Hi Friends,
Let’s recap the definition of Risk that I had given in my Blog Post – Risk Management.
“A Risk is any event that if happens can have a significant influence on execution”.
· if happens – amounts to the probability of happening – meaning it may happen or may not happen, but there is a likelihood of happening.
· Influence – amounts to impact on the execution.
Risk – An example –
In this blog, I will discuss Financial Risks.
What is a Financial Risk?
A financial risk is any risk associated with financing, with the potential for financial loss and uncertainty about its extent.
The term financial risk by itself is broad but can be understood better if we consider the different types of financial risks.
Types of Financial Risks
Financial risks can be categorized as follows –
Asset-backed Risk: The changes in one or more assets that support an asset-backed security will significantly impact the value of the supported security. For e.g. home loans. In order to finance home sales, banks issue bonds that serve as a debt obligation to its buyer. The buyer of the debt is essentially receiving the interest from the bank that the homebuyer is paying to it.
Credit Risk: A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments.
Liquidity Risk: The risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss or make the required profit.
Market Risk: Market risk is the risk of losses in positions arising from movements in market prices.
Operational Risk: The Basel II Committee defines operational risk as: "The risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events."
Financial Risks – Sub-categories
The risk categories, in turn, have several sub-categories, as depicted in the picture below.
Asset-backed risks include interest rate, term modification, and prepayment risk.
*Prepayment risk is the risk that the buyer goes ahead and pays off the mortgage. Therefore, the buyer of the bond loses the right to the buyer's interest payments over time.
*Interest rate risk refers an asset whose terms can change over time, such as a Variable Rate Mortgage payment.
A Credit risk can be of the following types:
*Credit default risk – The risk of loss arising from a debtor being unlikely to pay the loan obligations in full or the debtor is more than 90 days past due on any material credit obligation. Default risk may impact all credit-sensitive transactions, including loans, securities, and derivatives.
*Concentration risk – The risk associated with any single exposure or group of exposures with the potential to produce large enough losses to threaten a bank's core operations. It may arise in the form of single name concentration or industry concentration.
*Country risk – The risk of loss arising from a sovereign state freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk). This type of risk is prominently associated with the country's macroeconomic performance and its political stability.
Liquidity risk can be of the following:
*Asset liquidity - An asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of market risk.
*Funding liquidity - Risk that liabilities:
- Cannot be met when they fall due
- Can only be met at an uneconomic price
- Can be name-specific or system
The most commonly used types of Market risk are:
*Equity risk - the risk that stock or stock indices prices or their implied volatility will change.
*Interest rate risk - the risk that interest rates or their implied volatility will change.
*Currency risk - the risk that foreign exchange rates or their implied volatility will change.
*Commodity risk - the risk that commodity prices or their implied volatility will change.
Official Basel II types of Operational risks are the following:
*Internal Fraud – misappropriation of assets, tax evasion, intentional mismarking of positions, bribery.
*External Fraud – theft of information, hacking damage, third-party theft, and forgery
*Employment Practices and Workplace Safety – discrimination, workers’ compensation, employee health, and safety.
*Clients, Products, and Business Practice – market manipulation, antitrust, improper trade, product defects, fiduciary breaches, account churning.
*Damage to Physical Assets – natural disasters, terrorism, vandalism.
*Business Disruption and Systems Failures – utility disruptions, software failures, hardware failures.
*Execution, Delivery, and Process Management – data entry errors, accounting errors, failed mandatory reporting, negligent loss of client assets.
