Chapter 7: Definitions of Risk Flashcards
Market risk
Risk inherent from exposure to capital markets.
This can relate directly to the financial instruments held on the assets side (equities, bonds, etc) and also to the effect of these changes on the valuation of the liabilities.
2 Economic risks
Price and Salary inflation.
Interest rate risk
Risk arising from unanticipated changes in interest rates of various terms.
This can be changes in the overall level of interest rates, or in the shape of the yield curve.
Foreign Exchange risk
The risk present when cash flows received are in a currency different from the cash flows due.
Credit risk
Default risk.
2 Major credit risks affecting banks
- credit risks relating to the large number of loans to individuals and small businesses.
- Counter-party risk for derivative trades
Counter-party risk for derivative trades
The risk that the opposite side to a derivative transaction will be unable to make a payment if it suffers a loss on that transaction.
Main credit risk faced by insurers
Risk of reinsurer failure.
Main credit risk faced by pension schemes
Risk of sponsor insolvency.
Why is credit risk considered to be very similar to non-life insurance risk
There is both
- incidence (the probability of default),
- and intensity (the recovery rate)
3 Ways in which illiquidity can manifest itself
- high trading costs
- a necessity to accept a substantially reduced price for a quick sale
- the inability to sell at all in a short time scale
Funding liquidity risk
The risk that a firm cannot meet expected and unexpected current and future cash flows and collateral needs.
And hence, that the firm is unable to raise additional finance when required.
My might some illiquidity be desirable
if an institution can cope with a lack of marketability in a proportion of its assets, then it might be able to benefit from any premium payable for that illiquidity.
3 Common problems with illiquid assets
They might have other issues such as:
- higher transaction costs
- greater heterogeneity
(e. g. real estate and private equity) - they are less likely to be eligible to count fully towards the regulatory capital of a bank / insurer.
3 Ways in which assets can provide liquidity
through
- SALE for cash
- use as COLLATERAL
- through maturity or periodic PAYMENTS (dividends or coupons)
Systemic risk
The risk of failure of a financial system.
This occurs when many firms are similarly affected by a particular external risk either directly or through relationships with each other and more broadly.
Contagion risk
The risk that failure in one firm, sector or market will result in further failures.
4 Broad types of systemic risk
- financial infrustructure
- liquidity
- common market positions
- exposure to a common counter-party
Systemic risk relating to financial infrustructure
arises if a commonly used system fails.
This is particularly true if it relates to payment or settlement of financial transactions - such a failure can paralyse the entire financial system.
When might liquidity risk become a systemic risk
If a run on banks occurs, or if short-term money market become less liquid.
Both result in a reduced ability for banks to raise the capital they need to remain solvent.
Feedback risk
The risk that a change in price will result in further change sin the same direction.
Mortality risk
The risk that a portfolio will suffer from mortality being heavier than expected.
Longevity risk
The risk that a portfolio will suffer from mortality being lighter than expected.
4 types of mortality / longevity risk (Int. Actuarial Ass.)
- level
- volatility
- catastrophe
- trend
Mortality / longevity risk:
Level risk
The risk that the underlying mortality of a particular population differs from that assumed.
Mortality / longevity risk:
Volatility risk
The risk that the mortality experience will differ from that assumed due to there being a finite number of lives in the population considered.
Mortality / longevity risk:
Catastrophe risk
The risk of large losses due to some significant event increasing mortality rates beyond simple random volatility.
E.g. natural disasters.
Mortality / longevity risk:
Trend risk
The risk that mortality rates will improve over time at a rate different to that assumed.
Underwriting risk
The risk that the average level of claims
(as measured by insidence and intensity)
is different from that assumed.
Non-life insurance
Volatility risk
Risk that remains even if risks are correctly underwritten, and reflects uncertainty in the incidence and intesnity of claims resulting from the fact that only a finite number of policies exist.
Operational risks
A group of risks which impact on the way in which a firm carries on business.
Business continuity risk
The risk that an external event will affect the physical ability of a firm to carry on business at its normal place of work.
Regulatory risk
The risk that an organisation will be
- negatively impacted by a CHANGE in legislation or regulation,
- or will FALL FOUL of legislation or regulations that are already in place.
Technology risk
The risk of a failure in technology, including
- unintended loss or
- disclosure of confidential information,
- data corruption
- and computer system failure.
Or losses due to undiscovered errors in software used in an organisation. Such errors might result in losses from mispricing, or in incorrect payments being made.
Crime risk
Result from the dishonest behaviour of individuals in relation to a firm.
This includes the theft of money or intellectual property by an employee (fraud) and the unauthorised access of system by an outside party with the same aims (hacking).
People risk
A term reserved for non-criminal actions that can adversely affect an enterprise.
People risk:
Employment risk
The risk that the wrong people are employed.
It is impartant that the people employed have the skills an organisation needs to run its business.
Once employees have been recruited, it is important that the right ones are promoted.
Similarly, it is important that the right employees are retained.
Risks associated with losing employees
Losing employees can result in a
- loss of valuable intellectual capital
- and can damage the morale of remaining employees.
It can also be expensive:
- recruitment costs,
- time
- and money,
and every time a new recruit is taken on, there is the risk that the employee is not right for the role or the organisation.
People risk:
Adverse selection
The risk that the demand for insurance is possitevly correlated with the risk of loss.
Why does adverse selection arise
it arises as a result of asymmetry of information and the inability to differentiate risks when pricing.
Moral hazard
The risk that policyholder behaviour will depend on the level of their exposure to a particular risk.
Agency risk
The risk that one party appointed to act on behalf of another will instead act on its own behalf.
E.g. Company managers acting for themselves rather than the shareholders whose interests they are supposed to protect.
E.g. In banks, bonus systems might create perverse incentives for traders - eg if good results can give unlimited bonus potential, but the downside from poor results is limited, this can create an incentive for traders to take on too much risk.
Legal risk
The risk arising from poorly drafted legal documents within an organisation.
Process risk
The risk inherent in the processes used by firms.
Model risk
The risk that financial models used to assess risk, to determine trades, or otherwise to help make financial decisions are flawed.
The flaws may be in the structure of a model, which may be overly simplistic or otherwise unrealistic, or it can be in the choice of parameters used for an otherwise sound model.
It may also relate to the incorrect translation of a model from theory into code.
Also occurs if models are put to uses other than those for which they were intended.
Reputational risk
The risk that arises from other operational risks that result in a loss of confidence in an organisation due to reputational damage.
Project risk
An umbrella term covering all of the various operational risks in the context of a particular project.
The most basic Strategic risk
The risk that no coherent strategy for future development exists.
Residual risks
Those risks that remain once any action has been taken to treat the risks.
