Fri Apr 21 2023
Understanding financial risk and its many types is a good first step towards the creation of an effective risk management strategy and is applicable in both manual or algorithmic trading.
Put simply, financial risk is the possibility of losing money or valuable assets. In the context of financial markets, risk refers to the amount of money one can lose when trading or investing. Many financial services or transactions carry an inherent risk of loss, known as financial risk.
Knowing how to identify and mitigate financial risk in algorithmic cryptocurrency trading is an important aspect for every algo trader.
There are various ways of categorizing financial risks, and their definitions may differ significantly depending on the context. Here, we provide an overview of investment, operational, compliance, and systemic risks.
Investment risks are related to investing and trading activities. Market, liquidity, and credit risks are part of the investment risk group. Market risk refers to the risk associated with the fluctuating price of an asset. Liquidity risk is the risk of being unable to quickly buy or sell an asset without a drastic change in its price. Credit risk is the risk of a lender losing money due to counterparty default.
Operational risk is the risk of financial losses caused by failures in internal processes, systems, or procedures. These failures are often caused by accidental human mistakes or intentional fraudulent activities. To mitigate operational risks, every company should perform periodic security audits and adopt robust procedures and effective internal management.
Compliance risk relates to losses that may arise when a company or institution fails to follow the laws and regulations of their respective jurisdictions. To avoid such risks, many companies adopt specific procedures, such as Anti-money laundering (AML) and Know Your Customer (KYC). Compliance failures may lead to lawsuits, sanctions, and shut down of the company.
Systemic risk relates to the possibility of a certain event triggering an adverse effect in a certain market or industry. The Lehman Brothers collapse in 2008 triggered a serious financial crisis in the US, which ended up affecting many other countries. Systemic risks are evidenced by the strong correlation between companies that are part of the same industry.
It is virtually impossible to avoid risks completely in financial markets. The best thing a trader or investor can do is to mitigate or control these risks somehow. Market risk management starts by considering how much one might lose if the price of an asset moves against their positions. The next step is to create a strategy, which will define how to act in response to the market movements.
To mitigate liquidity risk, one should avoid investing in illiquid markets, diversify their portfolio, and keep cash reserves. Credit risk can be mitigated by performing credit checks, monitoring borrowers’ financial condition, and requiring collateral. Operational risks can be mitigated by performing security audits, adopting robust procedures, and effective internal management. Compliance risks can be mitigated by adopting specific procedures, such as AML and KYC. Systemic risks can be mitigated by combining low-correlated assets.
Understanding financial risk and its many types is a good first step towards the creation of an effective risk management strategy. Investors and traders should always be aware of the potential risks involved in their activities and take steps to mitigate them.