Financial risk is the threat of loss of funds or holdings as a result of investments, business deals, and so on. On financial fields, particularly on the cryptocurrency market, financial risk is expressed in terms of how much capital a participant risks to lose in the process of trade or investment in digital currencies.
Risk can be viewed as a potential danger of loss of cash that is hypothetical, but not guaranteed. A trader may face not only a potential loss, but also a possible return. Another words, it’s a two-end stick that can jeopardize your capital or lead to its growth.
Sometimes financial risk goes beyond the financial markets and affects the whole world economies, leading to the default of companies, banks, entire industries and even the collapse of governments. A good example is the bank collapse of Lehman Brothers in 2008. That year there was also a risk of the auto industry collapsing due to debt, but the U.S. government was able to save the industry. In the past, countries such as the Argentine Republic, Russian Federation and Republic of Lebanon have been unable to fulfill their debt commitments and have gone into default.
Financial risk can be either individually or collectively. And there are some other kinds of financial risks, which we will analyze in this article. We will also look at how they can be limited, although not completely avoided.
What types of financial risks exist?
There are many types of risk that can fall under the definition of financial risk. However, in actual experience, the more prevalent categories are market risk, leverage risk, liquidity risk, and operating risk.
Market risk
Market risk refers to exposures resulting from movements in the values of financial tools: equities, digital currencies, bonds, commodities, and so on. That is, swings in asset prices represent the market risk you are exposed to when buying or selling a specific holding.
For instance, you see that ether is in an uptrend and decide to purchase the ETH/USDT pair. A factor of market risk is present, as the instrument may be overpriced and selling pressure from large traders taking their gains could lead to a drop in the value of this currency pair.
To protect yourself from this threat, you need to develop a trading strategy. This is where managing risk really does come to play. As a general guideline, you should never risk more than 2% of your capital in any trade.
Market risk includes not only price swings, which represent straight market risk, as well as circumstantial market risk. Sources of circumstantial market risk comprise factors such as rising interest rates, company bankruptcy or country default, negative geopolitical events, etc.
The collapse of stocks and cryptocurrencies in 2022 was a factor of indirect market risk. The collapse was mainly influenced by the Federal Reserve’s decision to wind down its bond purchase program. Concerns about rising inflation led market participants to shift from initially more risky holdings, like equities and digital currencies, to those considered safer, such as bonds or commodities.
Credit risk
Credit risk is caused by a debtor being unable to repay a lender. By purchasing government bonds of a 3rd world country that is under heavy debt pressure and experiencing a severe economic downturn, you are exposing yourself to leverage risk. Should such a country go into default, the exposure will materialize. The banks are facing the same credit risks on a daily basis at the retail and institutional level, as individuals and companies may not be able to make their payments. As a result, banks are exposed to leverage risk.
Credit risk represents the greatest threat because most of the financial crises in this century and the last century occurred largely because of sovereign credit risks. This is likely to be the case as long as countries continue to build up debt. If this process becomes unsustainable, credit risk will turn into systemic credit risk, and a worldwide financial meltdown will be a possibility.
Liquidity risk
Liquidity risk is yet another major problem in the financial markets. This risk occurs when you are unable to buy or sell your assets. In addition, this risk can cause you to cover your existing positions with no impact on market values. The illiquid markets are becoming a major pain for traders who have to quickly liquidate their exposure to different unexpected events.
There is a cautionary tale about how a novice investor started purchasing orange juice in the inventory market. The higher he purchased, the bigger the price went up, and eventually he decided to sell the juice to lock in his profit. However, his orders remained unexecuted. When he called his broker and asked why he still hadn’t sold his position, the broker inquired: «To whom?». The orange juice market at the time was very illiquid — the number of buyers and sellers was minimal. Therefore, the risk of liquidity is very real. To mitigate this risk, it is worth it to invest in higher liquidity marketplaces and holdings.
Operational risk
Operational risk involves all the inherent dangers and factors that a company faces while doing business in its respective industry. This risk can occur due to the failure of employees to comply with in-house security processes and protocols, comply with requirements, and so on. The problem isn’t external and isn’t related to overall market terms.
Bad administration, insight trading, misplaced priorities, lack of control, inability to support systems and facilities and any other human level failures within the company can be instances of operating hazard. Therefore, this risk can be categorized as a business risk.
Final thoughts
We cannot completely avoid risks. But we can alleviate them and establish a robust governance strategy. Understanding which kinds of risks may lie ahead for a trader is the initial step to managing risk successfully.
