and increased, selling pressure from big players who lock in their profits may cause the pair to drop.  

You have to create a trading strategy to defend yourself from such market headwinds. That’s where risk management comes into play. As a rule of thumb, you should not risk more than 2% of your equity on any given trade, in this case, your ETH/USD trade

On the other hand, market risk involves not only price fluctuations, which deal with direct market risk, but also indirect market risk. This includes but is not limited to interest rates, bankruptcy or a company or country, geopolitical and sociopolitical events, unexpected news, etc. 

The most recent collapse in stocks and cryptocurrencies was connected to indirectional market risk. This was affected mainly by the Federal Reserve decision to unwind their bond-buying program. Furthermore, their worry about the rising inflation, caused market players to move from inherently riskier assets such as stocks, and cryptocurrencies to those that are considered safer ones, such as bonds or commodities. 

Credit risk

Credit risk is attributed to the risk of a debtor that fails to pay the creditor. If you buy government bonds of a third-world country that is experiencing a heavy burden of debt, and undergoing a severe economic downturn, you are running a credit risk. If the country defaults, the risk will materialize. Banks face similar credit risks every day on retail and institutional levels since private individuals and companies can default on their payments which will cause banks to face a credit risk. 

This aspect of financial risk can be critical as most financial crises in this, and the previous century occurred primarily due to sovereign credit risks. It will probably remain so as long as countries keep piling on more debt. If the process becomes unsustainable, you may see the credit risk develop into a systemic risk when a global financial collapse becomes possible. 

Liquidity risk

Liquidity risk is another critical issue in financial markets. It may occur when you cannot buy or sell your assets. It might also close your open position without affecting market prices. Illiquid markets become a headache for investors who need to liquidate their positions fast due to various unforeseen circumstances.   

There’s an edifying story of how a newbie investor was excited to buy apple juice in the commodity market. The more he bought, the more the price rose which led to that eventually, he decided to sell to lock in his profits. His orders remained unfilled, and when he called his broker to ask why he hadn’t sold his position yet, the broker asked:” To whom?” The apple juice market was very illiquid at the time, with very few buyers and sellers participating in transactions. Thus liquidity risk is real and you should focus on trading and investing in more liquid markets and assets to mitigate this risk.   

Operational risk

Operational risk includes all the internal factors and dangers a company encounters while doing their business in its respective industry daily. This risk may arise due to the failure of employees  ability to follow internal safety procedures, protocol, compliance, etc. The trouble is not external and cannot be attributed to general market conditions. 

Poor management, insider trading, incorrectly formulated priorities, lack of supervision, failure to maintain systems and equipment, and any other malfunctioning on a human level inside the company could be examples of operational risk. Thus, we should put this risk into the category of business risk. 

Concluding thoughts

As financial markets are inherently risky, we cannot avoid risks altogether. However, we can mitigate them, and develop a sound risk management strategy. Knowing what types of risks await an investor, is the first step to effective risk management.    

For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.

Essence of Crypto. Nothing else.

Latest lessons in your inbox every week.


Don’t miss the new CEX.IO University content.

Subscribe to CEX.IO University updates, and receive our newsletter packed with useful guides and tips every week.