What is Risk?
Risk, in financial terms, is the probability of the actual return being different from the expected return. According to the Capital Asset Pricing Model (CAPM), risk is defined as the volatility of returns.
For instance, an investment is expected to bring 20% profit after 1 year. If the return is 30% or 10% greater or less than the expected return after the 1-year period, it means risks have occurred.
Therefore, risks are not limited to lower returns than expected, but higher returns than expected for unknown reasons are also considered risks.
For example, short squeezing often leads to many short positions being liquidated, making the price surge. In most cases, this is caused by a whale or a large organization losing, leading to many consequences involving different parties, even though the asset price increased.
How to measure risks?
As defined above, risks can be measured by the volatility relative to the expected return. Typically, risk assessment methods are based on historical data and are measured based on the standard deviation.
The higher the standard deviation, the more volatile an asset (based on historical data), which means the risk is higher. To measure standard deviation, the STDEV function on Google Sheets might come in handy.
As seen in the above picture, the daily returns of BTC and ETH from July 1 to August 9, 2022 (by CoinMarketCap) show that ETH is the asset with higher risk than BTC within this period. The standard deviation of ETH is 0.05, higher than 0.03 of BTC.
ETH's 0.05 standard deviation suggests that ETH returns will tend to fluctuate approximately 5% around the average return of 1.31% within the stated time frame.
In addition, we can evaluate investment performance with the return/risk ratio, a.k.a the Sharpe Ratio, calculated by expected return divided by risk (or standard deviation). The above example also shows that ETH has better investment performance than BTC within the stated time frame.
This is the most basic way to measure the return risk of an asset based on historical data. There are also many other different methods to measure risk levels.
Another important note is that standard deviation is measured based on historical data, and this coefficient may change in the future. Therefore, this method should be applied to asset classes with a lot of historical data. In addition, when assessing the risk of a certain asset, we need to consider data associated with different events and time frames before making statistics, from which to conclude an appropriate risk level.
Types of risks in the financial market
There are two main types of risk to consider during the investment process: systemic risk and unsystematic risk.
Systemic risk is also known as market risk. This type of risk can affect most or all of the market at the same time, causing prices to move in the same direction (usually down). These risks are often caused by factors outside the control of individuals or companies.
Some examples of systemic risks include interest rate risk, economic risk, inflation risk, liquidity risk, etc.
For the crypto market, an example of systemic risk is the bearish price action in the first half of 2022 due to macro-related reasons, such as the geopolitical conflict between Russia and Ukraine. This caused rising inflation, economic difficulties and impacted the Fed's decision to tighten monetary policy.
Due to the simultaneous impact on all or some asset classes, it is quite difficult to limit systemic risk through diversification of asset classes.
Therefore, when systemic risk happens, investors need to track and evaluate their portfolios carefully. It is best to make plans to rebalance portfolios with assets that may potentially increase in the short term to limit risks, such as gold.
Unsystematic risk originates from the intrinsic value of an asset, or the company that issues and monitors the asset.
When unsystematic risk occurs, it usually affects only one or a certain group of assets that are subject to assets with unsystematic risk.
For example: Unsystematic risks may occur to a business such as operation risk, competition, profit or financial risk of possible default, leading to the price of shares, or possibly the entire industry, to decline. However, such risks have less impact on the market as a whole than systemic risks.
In contrast with systematic risk, unsystematic risk can easily be prevented and reduced by portfolio diversification.
For example: A portfolio contains shares in different industries, such as Finance, Technology, Energy, Retail, etc.
When the Technology shares decrease, yet the Energy shares increase (such as during the first half of 2022), unsystematic risks have happened to Technology shares.
Since the Energy shares increased, the portfolio could avoid heavy losses with reasonable asset proportions.
How to identify risks in crypto
Crypto is also considered a financial asset, therefore, it is always possible for the aforementioned risks to happen.
In the crypto market, a sharp drop in the BTC and ETH price will impact all other coins. Therefore, it is reasonable to consider the risks associated with BTC and ETH as a kind of systemic risk to the entire crypto market.
Some examples of market-wide risks are as follows:
- Macro-related risks: Monetary policy from the Fed, geopolitical risks, legal risks, energy risks, weather risks (affecting miners), etc.
- Liquidity risks: Related to leveraged positions or collateralized BTC & ETH, etc.
- Blockchain technical risks.
- And so on.
Unsystematic risks in the crypto market include:
- Impermanent loss: This risk usually happens when providing liquidity.
- Slippage: When making swaps with high slippage, the actual amount that users receive may be less than expected.
- Smart contract: Due to smart contract error, assets might be vulnerable when sent to different platforms.
- Hacks/Exploits: Users may experience losses if they deposit on platforms with risks of being exploited.
- Phishing Attacks: Hackers may impersonate legitimate parties to steal assets from victims.
- And so on.
Risk measurement methods
Most crypto assets don't have enough historical price data for traditional risk measurement methods (like standard deviation) to be reliable, except for BTC or ETH. Therefore, it is difficult to have a definite method to measure risk accurately in the crypto market. Statistical methods are now commonly used to measure risks for token prices.
For example, the Bridge array is known to be more vulnerable to hacks or exploits. Therefore, statistical data must be collected to determine risks when investing in coins/tokens in this array.
Some basic statistics are:
Out of 70 bridge platforms, 8 hacks have happened (according to the above demo data), accounting for 11.4%. Therefore, when investing in the Bridge array tokens, the possibility of being hacked is 11.4%.
This number might decrease in the future as builders learn from previous mistakes.
It is worth noting that with every type of risk comes a different measurement and analyzation method. The crypto market is still young and is yet to have a scientifically approved method, therefore, continuous experimenting and evaluating is necessary to determine risks in this market.
Risk is one of the important factors to consider and evaluate regularly when investing in financial markets. When the specific risks are quantified, careful observation and monitoring can be given to better protect investment portfolios.