Risk is the potential of loss (an undesirable outcome, however not necessarily so)
resulting from a given action, activity and/or inaction. The notion implies that a choice
having an influence on the outcome sometimes exists (or existed). Potential losses
themselves may also be called "risks". Whether it is investing, driving or just walking
down the street and even browsing the internet, everyone exposes themselves to risk.
Your personality and lifestyle play a big role in how much risk you are comfortably
able to take on. If you invest in stocks and have trouble sleeping at night, you are
probably taking on too much risk. Those of us who work hard for every penny we
earn have a hard time parting with money. Therefore, people with less disposable
income tend to be, by necessity, more risk averse. On the other end of the spectrum,
day traders feel that if they aren't making dozens of trades a day, there is a problem.
These people are risk lovers.
Every human endeavour carries some risk, but some are much riskier than others.
There is an element of Risk in everything that we do in order to survive but we will
concentrate our time and energy in discussing Risk in the Finance/Economics
context. There are different types of risks that an organization/firm/individual is
exposed to and needs to manage. Widely, risks can be classified into three types:
Business Risk, Non-Business Risk and Financial Risk. It is the last one which is
of our focus. When investing in stocks, bonds or any other investment instrument,
there is a lot more risk than you'd think.
Financial risk is an umbrella term for multiple types of risk associated with financing,
including financial transactions that include loans in risk of default. Risk is a term
often used to imply downside risk, meaning the uncertainty of a return and the
potential for financial loss. In finance, risk is the probability that the return achieved
on an investment will be different from that expected, and also takes into account the
size of the difference. This includes the possibility of losing some or all of the original
investment. Financial risk may be market-dependent, determined by numerous
market factors, or operational, resulting from fraudulent behaviour. Recent studies
suggest that testosterone level plays a major role in risk-taking in financial decisionmaking. A fundamental idea in finance is the relationship between risk and return
(modern portfolio theory). The greater the potential return one might seek, the greater
the risk that one generally assumes. A free market reflects this principle in the pricing
of an instrument: strong demand for a safer instrument drives its price higher (and its
return correspondingly lower) while weak demand for a riskier instrument drives its
price lower (and its potential return thereby higher).
Example: a Government bond is considered to be one of the safest investments and,
when compared to a corporate bond, provides a lower rate of return. The reason for
this is that a corporation is much more likely to go bankrupt than the government.
Because the risk of investing in a corporate bond is higher, investors are offered a
higher rate of return.
Financial markets are considered to be a proving ground for general methods of risk
assessment. However, these methods are also hard to understand. The
mathematical
difficulties
interfere
with
other
social
goods
such
as
disclosure, valuation and transparency. In particular, it is not always obvious if
such financial instruments are "hedging" (purchasing/selling a financial instrument
specifically to reduce or cancel out the risk in another investment) or "speculation"
(increasing measurable risk and exposing the investor to catastrophic loss in pursuit
of very high windfalls that increase expected value).
In financial markets, one may need to measure credit risk, information timing and
source risk, probability model risk, and legal risk if there are regulatory or civil actions
taken as a result of some "investor's regret". Knowing one's risk appetite in
conjunction with one's financial well-being are important.
Financial risk can be divided into the following broad categories but the ones which
are of most concern and also the most researched are Market Risk & Liquidity Risk.
Market risk
•
Equity risk
•
Interest rate risk
•
Currency risk
•
Commodity risk
•
Volatility risk
Liquidity Risk
•
Market liquidity risk
•
Funding liquidity risk
•
Refinancing risk
Credit risk
•
Credit default risk
•
Concentration risk
•
Country risk
•
Counterparty risk
Operational risk
•
Legal risk
•
Model risk
•
Political risk
•
Valuation risk
Settlement risk
Profit risk
Systemic risk
Market risk
The two major categories of investment risk are market risk and specific risk. Specific
risk, also called "unsystematic risk," is tied directly to the performance of a particular
security and can be protected against through investment diversification. One
example of unsystematic risk is that a company, whose stock you own will declare
bankruptcy, thus making your stock worthless.
Market risk is the risk that the value of an investment will decrease due to moves in
market factors. It is the possibility for an investor to experience losses due to factors
that affect the overall performance of the financial markets. Market risk, also called
"systematic risk," cannot be eliminated through diversification, though it can be
hedged against. The risk that a major natural disaster will cause a decline in the
market as a whole is an example of market risk. Other sources of market risk include
recessions, political turmoil, changes in interest rates and terrorist attacks.
Market risk is typically measured using a Value at Risk methodology. It is the most
popular, and also the most vilified lately, risk measurement technique. There are
different types of VaR - Long Term VaR, Marginal VaR, Factor VaR and Shock
VaR. The latter is used in measuring risk during the extreme market stress conditions.
Value at risk is well established as a risk management technique, but it contains a
number of limiting assumptions that constrain its accuracy. The first assumption is
that the composition of the portfolio measured remains unchanged over the single
period of the model. For short time horizons, this limiting assumption is often
regarded as acceptable. For longer time horizons, many of the transactions in the
portfolio may mature during the modelling period. Intervening cash flow, embedded
options, changes in floating rate interest rates, and so on are ignored in this single
period modelling technique.
Market risk can also be contrasted with Specific risk, which measures the risk of a
decrease in ones investment due to a change in a specific industry or sector, as
opposed to a market-wide move. Volatility frequently refers to the standard deviation
of the change in value of a financial instrument with a specific time horizon. It is often
used to quantify the risk of the instrument over that time period. Volatility is typically
expressed in annualized terms, and it may either be an absolute number ($5) or a
fraction of the initial value (5%).
Classification of Market risk
•
Equity risk, the risk that stock or stock indices (e.g. Nifty, Sensex etc. )
prices and/or their implied volatility will change. It implies that one's
investments will depreciate because of stock market dynamics causing one to
lose money. The measure of risk used in the equity markets is typically the
standard deviation of a security's price over a number of periods. The
standard deviation will delineate the normal fluctuations one can expect in
that particular security above and below the mean, or average. However,
since most investors would not consider fluctuations above the average return
as "risk", some economists prefer other means of measuring it.
•
Interest rate risk, the risk that interest rates and/or their implied volatility will
change. It is risk to the earnings or market value of a portfolio due to
uncertain future interest rates. Discussions of interest rate risk can be
confusing because there are two fundamentally different ways of approaching
the topic. People who are accustomed to one often have difficulty grasping
the other. The two perspectives are: a book value perspective, which
perceives risk in terms of its effect on accounting earnings, and a market
value perspective - sometimes called an economic perspective - which
perceives risk in terms of its effect on the market value of a portfolio. The first
perspective is typical in insurance and corporate treasuries, where book value
accounting prevails. The latter is typical in a trading or investment
management context.
•
Currency risk, the risk that foreign exchange rates (e.g INR/USD, INR/EUR
etc.) and/or their implied volatility will change. It is a financial risk posed by an
exposure
to
unanticipated
changes
in
the
exchange
rate between
two currencies. Investors and multinational businesses exporting or importing
goods and services or making foreign investments throughout the global
economy are faced with an exchange rate risk which can have severe
financial consequences if not managed. Various types of Exposure Transaction Exposure, Economic Exposure (also known as operating
exposure), Translation Exposure and Contingent exposure
•
Commodity risk, the risk that commodity prices (e.g. Crude, Copper,
Aluminium etc.) and/or their implied volatility will change. Commodity
risk refers to the uncertainties of future market values and of the size of the
future income, caused by the fluctuation in the prices of commodities. These
commodities
may
be grains, metals, gas, electricity etc.
A
commodity
enterprise needs to deal with the following kinds of risks - Price risk, Quantity
risk, Cost risk and Political risk
•
Volatility risk is the risk of a change of price of a portfolio as a result of
changes in the volatility of a risk factor. It usually applies to portfolios of
derivatives instruments, where the volatility of its underlyings is a major
influencer of prices.
Liquidity risk
It is the risk that a, company or bank may be unable to meet short term financial
demands. This usually occurs due to the inability to convert a security or hard
asset to cash without a loss of capital and/or income in the process.
Liquidity risk generally arises when a business or individual with immediate cash
needs, holds a valuable asset that it can not trade or sell at market value due to a
lack of buyers, or due to an inefficient market where it is difficult to bring buyers and
sellers together. Purchasers and owners of long term assets must take into account
the saleability of assets when considering their own short term cash needs. Assets
that are difficult to sell in an illiquid market carry a liquidity risk since they can not be
easily converted to cash at a time of need. Liquidity risk may lower the value of
certain assets or businesses due to the increased potential of capital loss.
Types of liquidity risk
•
Market liquidity – An asset cannot be sold due to lack of liquidity in the
market – essentially a sub-set of market risk. This can be accounted for by:
Widening bid/offer spread
Making explicit liquidity reserves
Lengthening holding period for VaR calculations
•
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 systemic
For example, consider a Rs.50,00,00,000 home in Mumbai with no buyers. The
home obviously has value, but due to market conditions at the time, there may be no
interested buyers. In better economic times when market conditions improve and
demand increases, the house may sell for well above that price. However, due to the
home owner’s need of cash to meet near term financial demands, the owner may be
unable to wait and have no other choice but to sell the house in an illiquid market at a
significant loss. Hence, the liquidity risk of holding this asset.
Refinancing risk (Sub-set of Liquidity risk)
Probability that a bank will not be able to
1. Refinance maturing deposits, liabilities, and/or
2. if they are refinanced, the maturity and interest rate of the financing will
adversely affect net interest income.
In banking and finance, refinancing risk is the possibility that a borrower cannot
refinance by borrowing to repay existing debt. Many types of commercial lending
incorporate balloon payments at the point of final maturity; often, the intention or
assumption is that the borrower will take out a new loan to pay the existing lenders.
A borrower that cannot refinance their existing debt and does not have sufficient
funds on hand to pay their lenders may have a liquidity problem. The borrower may
be considered technically insolvent: even though their assets are greater than their
liabilities, they cannot raise the liquid funds to pay their creditors. Insolvency may
lead to bankruptcy, even when the borrower has a positive net worth.
In order to repay the debt at maturity, the borrower that cannot refinance may be
forced into a fire sale of assets at a low price, including the borrower's own home and
productive assets such as factories and plants. Most large corporations and
banks face this risk to some degree, as they may constantly borrow and repay loans.
Refinancing risk increases in periods of rising interest rates, when the borrower may
not have sufficient income to afford the interest rate on a new loan.
Most commercial banks provide long term loans, and fund this operation by taking
shorter term deposits. In general, refinancing risk is only considered to be substantial
for banks in cases of financial crisis, when borrowing funds, such as inter-bank
deposits, may be extremely difficult.
Refinancing is also known as “rolling over” debt of various maturities, and so
refinancing risk may be referred to as rollover risk.
Credit Risk
The risk of loss of principal or loss of a financial reward stemming from a borrower's
failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises
whenever a borrower is expecting to use future cash flows to pay a current debt.
Investors are compensated for assuming credit risk by way of interest payments from
the borrower or issuer of a debt obligation. Credit risk is closely tied to the potential
return of an investment, the most notable being that the yields on bonds correlate
strongly to their perceived credit risk.
The higher the perceived credit risk, the higher the rate of interest that investors will
demand for lending their capital. Credit risks are calculated based on the borrowers'
overall ability to repay. This calculation includes the borrowers' collateral assets,
revenue-generating ability and taxing authority (such as for government and
municipal bonds). Credit risks are a vital component of fixed-income investing, which
is why ratings agencies such as S&P, Moody's and Fitch evaluate the credit risks of
thousands of corporate issuers, municipalities and sovereigns on an ongoing basis.
While the definition of credit risk may be straight forward, measuring it is
not. Many factors can influence an issuer's credit risk and in varying degrees. Some
examples are poor or falling cash flow from operations (which is often needed to
make the interest and principal payments), rising interest rates (if the bonds are
floating-rate notes, rising interest rates increase the required interest payments), or
changes in the nature of the marketplace that adversely affect the issuer (such as a
change in technology, an increase in competitors, or regulatory changes). The credit
risk associated with foreign bonds also includes the home country's socio-political
situation
and
the
stability
and
regulatory
practices
of
its
government.
Ratings agencies like Fitch, Moody's and Standard & Poor's analyze bond offerings
in an effort to measure an issuer's credit risk on a particular security. Their results are
published as ratings that investors can track and compare with other issuers.
S&P's ratings range from AAA (the most secure) to D, which means the issuer is
already in default. Moody's ratings go from AAA to C. Only bonds rated BBB or better
are considered "investment grade." Bonds rated below BBB- or BAA3 are considered
"junk."
Credit risk is one of the most fundamental types of risk. After all, it represents the
chance the investor will lose his or her investment. All bonds, except for those issued
by the government, carry some credit risk. The loss may be complete or partial and
can arise in a number of circumstances.
Examples of Credit Risk
•
A consumer may fail to make a payment due on a mortgage loan, credit
card, line of credit, or other loan
•
A company is unable to repay amounts secured by a fixed or floating
charge over the assets of the company
•
A business or consumer does not pay a trade invoice when due
•
A business does not pay an employee's earned wages when due
•
A business or government bond issuer does not make a payment on
a coupon or principal payment when due
•
An insolvent insurance company does not pay a policy obligation
•
An insolvent bank won't return funds to a depositor
•
A government grants bankruptcy protection to an insolvent consumer or
business
Classification of credit risk
•
Credit default risk - The risk of loss arising from a debtor being unlikely to
pay its 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. There are two types of concentration risk. These
types are based on the sources of the risk. Concentration risk can arise from
uneven distribution of exposures (or loan) to its borrowers. Such a risk is
called Name Concentration risk. Another type is Sectoral Concentration
risk which can arise from uneven distribution of exposures to particular
sectors, regions, industries or products.
•
Country risk/ Sovereign 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. Sovereign risk is the risk of a government becoming unwilling or
unable to meet its loan obligations, or reneging on loans it guarantees. Many
countries have faced sovereign risk in the late-2000s global recession. The
existence of such risk means that creditors should take a two-stage decision
process when deciding to lend to a firm based in a foreign country. Firstly one
should consider the sovereign risk quality of the country and then consider
the firm's credit quality. Five macroeconomic variables that affect the
probability of sovereign debt default/rescheduling are:
Debt service ratio
Import ratio
Investment ratio
Variance of export revenue
Domestic money supply growth
•
Counterparty risk - A counterparty risk, also known as a default risk, is a risk
that a counterparty will not pay what it is obligated to do on a bond, credit
derivative, trade credit insurance or payment protection insurance contract, or
other trade or transaction when it is supposed to. Financial institutions
may hedge or take out credit insurance of some sort with a counterparty,
which may find themselves unable to pay when required to do so, either due
to temporary liquidity issues or longer term systemic reasons.
Operational Risk
A form of risk that summarizes the risks a company or firm undertakes when it
attempts to operate within a given field or industry. Operational risk is the risk that is
not inherent in financial, systematic or market-wide risk. It is the risk remaining after
determining financing and systematic risk, and includes risks resulting from
breakdowns in internal procedures, people and systems. Operational risk can be
summarized as human risk; it is the risk of business operations failing due to human
error. Operational risk will change from industry to industry, and is an important
consideration to make when looking at potential investment decisions. Industries with
lower human interaction are likely to have lower 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." However, the Basel Committee recognizes that operational risk is a term
that has a variety of meanings and therefore, for internal purposes, banks are
permitted to adopt their own definitions of operational risk, provided that the minimum
elements in the Committee's definition are included.
Types of Operational risk
•
Legal risk – is a risk of loss that results from a counterparty being unable to
legally enter into a contract. Another legal risk relates to regulatory risk, i.e.,
that a transaction could conflict with a regulator's policy or, more generally,
that legislation might change during the life of a financial contract. The Risk
Principle is an area of law closely tied to legal causation in negligence. It
provides limits on negligence for harm caused unforeseeably.
•
Model risk - In finance, model risk is the risk of loss resulting from using
models to make decisions, initially and frequently referring to valuing financial
securities. However model risk is more and more prevalent in industries other
than financial securities valuation, such as consumer credit score, real-time
probability prediction of a fraudulent credit card transaction to the probability
of air flight passenger being a terrorist.
•
Political risk - is the risk of financial, market or personnel losses because of
political decisions or disruptions. Also known as "geopolitical risk." There are
many environmental factors facing business. Besides market-based causes,
business can be affected by political decisions or changes. Political decisions
by governmental leaders about taxes, currency valuation, trade tariffs or
barriers, investment, wage levels, labor laws, environmental regulations and
development priorities, can affect the business conditions and profitability.
Similarly, non-economic factors can affect a business. For example, political
disruptions such as terrorism, riots, coups, civil wars, international wars, and
even political elections that may change the ruling government, can
dramatically affect businesses’ ability to operate.
Political risks are faced equally by investors in international businesses and
investment fund portfolios. These political risks are part of the estimation and
disclosure
of
risk
factors,
usually
found
in
a
company
or
portfolio's prospectus. Political risk can affect the operations and profitability
of a business as directly and quickly as any financial, physical, or market
risk factor. The impact of political risk is considered to be long-term because
the risk rises over time, given the greater potential for events and changes
over time. Although political risk is extremely difficult to quantify, companies
and investors must examine and understand the potential for political risks by
closely examining the location's history, political institutions, and political
forces at work in the region. There are both macro- and micro-level political
risks. Macro-level political risks have similar impacts across all foreign actors
in a given location. While these are included in country risk analysis, it would
be incorrect to equate macro-level political risk analysis with country risk as
country risk only looks at national-level risks and also includes financial and
economic risks. Micro-level risks focus on sector, firm, or project specific risk.
•
Valuation Risk - is the financial risk that an asset is overvalued and is worth
less than expected when it matures or is sold. Factors contributing to
valuation risk can include incomplete data, market instability, financial
modelling uncertainties and poor data analysis by the people responsible for
determining the value of the asset. This risk can be a concern for investors,
lenders, financial regulators and other people involved in the financial markets.
Overvalued assets can create losses for their owners and lead to reputational
risks; potentially impacting credit ratings, funding.
•
Reputational risk, often called reputation risk, is a risk of loss resulting from
damages to a firm's reputation, in lost revenue or destruction of shareholder
value, even if the company is not found guilty of a crime. Reputational risk
can be a matter of corporate trust, but serves also as a tool in crisis
prevention. This type of risk can be informational in nature that may be
difficult to realize financially. Extreme cases may even lead to bankruptcy (as
in the case of Arthur Andersen). Recent examples of companies include:
Toyota, Goldman Sachs, Oracle Corporation, NatWest and BP.
Few other risk types under Financial Risk
Settlement risk - It is the risk that a counterparty does not deliver a security
or its value in cash as per agreement when the security was traded after the
other counterparty or counterparties have already delivered security or cash
value as per the trade agreement. Settlement risk is inherent in any
transaction between two parties. In the event one party does not uphold their
obligations in a transaction, it represents a loss on the part of the other party.
For this reason, settlement risk is the risk of loss for either party should the
counterparty not come through. The recent example is of NSEL.
Profit Risk - When a company’s earnings are derived from a limited number
of customer accounts, products, markets, delivery channels (e.g., branches/
stores/other delivery points), and/or salespeople, these concentrations result
in significant net income risk that can be quantified. A loss of just a handful of
customer accounts, a loss of a limited number of products, a loss of a select
market, a loss of a small number of delivery channels, and/or a loss of a few
salespeople can result in significant net income volatility. At this stage,
income loss risk is present and the company has reached a level of profit risk
that is unhealthy for sustaining net income. The method for quantifying and
assessing this potential income loss risk and the volatility that it creates to the
company’s income statement is profit risk measurement and management.
For
financial
institutions,
profit
risk
management
is
similar
to
the diversification strategies commonly used for investment asset allocations,
real estate diversification, and other portfolio risk management techniques.
Systemic risk - In finance, systemic risk is the risk of collapse of an entire
financial system or entire market, as opposed to risk associated with any one
individual entity, group or component of a system. It can be defined as
"financial system instability, potentially catastrophic, caused or exacerbated
by idiosyncratic events or conditions in financial intermediaries". It refers to
the risks imposed by inter-linkages and interdependencies in a system or
market, where the failure of a single entity or cluster of entities can cause
a cascading failure, which could potentially bankrupt or bring down the entire
system or market. It is also sometimes erroneously referred to as "systematic
risk".
Systemic risk has been compared to a bank run which has a cascading
effect on other banks which are owed money by the first bank in trouble,
causing a cascading failure. As depositors sense the ripple effects of default,
and liquidity concerns cascade through money markets, a panic can spread
through a market, with a sudden flight to quality, creating many sellers but few
buyers for illiquid assets. These inter-linkages and the potential "clustering"
of bank runs are the issues which policy makers consider when addressing
the issue of protecting a system against systemic risk. In simple English, this
means that some companies are viewed as too big and too interconnected to
fail. Policy makers frequently claim that they are concerned about protecting
the