Risk, in the realm of finance, is defined as the probability of actual returns deviating from expected returns. The Capital Asset Pricing Model (CAPM) defines risk as the volatility of returns. Simply put, if you expect a 20% return on an investment after one year, but the actual return is 30% or 10%, risk has materialized.
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It’s important to understand that risk isn’t just about prices falling below expectations. Unexpected price surges, especially without a clear cause, also constitute risk. A prime example is a short squeeze, where massive liquidation of short positions causes a sharp price spike. This can indicate significant losses for a large entity, potentially triggering systemic consequences.
Quantifying Risk
As previously defined, risk can be measured by the degree of deviation from expected returns. Traditional risk assessment relies on historical data and is often calculated using the standard deviation of expected returns. A higher standard deviation indicates greater historical volatility, implying higher risk. The STDEV function in spreadsheet software like Google Sheets can be used to calculate standard deviation.
The example above (using Coinmarketcap data for daily returns of BTC and ETH from July 1st to August 9th) illustrates that ETH exhibited higher risk than BTC during this period, due to its higher standard deviation (0.05 vs. 0.03 for BTC). ETH’s standard deviation of 0.05 suggests its returns tend to fluctuate within approximately +/- 5% around its average return of 1.31% (during the specified period).
The Sharpe Ratio, calculated by dividing expected return by risk (standard deviation), provides a risk-adjusted measure of investment performance. In the example above, ETH had a higher Sharpe Ratio than BTC, indicating superior risk-adjusted performance during that period. This is a basic illustration of measuring return risk using historical data. In practice, numerous methods exist for risk assessment.
Importantly, standard deviation relies on past data, which may not accurately predict future volatility. This method is best suited for assets with extensive historical data. Furthermore, a comprehensive risk assessment should consider data across various events and time periods for a more nuanced understanding.
Systemic vs. Non-Systemic Risk
Two primary risk categories in investing are systemic risk and non-systemic risk.
Systemic Risk
Systemic risk, also known as market risk, impacts most or all of the market simultaneously, causing widespread price movements, typically downwards. These risks often stem from factors beyond the control of individuals or companies, including interest rate fluctuations, economic downturns, inflation, liquidity crises, and geopolitical events.
In the cryptocurrency market, the first half of 2022 exemplified systemic risk. The decline in cryptocurrency prices was largely attributed to macroeconomic factors like the Russia-Ukraine conflict, which fueled inflation, economic uncertainty, and ultimately, the Federal Reserve’s monetary tightening policies.
Mitigating systemic risk through diversification is challenging because it affects broad asset classes. The first half of 2022 saw declines in stocks, bonds, cryptocurrencies, and even cash due to inflationary pressures. While gold initially rallied 13.6% due to geopolitical tensions, its year-to-date return was only 0.2%.
During periods of systemic risk, careful portfolio monitoring, rebalancing, and consideration of short-term performance potential in specific assets (like gold) are crucial.
Non-Systemic Risk
Non-systemic risk originates from factors specific to an asset or the entity issuing or managing it. This type of risk typically affects only the specific asset or a related group, rather than the entire market. Examples include business risks, competition, profitability concerns, or financial distress leading to potential default. These risks can negatively impact a company’s stock price or even an entire industry but have less widespread market impact than systemic risks.
Unlike systemic risk, non-systemic risk can be mitigated through portfolio diversification. For instance, a diversified stock portfolio spanning various sectors (finance, technology, energy, retail) can offset losses in one sector with gains in another. The energy sector’s growth in the first half of 2022, while technology stocks declined, demonstrates this principle.
Assessing Risk in Cryptocurrency Investments
Common Cryptocurrency Risks
Cryptocurrencies, like traditional financial assets, are subject to both systemic and non-systemic risks. In the crypto market, significant price drops in Bitcoin and Ethereum often trigger broader market declines. Therefore, risks associated with BTC and ETH can be considered systemic for the entire crypto market. These include:
- Macroeconomic factors: Federal Reserve policies, geopolitical events, regulatory changes, energy concerns, and even weather impacting mining operations.
- Liquidity risk: Related to leveraged positions or using BTC/ETH as collateral for loans.
- Blockchain technical issues: Underlying platform vulnerabilities or disruptions.
Non-systemic risks in the crypto market include:
- Impermanent Loss: Potential losses when providing liquidity to decentralized exchanges.
- Slippage: Receiving less than the expected amount during a token swap due to price fluctuations.
- Smart Contract Risks: Vulnerabilities in smart contracts can expose assets to hacks or exploits.
- Hacking and Exploits: Loss of funds due to platform breaches.
- Phishing Attacks: Scams that trick users into revealing private keys or sensitive information.
Measuring Cryptocurrency Risk
Most cryptocurrencies lack sufficient historical price data (except for established assets like BTC and ETH) to rely on traditional statistical methods like standard deviation for accurate risk assessment. Therefore, quantifying risk in the crypto market often requires alternative approaches, such as statistical analysis of specific risk factors.
For example, when investing in bridge protocols, which are susceptible to hacks and exploits, analyzing historical hack data can provide insights into potential risks.
Basic metrics for analysis include:
With approximately 8 hacks out of over 70 bridge platforms (according to Quantstamp), the historical hack rate is around 11.4%. This suggests an approximate 11.4% probability of a bridge protocol being hacked based on past data. This figure may decrease as developers learn from previous incidents. Most hacked bridges lacked audits (per Rekt news). Statistical analysis reveals that post-hack:
- Nearly 100% of assets on the affected bridge are compromised (with rare exceptions like Ronin Bridge offering refunds).
- Within 7 days of a hack, token value typically declines by 10-90%.
- Longer-term price declines are also possible.
- Thorchain, due to the relatively small value hacked compared to its TVL, experienced price growth after a second hack. However, deeper analysis might reveal underlying risks.
This illustrates a method for estimating hack risk in bridge investments. Additional factors like the hack-to-TVL ratio at the time of the incident and price volatility across various timeframes can refine risk assessment.
Note: Different risk types in the crypto market require different analytical approaches. Due to the nascent nature of the crypto market, standardized risk assessment methodologies are still evolving. Continuous experimentation and analysis are crucial for navigating risks in this dynamic landscape.
Conclusion
Risk assessment is a cornerstone of sound financial decision-making. Quantifying and understanding various risk types allows for informed portfolio management and proactive responses to market events. By developing robust risk assessment frameworks, investors can navigate the complexities of financial markets and strive to achieve their investment objectives.
