Generally speaking, there are two ways to define risk: one definition emphasizes the uncertainty of the future, and the other emphasizes the loss.

In constructing a portfolio, it is important to understand the associated risk involved in each asset class. Let's talk about the two general categories of risk: financial and non-financial.

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Financial Risk

Financial risk refers to risk derived from financial markets. Let’s introduce three types of financial risk: market, credit, and liquidity.

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Market risk

Market risk arises due to changes in interest rates, exchange rates, stock prices, or commodity prices. It typically arises from certain fundamental economic conditions, events in the economy or industry, or developments in specific companies.

Market risks are among the most obvious and visible risks investors face. For example, the entire market pays close attention to Fed announcements on interest-rate policies.

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Credit risk

Credit risk refers to the possible loss caused by a party's failure to repay a loan or honor a contractual obligation.

More specifically, credit risk arises from the borrower's failure to repay interest and principal in a loan, such as bonds. Therefore, for bondholders, it is crucial to pay attention to the credit risk of borrowers.

For derivative contracts, only one party owes money to the other in some derivatives, but in other types of derivatives, either party can owe the other.

That's why sometimes credit risk is called default risk or counterparty risk.

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Liquidity risk

Liquidity risk refers to the risk of a significant downward valuation adjustment when selling a financial asset due to insufficient market volume or lack of buyers.

For example, the bid-ask spreads of some thinly traded options contracts are considerable. Moreover, the bigger the position size, the higher the cost and uncertainty associated with liquidating.

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Non-Financial Risk

In practice, some risks, such as compliance or legal risks, do not always arise from the financial market. These are referred to as non-financial risks.

Let's see a notorious case caused by non-financial risk. Barings Bank, a 200-year company, went bankrupt on February 26, 1995, because a "rough trader" engaged in a series of highly speculative trades to cover up the loss.

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