Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that

include company loans in risk of default.[1][2] Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss.
[3][4]

A science has evolved around managing market and financial risk under the general title of modern portfolio theory initiated by Dr. Harry Markowitz in 1952 with his article, "Portfolio Selection".[5]
Contents
[hide]

o o o o o o o

1 Types of risk 1.1 Asset-backed risk 1.2 Credit risk 1.3 Foreign investment risk 1.4 Liquidity risk 1.5 Market risk 1.6 Operational risk 1.7 Model risk 2 Diversification 3 Hedging 4 Financial / Credit risk related acronyms 5 See also 6 References

[edit]Types

of risk
risk

[edit]Asset-backed

Risk that the changes in one or more assets that support an asset-backed security will significantly impact the value of the supported security. Risks include interest rate, term modification, andprepayment risk. [edit]Credit

risk

Main article: Credit risk Credit risk, also called default risk, is the risk associated with a borrower going into default (not making payments as promised). Investor losses include lost principal and interest, decreased cash flow, and increased collection costs. An investor can also assume credit risk through direct or indirect use of leverage. For example, an investor may purchase an investment using margin. Or an investment may directly or indirectly use or rely on repo, forward commitment, or derivativeinstruments.

Investment risk has been shown to be particularly large and particularly damaging for very large, one-off investment projects, so-called "megaprojects". This is because such projects are especially prone to end up in what has been called the "debt trap," i.e., a situation where due to cost overruns, schedule delays, etc. the costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the debt.[6] [edit]Foreign

investment risk

Risk of rapid and extreme changes in value due to: smaller markets; differing accounting, reporting, or auditing standards; nationalization,expropriation or confiscatory taxation; economic conflict; or political or diplomatic changes. Valuation, liquidity, and regulatory issues may also add to foreign investment risk. [edit]Liquidity

risk

Main article: Liquidity risk See also: Liquidity This is 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). There are two types of liquidity risk: Asset 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: [edit]Market Widening bid-offer spread Making explicit liquidity reserves Lengthening holding period for VaR calculations Cannot be met when they fall due Can only be met at an uneconomic price Can be name-specific or systemic

Funding liquidity - Risk that liabilities:

risk

Main article: Market risk This is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices: Equity risk is the risk that stock prices in general (not related to a particular company or industry) or the implied volatility will change. Interest rate risk is the risk that interest rates or the implied volatility will change. Currency risk is the risk that foreign exchange rates or the implied volatility will change, which affects, for example, the value of an asset held in that currency. Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) or implied volatility will change.

[edit]Operational

risk

Main article: Operational risk Reputational risk Legal risk IT risk

[edit]Model

risk

Main article: Model risk [edit]Diversification Main article: Diversification (finance) Financial risk, market risk, and even inflation risk, can at least partially be moderated by forms of diversification. The returns from different assets are highly unlikely to be perfectly correlated and the correlation may sometimes be negative. For instance, an increase in the price of oil will often favour a company that produces it,[7] but negatively impact the business of a firm such an airline whose variable costs are heavily based upon fuel.[8] However, share prices are driven by many factors, such as the general health of the economy which will increase the correlation and reduce the benefit of diversification. If one constructs a portfolio by including a wide variety of equities, it will tend to exhibit the same risk and return characteristics as the market as a whole, which many investors see as an attractive prospect, so that Index Funds have been developed that invest in equities in proportion to the weighting they have in some well known index such as the FTSE. However, history shows that even over substantial periods of time there is a wide range of returns that an index fund may experience; so an index fund by itself is not "fully diversified". Greater diversification can be obtained by diversifying across asset classes; for instance a portfolio of many bonds and many equities can be constructed in order to further narrow the dispersion of possible portfolio outcomes. A key issue in diversification is the correlation between assets, the benefits increasing with lower correlation. However this is not an observable quantity, since the future return on any asset can never be known with complete certainty. This was a serious issue in the Late-2000s recession when assets that had previously had small or even negative correlations[9] suddenly starting moving in the same direction causing severe financial stress to market participants who had believed that their diversification would protect them against any plausible market conditions, including funds that had been explicitly set up to avoid being affected in this way [10] Diversification has costs. Correlations must be identified and understood, and since they are not constant it may be necessary to rebalance the portfolio which incurs transaction costs due to buying and selling assets. The is also the risk that as an investor or fund manager diversifies their ability to monitor and understand the assets may decline leading to the possibility of losses due to poor decisions or unforeseen correlations. [edit]Hedging

Hedging is a method for reducing risk where a combination of assets are selected to offset the movements of each other. For instance when investing in a stock it is possible to buy an option to sell that stock at a defined price at some point in the future. The combined portfolio of stock and option is now much less likely to move below a given value. As in diversification there is a cost, this time in buying the option for which there is a premium. [edit]Financial

/ Credit risk related acronyms

ACPM Active credit portfolio management EAD Exposure at default EL Expected loss ERM Enterprise risk management LGD Loss given default PD Probability of default KMV quantitative credit analysis solution developed by credit rating agency Moody's VaR value at risk, a common methodology for measuring risk due to market movements

Definition
The probability of loss inherent in financing methods which may impair the ability to provide adequate return. Read more: http://www.businessdictionary.com/definition/financial-risk.html#ixzz1tV7cldqy

Issues in financial risk management

By H. Jamal Zubairi | From InpaperMagzine | 18th October, 2010

0
This article focuses on issues pertaining to risk management in the context of financial assets which give rise to variability or deviation in the expected return. Financial assets represent claims to ownership/cash/income as in the case of share certificates, or debt instruments like bonds, term finance certificates (TFCs) and government securities. The evidence of ownership or creditorship is now increasingly available only as an electronic entry to an account on a computer system. People are generally said to be risk averse. But is it possible to find an investment which is completely free from risk? The answer is a firm no! Why? Because a completely risk free investment would be one which would repay at a future date, an amount equivalent in purchasing power to that represented by the amount originally invested. For this to happen, two necessary conditions should be complied:

(i) The promised amount is actually paid i.e. there is no chance of default; (ii).an additional amount is also paid, if required, to compensate for decline in purchasing power, measured in terms of the price index of the consumption basket of the investor. When the issuer of security is a sovereign government empowered to print currency, condition No (i) can usually be met but no issuer of a security would perhaps ever be able to offer anything close to what condition No. (ii) represents. Investment options and risks: Individual investors have the following investment options available: short to medium-term and long-term government securities; various short to long-term deposit schemes, COIs etc offered by commercial banks and non-banking financial institutions (NBFI`s); stock market shares; long and short-term finance certificates; real estate; gold, silver and precious stones and foreign currencies. How can an investor minimise the investment risk? The main option currently appears to be diversification of investments because hedging devices like derivatives are not available in our markets. Moreover, derivatives like options and futures are considered to be un-Islamic. Diversification however, is not very effective in the case of small investors with limited funds. Thus the need to be satisfied with a relatively low return by investing a certain percentage (depending on their appetite for risk) of their funds in low risk government securities. Institutional investors can do the same and generally their average return on investment should be higher than that of the individual investors, given their greater ability to take risk. In the short run, diversification appears to be the main risk minimisation tool, with an important income smoothening role being played by the government securities. How ever, in the long run, effective regulatory intervention to minimise the manipulation component of the risk would be the key, followed by development of debt instruments conforming to the Shariah. Secondary market for debt instruments: Presently about 685 companies are listed on the Karachi Stock Exchange. However, the secondary market for shares is far more developed than the market for debt instruments, with less than five per cent of listed companies currently having debt securities listed on the Karachi Stock Exchange. The listed debt securities are term finance certificates (TFCs) and Sukuks (Islamic bonds), which are equivalent to bonds traded worldwide on security exchanges. It is pertinent to examine the inhibiting factors for issuance of debt securities by companies. After all, there can be no secondary debt market development without the primary market first being firmly in saddle. The matter can be examined both from the prospective holders (buyers) of TFCs and from the issuers viewpoint. The two main categories of buyers of TFCs are individual investors and institutional investors. Individual investors belonging to the segment of

retired salaried employees generally do not have a significant capacity to face the risk of default. Thus, they have traditionally favoured the National Savings Schemes. The monthly income scheme and special saving certificates (offering six monthly returns with a three-year maturity) are popular for providing regular near risk free income. The Defence Savings Certificates, with maturities up to ten years give an option for long-term capital appreciation for people who can afford to set aside some amount for the long term but are not willing to take the risk of default. The rate of return on these schemes has not been able to keep pace with the rate of inflation. The government would like to restrict the cost of borrowing. Realising that the risk taking ability of a majority of individual investor is low, the government perhaps does not foresee a significant fall in deposits into its saving schemes, despite the lowering of returns. This has really hit the individual investor hard, particularly the retired salaried class. This category of people would be keen to invest at least a portion of their funds in TFCs, if the promised yield is even 2-3 percentage points more than government schemes. This class is the least likely to subject, even a part of their life time savings, to the volatility of our stock exchanges. Private limited and public limited companies would also be interested to varying degrees in picking up TFCs. This is the type of investment, which can serve to smoothen the fluctuations in a company`s earnings. The extent of interest of any company in such investments would of course depend upon its cash flow pattern, liquidity and reserves position, its stage of development i.e. whether it has vertical or horizontal growth opportunities still available or its products or services are at the maturity stage, the tax implications of its earnings on TFCs etc. Apparently, the companies generally would be interested in investing some portion of their earnings in debt instruments like TFCs and with a higher capacity to take risks as compared to individual investors. However, they have to be reasonably sure that the secondary market is sufficiently developed to give them comfort on the liquidity aspect of the investments. This is important because while the individual investor would also be interested in assured return and liquidity, the corporate investor would place a much higher premium on liquidity. For instance, no company having a seasonal requirement of funds, say for purchase of raw material, would like to be in a situation where it has investments in hand which it cannot quickly convert into cash at the time of need. From the TFC issuing company`s viewpoint, the following matters need to be considered: * Will it be easier to get a loan from the banking system or to issue a TFC?

* Would the effective cost of funds be lower if TFC financing is resorted to rather than going for a loan from a bank or a consortium of banks? * Should the company go for rating of their TFC issue? What if it gets a poor rating? * If the TFC issue is under-subscribed, what implications will it hold for continuance of the company as a going concern? * Is the government supportive in promoting the growth of TFCs or is it applying brakes to restrict their issuance? During the first six months of 1998, a number TFC issues were under active processing and the chances of development of secondary markets appeared bright, with the major brokerage houses gearing themselves to play the role of market makers and reputed foreign banks as well local DFIs teaming up to underwrite their public issues. However, the feverish activity going on at that time suddenly came to a grinding halt when the government decided to withdraw the tax exemption facility on income from TFCs, previously applicable to corporate TFC investors. Another limiting factor was that for companies with good standing, who had the opportunity to raise funds through the banking system, the TFC option did not entail a significant advantage in terms of the effective borrowing cost after accounting for the public floatation costs, rating cost, private placement and underwriting commissions etc. The same would more or less hold true today. What prompted government`s action which virtually killed the TFCs market? Perhaps the government apprehended that if the TFCs market developed too fast, the individual investor might tilt towards it and thereby the government may lose a substantial part of its major source of public debt i.e. investment in its national savings schemes. It also appears that the underwriting institutions were unable to generate sufficient public interest in the TFCs. Perhaps the public also perceived the default risk to be high, given the history of bank loan defaults. Foreign investment in the TFCs has been virtually absent. Apparently due to a high degree of perceived sovereign risk of Pakistan, high default risk, as well as foreign exchange risk of rupee denominated TFCs. Presently, it seems that the debt securities market would not pick up much until the Sukuk market picks up momentum. However, an enabling regulatory framework, though necessary, will not be sufficient to provide a fillip to the debt market. It is also essential that the economy should pick up and generate requirement for long term debt funds. Risk management practices : In order to have an idea about how the brokerage houses play their risk management role, relative to their own risk and that of their clients, a questionnaire was circulated amongst 26

registered corporate members of the Karachi Stock Exchange. Only nine responses were received but still they have been helpful in understanding, how the brokerage houses view risk, the risks they handle and what technologies they employ. The main operating income of brokerage houses is through commission they earn on buying/selling on behalf of their clients. Usually they do not buy/sell on their own account but whenever they do, the earnings or losses would be classified as `other income / (loss)`. In other words, exposing their own funds to stock market risk is not the usual operating activity of the brokerage houses Risk management by brokerage houses can be divided into the following main parts: * Default risk i.e. the risk that a client fails to settle payment against a transaction undertaken by the brokerage house on its behalf, on the backing of a margin account * Investment risk of clients Discussions with brokerage house executives reveal that brokerage houses do not generally ask for margin deposits from institutional clients, as chances of default are not considered significant. However, in the case of small clients or individuals, brokerage houses do operate on margins. Based on the judgment of risk involved, such clients are required to maintain a minimum margin, with the brokerage house. This normally ranges between 2530 per cent of the amount of total exposure taken by the brokerage house, on behalf of a client. In effect the margin percentage reflects the brokerage houses` assessment of the maximum price erosion during the normal settlement period of one week. Should default occur, the brokerage house has the option to sell the shares at the reduced market price and use the margin to cover its loss. In the case of investment risk of its client, the risk has to be borne entirely by the clients because it is their funds which have been invested. However, as investment advisors, it is the moral and professional obligation of brokerage houses to give the best possible advice and help manage the clients` risk. Thus, although the brokerage house is not directly exposed to investment risk, it faces the risk of losing reputation and clients, should its advice turn out to be wrong too often. From the responses received to the questionnaire circulated amongst brokerage houses, it is gathered that a majority of them are using sophisticated customised computer software. Only one out of nine respondents has indicated that they do not use any computer software for risk management purposes. Computer software is used both for monitoring the margin maintenance of clients and for undertaking technical/fundamental analyses of specific companies and sectors.

As for risk minimisation options used by the brokerage houses, it was not at all surprising that all the respondents believe in diversification and advise their clients to diversify their investments across companies, as well as across industrial sectors. However, it was surprising that only one of the respondents has indicated hedging as a tool being used for minimising investment risk. Apparently most of the brokerage houses believe that there are no hedging instruments currently available in the financial system. Six out of nine respondents say that no hedging instruments exist. However, three of the respondents regard TFCs as a hedging instrument from the point of view of capital preservation and providing a minimum stable income component to a balanced portfolio. These respondents have mentioned one or more out of following as hedging instruments, besides TFCs: (the use of these instruments remains very limited, however). National Saving Certificates, high return deposit accounts, Certificates of Investments (COIs), foreign currency accounts, treasury bills and Pakistan Investment Bonds (PIBs).

Managing financial risks

As financial services firms adopt new product lines, enter new markets and lose the protection of traditional industry barriers, managing risk has become a major concern. In today's financial markets, many firms offer products and services that cross what had once been traditional boundaries. As a result, they must now managedefault, interest-rate and market risks as well as risks associated with liquidity and operations. To address such wide-ranging risks, financial services firms now require new business practices in order to control, transfer and profitably manage the broader risks they now regularly assume. To help identify those practices, the Center has sent faculty researchers and doctoral students into the field to analyze the current risk systems of commercial banks, investment firms and insurance companies. Key studies, forums and programs The Center has offered its initial risk management findings to the industry in a status report on risk management system implementation. In addition, key researchers led by Anthony Santomero, former Center director, have discussed these findings in forums with industry leaders, federal regulators and other interested parties. For some of the research findings, please see our Working Papers The Place of Risk Management in Financial Institutions andCommercial Bank Risk Management: An Analysis of the Process. Among its findings, the research team found that risk management practices within specific industry sectors were seen to be uneven, at best, and there is even wider variation across the industry as a whole. Subsequent discussion with industry practitioners and regulators has led to significant improvement of the industry's risk management practices. The Center's has also hosted a number of academic conferences on risk management, focusing

specifically on the insurance and bankingsectors. The series has drawn leading scholars and practitioners from around the world to examine new frontiers in risk theory and practice. In yet another initiative, the Center has joined with consumer lending executives to forge a multiyear investigation of retail credit. The study's topics include analyses of credit availability, its impact on the economy, the causes and effects of personal bankruptcy, and the public policy implications surrounding these issues. The Center is also conducting an annual Financial Risk Management Roundtables series cosponsored with Oliver, Wyman & Co. that focuses on trading risk management and measurement. The Roundtable brings together leading academics and practitioners to examine current issues related to risk management in highly complex, global trading environments. Topics addressed during past Roundtables include: market contagion and crisis management the legal implications of measuring and managing global financial risk modeling crash probabilities using scaling to convert from short- to long-horizon volatility mechanisms for adequate risk-adjusted performance measurement compensation and methodologies for measuring market estimates of asset risk creating value in the life insurance industry innovation and risk management in real estate markets model governance and model validation liquidity risk management in crisis conditions managing credit risk after the sub-prime lending crisis

Through discussions on such topics, the Financial Risk Management Roundtables are fulfilling their goal to explore new trading risk frontiers and to question existing risk measuring methodologies in light of available empirical evidence.

5 types of financial risk that every human must know

June 9th, 2009wiseinvestorLeave a commentGo to comments If you're new here, you may want to subscribe to my RSS feed. Thanks for visiting! When it comes to saving, consuming and investing, or simply life itself, risk is often a much talk about word. Let us now break down risk into 5 types that everyone of us face, even if you are a citizen of a third world country. 1. Inflation Risk We all know what Zimbabwe is famous for. Rising prices for consumer goods will eventually reduce the purchasing power of dollars. There are some items that you need to buy now, like a good vacation during prime time of life like 20s and 30s, instead of waiting until 70 years old.

Because the cost of going for a vacation to the same place will definitely increase 40 years later, not to mention the fact that you may get rammed over by a car the next day so that your relatives can go for holidays at exotic locations after inheriting what you have left. But for the purchasing of personal computers, one should only buy it later, as and when it is necessary. This is simply because the same $2000 one year later can buy a computer with double the processor speed, memory and hard drive space, etc. 2. Income Risk If you know that you are someone who is not good in interpersonal skills and work capabilities is also not that outstanding either. Then you do face a higher risk of losing your job and earned income. Or that realize the fact that age is catching up and you know that you are not really indispensable to the whole company, then one also need to prepare for that day of being fired and/or retrenched which is another better sounding word for fired. 3. Liquidity Risk Liquidity risk is simply the loss in value when converting assets into cash within a short notice. Real estate and properties have a higher liquidity risk than stocks and fixed deposits. If a house is worth $1 million and need to be sold and converted into cash within the next few days, there is a good chance that you wont be able to find someone who can buy your house for $1 million in the next few days. But if you sell it at a price of $10, you know that you can quickly find a buyer but there is significantly lost in value. That is liquidity risk. 4. Interest Rate Risk As an ordinary person, without the wealth of Buffet, one does need to burrow when buying cars and save in certificates of deposits for a rainy day. Changing interest rates will affect your interest for good or worse. For example, placing cash in fixed deposits when interest rate is low reduces return. But burrowing money at low interest rate means that you are paying less interest on your debt. 5. Personal Risk This is what an individual does and his habits that can affect their financial standing now and in future. It is hard for a hard core gambler and smoker to change their costly habits. This basically results in much more additional spending on gambling, cigarettes and increased premiums on insurance polices. When it comes to investing in stocks, most people are greedy when others are also greedy and fearful and others are also fearful, instead of the other way round.

Only a select few, who master this particular personal risk and is the other way round likeWarren Buffet, become very rich while the masses lose money in the stock market.

ypes of Risk
Unfortunately, the concept of risk is not a simple concept in finance. There are many different types of risk identified and some types are relatively more or relatively less important in different situations and applications. In some theoretical models of economic or financial processes, for example, some types of risks or even all risk may be entirely eliminated. For the practitioner operating in the real world, however, risk can never be entirely eliminated. It is ever-present and must be identified and dealt with. In the study of finance, there are a number of different types of risk the been identified. It is important to remember, however, that all types of risks exhibit the same positive risk-return relationship. Some of the most important types of risk are defined below.

Default Risk The uncertainty associated with the payment of financial obligations when they come due. Put simply, the risk of non-payment. Interest Rate Risk The uncertainty associated with the effects of changes in market interest rates. There are two types of interest rate risk identified; price risk and reinvestment rate risk. The price risk is sometimes referred to as maturity risk since the greater the maturity of an investment, the greater the change in price for a given change in interest rates. Both types of interest rate risks are important in banking and are addressed extensively in Bank Management classes. Price Risk The uncertainty associated with potential changes in the price of an asset caused by changes in interest rate levels and rates of return in the economy. This risk occurs because changes in interest rates affect changes in discount rates which, in turn, affect the present value of future cash flows. The

relationship is an inverse relationship. If interest rates (and discount rates) rise, prices fall. The reverse is also true.

Since interest rates directly affect discount rates and present values of future cash flows represent underlying economic value, we have the following relationships.

Reinvestment Rate Risk The uncertainty associated with the impact that changing interest rates have on available rates of return when reinvesting cash flows received from an earlier investment. It is a direct or positive relationship. This type of interest rate risk is also covered extensively in the Bank Management courses.

Liquidity risk The uncertainty associated with the ability to sell an asset on short notice without loss of value. A highly liquid asset can be sold for fair value on short notice. This is because there are many interested buyers and sellers in the market. An illiquid asset is hard to sell because there there few interested buyers. This type of risk is important in some project investment decisions but is discussed extensively in Investment courses.

Inflation Risk (Purchasing Power Risk) The loss of purchasing power due to the effects of inflation. When inflation is present, the currency loses it's value due to the rising price level in the economy. The higher the inflation rate, the faster the money loses its value.

Market risk Within the context of the Capital Asset Pricing Model (CAPM), the economy wide uncertainty that all assets are exposed to and cannot be diversified away. Often referred to as systematic risk, beta risk, non-diversifiable risk, or the risk of the market portfolio. This type of risk is discussed extensively in Investment courses.

Firm specific risk The uncertainty associated with the returns generated from investing in an individual firms common stock. Within the context of the Capital Asset Pricing Model (CAPM), this is the investment risk that is eliminated through the holding of a well diversified portfolio. Often referred to as un-systematic risk or diversifiable risk. This type of risk is discussed extensively in Investment courses.

Project risk In the advanced capital budgeting topics, the total risk associated with an investment project. Sometimes referred to as stand-alone project risk. In advanced capital budgeting, project risk is partitioned into systematic and unsystematic project risk.

Financial risk The uncertainty brought about by the choice of a firms financing methods and reflected in the variability of earnings before taxes (EBT), a measure of earnings that has been adjusted for and is influenced by the cost of debt financing. This risk is often discussed within the context of the Capital Structure topics.

Business risk

The uncertainty associated with a business firm's operating environment and reflected in the variability of earnings before interest and taxes (EBIT). Since this earnings measure has not had financing expenses removed, it reflect the risk associated with business operations rather than methods of debt financing. This risk is often discussed in General Business Management courses.

Foreign Exchange Risks Uncertainty that is associated with potential changes in the foreign exchange value of a currency. There are two major types: translation risk and transaction risks. Translation Risks Uncertainty associated with the translation of foreign currency denominated accounting statements into the home currency. This risk is extensively discussed in Multinational Financial Management courses. Transactions Risks Uncertainty associated with the home currency values of transactions that may be affected by changes in foreign currency values. This risk is extensively discussed in the Multinational Financial Management courses.

Total Risk
While there are many different types of specific risk, we said earlier that in the most general sense, risk is the possibility of experiencing an outcome that is different from what is expected. If we focus on this definition of risk, we can define what is referred to as total risk. In financial terms, this total risk reflects the variability of returns from some type of financial investment.

Measures of Total Risk The standard deviation is often referred to as a "measure of total risk" because it captures the variation of possible outcomes about the expected value (or mean). In financial asset pricing theory there is a pricing model (Capital Asset Pricing Model or CAPM) that separates this "total risk" into two different types

of risk (systematic risk and unsystematic risk). Another related measure of total risk is the "coefficient of variation" which is calculated as the standard deviation divided by the expected value. The following notes will discuss these concepts in more detail.
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised.[1]Such an event is called a default. Investor losses include lost principal and interest, decreased cash flow, and increased collection costs, which arise in a number of circumstances:[2] A consumer does not make a payment due on a mortgage loan, credit card, line of credit, or other loan A business does not make a payment due on a mortgage, credit card, line of credit, or other loan 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
Contents
[hide]

o o

1 Types of credit risk 2 Assessing credit risk 2.1 Sovereign risk 2.2 Counterparty risk 3 Mitigating credit risk 4 Credit risk related acronyms 5 See also 6 Further reading 7 References 8 External links

[edit]Types

of credit risk

Credit risk can be classified in the following way:[3]

 Credit Default Risk - The risk of loss when the bank considers that the obligor is unlikely to pay its credit obligations in full or the obligor 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 when a sovereign state freezes foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk). [edit]Assessing

credit risk

Main articles: Credit analysis and Consumer credit risk Significant resources and sophisticated programs are used to analyze and manage risk.[4] Some companies run a credit risk department whose job is to assess the financial health of their customers, and extend credit (or not) accordingly. They may use in house programs to advise on avoiding, reducing and transferring risk. They also use third party provided intelligence. Companies like Standard & Poor's, Moody's Analytics, Fitch Ratings, and Dun and Bradstreet provide such information for a fee. Most lenders employ their own models (credit scorecards) to rank potential and existing customers according to risk, and then apply appropriate strategies.[5] With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa.[6][7] With revolving products such as credit cards and overdrafts, risk is controlled through the setting of credit limits. Some products also require security, most commonly in the form of property. Credit scoring models also form part of the framework used by banks or lending institutions grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively. Once this information has been fully reviewed by credit officers and credit committees, the lender provides the funds subject to the terms and conditions presented within the contract (as outlined above). Credit risk has been shown to be particularly large and particularly damaging for very large investment projects, so-called megaprojects. This is because such projects are especially prone to end up in what has been called the "debt trap," i.e., a situation where due to cost overruns, schedule delays, etc. the costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the debt.[8] [edit]Sovereign

risk

Sovereign risk is the risk of a government becoming unwilling or unable to meet its loan obligations, or reneging on loans it guarantees.[9]Many countries have faced sovereign risk in the late-2000s global recession.[10] 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.[11]

Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:[12] Debt service ratio Import ratio Investment ratio Variance of export revenue Domestic money supply growth

The probability of rescheduling is an increasing function of debt service ratio, import ratio, variance of export revenue and domestic money supply growth. Frenkel, Karmann and Scholtens also argue that the likelihood of rescheduling is a decreasing function of investment ratio due to future economic productivity gains. Saunders argues that rescheduling can become more likely if the investment ratio rises as the foreign country could become less dependent on its external creditors and so be less concerned about receiving credit from these countries/investors.[13] [edit]Counterparty

risk

Counterparty risk, known as default risk, is the risk that an organization does not pay out on a bond, credit derivative, trade credit insuranceor payment protection insurance contract, or other trade or transaction when it is supposed to.[14] Even organizations who think that they have hedged their bets by buying credit insurance of some sort still face the risk that the insurer will be unable to pay, either due to temporary liquidity issues or longer term systemic issues.[15] Large insurers are counterparties to many transactions, and thus this is the kind of risk that prompts financial regulators to act, e.g., the bailout of insurer AIG. On the methodological side, counterparty risk can be affected by wrong way risk, namely the risk that different risk factors be correlated in the most harmful direction. Including correlation between the portfolio risk factors and the counterparty default into the methodology is not trivial, see for example Brigo and Pallavicini.[16] A good introduction can be found in a paper by Michael Pykhtin and Steven Zhu.[17] [edit]Mitigating

credit risk

Lenders mitigate credit risk using several methods: Risk-based pricing: Lenders generally charge a higher interest rate to borrowers who are more likely to default, a practice called risk-based pricing. Lenders consider factors relating to the loan such as loan purpose, credit rating, and loan-to-value ratio and estimates the effect on yield (credit spread). Covenants:[18] Lenders may write stipulations on the borrower, called covenants, into loan agreements: Periodically report its financial condition Refrain from paying dividends, repurchasing shares, borrowing further, or other

specific, voluntary actions that negatively affect the company's financial position

Repay the loan in full, at the lender's request, in certain events such as changes in

the borrower's debt-to-equity ratio or interest coverage ratio Credit insurance and credit derivatives: Lenders and bond holders may hedge their credit risk by purchasing credit insurance orcredit derivatives. These contracts transfer the risk from the lender to the seller (insurer) in exchange for payment. The most common credit derivative is the credit default swap. Tightening: Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30to net 15. Diversification:[19] Lenders to a small number of borrowers (or kinds of borrower) face a high degree of unsystematic credit risk, calledconcentration risk. Lenders reduce this risk by diversifying the borrower pool. Deposit insurance: Many governments establish deposit insurance to guarantee bank deposits of insolvent banks. Such protection discourages consumers from withdrawing money when a bank is becoming insolvent, to avoid a bank run, and encourages consumers to hold their savings in the banking system instead of in cash.

Risk And Diversification

1. 2. 3. 4. 5. 6.
Introduction What Is Risk? Different Types of Risk The Risk-Reward Tradeoff Diversifying Your Portfolio Conclusion

Filed Under Retirement Email Print Reprints Feedback

Different Types of Risk

Sponsor: At last, an easy way to predict stock trends get your FREE copy of 5 Chart Patterns You Need to Know.
Let's take a look at the two basic types of risk:

Systematic Risk - Systematic risk influences a large number of assets. A significant political event, for example, could affect several of the assets in your portfolio. It is virtually impossible to protect yourself against this type of risk.

Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect yourself from unsystematic risk. (We will discuss diversification later in this tutorial).

Now that we've determined the fundamental types of risk, let's look at more specific types of risk, particularly when we talk about stocks and bonds.

Credit or Default Risk - Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and the lowest returns, while corporate bonds tend to have the highest amount of default risk but also higher interest rates. Bonds with a lower chance of default are considered to be investment grade, while bonds with higher chances are considered to bejunk bonds. Bond rating services, such as Moody's, allows investors to determine which bonds are investment-grade, and which bonds are junk. (To read more, see Junk Bonds: Everything You Need To Know, What Is A Corporate Credit Rating and Corporate Bonds: An Introduction To Credit Risk.)

Country Risk - Country risk refers to the risk that a country won't be able to honor its financial commitments. When a country defaults on its obligations, this can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit. (For related reading, see What Is An Emerging Market Economy?)

Foreign-Exchange Risk - When investing in foreign countries you must consider the fact that currency exchange rates can change the price of the asset as well. Foreignexchange risk applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you are a resident of America and invest in some

Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the American dollar.

Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks. (To learn more, read How Interest Rates Affect The Stock Market.)

Political Risk - Political risk represents the financial risk that a country's government will suddenly change its policies. This is a major reason why developing countries lack foreign investment.

Market Risk - This is the most familiar of all risks. Also referred to as volatility, market risk is the the day-to-day fluctuations in a stock's price. Market risk applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear market - volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behavior, or "temperament", of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money from stocks, volatility is essential for returns, and the more unstable the investment the more chance there is that it will experience a dramatic change in either direction.

Read more: http://www.investopedia.com/university/risk/risk2.asp#ixzz1tVAdsaVh

3. Types of Financial Risk

3.1 Participants in both clearing systems and typical financial markets are exposed to several types of financial risk. First, they bear credit risk. This is the risk that a counterparty will not meet an obligation when due, and will never be able to meet that obligation for full value. The bankruptcy of a counterparty is often associated with such difficulties, but there may be other causes as well. In a payment netting system, losses from defaults due to the bankruptcy of counterparties can be measured as the principal amount due less recoveries from defaulting parties. Forgone interest can also be an important loss. In anobligations netting system, losses from the default of a counterparty would typically be calculated from the replacement costs of one or more contracts that are not settled. If, however, one party to a contract defaults after having received settlement payments from another party, but before making required counter-payments (in the same or another currency), the loss would again be for a principal amount (less recoveries). 3

3.2 Second, participants bear liquidity risk. Narrowly defined, this is the risk that clearing, or settlement, payments will not be made when due, even though one or more counterparties do have sufficient assets and net worth ultimately to make them. For example, a temporary inability to convert assets to cash, operational difficulties of various kinds, or the inability of correspondents to perform settlement functions will all create liquidity problems. 3.3 The risk that a party will default on clearing obligations to one or more counterparties is sometimes referred to as settlement risk. This risk may contain elements of either credit risk or liquidity risk, or both. The usage of the term "settlement risk" varies considerably, and may also depend on the situation being analysed. For purposes of clarity in this report, the term is not used or discussed further. Instead, the concepts of credit or liquidity risk are employed when one of these is the ultimate financial risk being addressed. 3.4 The concept of liquidity risk is usually defined more broadly, with reference to a whole range of obligations that participants in financial markets incur, including payments due within specific clearing systems. The risk is that a financial market participant will have insufficient liquid resources to make all its payments on the due date, including its liabilities in a payment system. This notion is useful because it implicitly recognises that liquidity problems in a payment system can add to, or be part of, much larger liquidity difficulties in an economy. 3.5 Third, payment systems and financial markets generally can be subject to system, or systemic, risk. This is the risk that the inability of one participant in a payment system, or in the financial markets, to meet obligations when due will cause other participants to fail to meet their obligations when due. For some analytical purposes it is possible to distinguish "systemic liquidity risk" from "systemic credit risk". Of the various kinds of risk, it is usually systemic risk in some form that is of most concern in assessing the risks associated with payment systems. Footnotes: 3. Administrative and similar expenses are usually associated with any defaults.

Contact us * Risk Library * Documents by Author * Committees at the Bank for International Settlement (BIS) * Report on Nett