Module 3: Introduction to risk taxonomy Flashcards
Definition of risk
There is no single definition of risk that is applicable to all circumstances.
However, most definitions encompass:
- the UNCERTAINTY of possible future random events
- the nature and degree of harm associated with each such event, eg failure to meet objectives, specified financial loss etc.
A common, basic risk categorisation is made up of 4 risk types:
- Market risk
- Credit risk (default / counterparty)
- Operational risk
- Underwriting / Insurance risk
Market risk
Risk arising from changes in investment market values, or other features correlated with investment markets, such as interest and inflation rates.
Includes the consequence of investment market value changes on liabilities, and may also include the consequence of mismatching asset and liability cashflows.
Underwriting / insurance risk
The risk of accepting risks which turn out to be inappropriate or pricing accepted risks inappropriately.
4 Financial risks
- Market risks
- Credit risks
- Business risks
- Liquidity risks
Financial risks:
—- 4 Business risks
- Underwriting
- Insurance
- Financing
- Exposure
2 Non-financial risks
- Operational risks
- External risks
3 Types of market risk
- Trading risk
- Asset / Liability mismatch
- Liquidity risk
Causes of trading risk
- changes in prices (equity, commodity) or rates (interest, exchange)
- other market driven risks
- basis risk
2 Characteristics of trading risk
- short-term
- able to close-out or hedge in a few days
4 Parties exposed to trading risk
- investment banks
- dealers
- market-making energy firms
- non-financials with trading book
3 Causes of Asset / Liability mismatch risk
- unmatched interest rate sensitivity of assets and liabilities
- foreign exchange risk
- basis risk
2 Characteristics of Asset / Liability mismatch risk
- takes longer to close out than for interest rate trading risk
- can be hedged more frequently than other types of risk.
4 Parties exposed to Asset / Liability mismatch risk
- commercial and retail banks
- investment banks
- insurance companies
- energy firms (input / output price mismatches)
2 Causes of liquidity risk
- inability to fund financial obligations without sizeable losses
- insufficient market capacity leading to adverse impact on market price when a deal is required
Economic risk
Refers to risks arising from the impact of microeconomic factors on an organisation and/or its customers.
Examples are inflation risks and changes in demand.
Factors include:
- aggregate supply and demand
- own and foreign governments’ policies
- employment levels
- inflation, interest and exchange rates
- accommodation costs
Interest rate risk
Risks arising from changes in interest rates, which could include impact on customer behaviour as well as the financial impact.
Can be considered a subset of market risk and economic risk.
Foreign exchange risk
Risk arising due to exposure to movement in foreign exchange rates.
Can be considered a subset of market risk and economic risk.
Basis risk
The risk arising from differences in the movements of two comparable indices, e.g. different stock market indices, so that offsetting investments in a hedging strategy will not experience exactly offsetting movements.
Credit risk
The risk that a counterparty to an agreement will be unable or unwilling to make the payments required.
Some definitions define credit risk more narrowly as the risk that a borrower will partially or wholly default on repayment of debt.
Counterparty risk
The risk that another party to a transaction or agreement fails to perform its contractual obligations, including failure to perform them in a timely manner.
2 Components of credit risk
- the probability of default
- the loss (or recovery) on default
Liquidity risk
Can refer to:
- the risk of money markets not being able to supply funding to businesses when required (funding liquidity risk)
- or more broadly to the management of short-term cashflow requirements
Alternatively it may refer to:
the insufficient capacity in the market to handle asset transactions at the time when the deal is required (market liquidity risk).
Insurance risk
Arises from fluctuations in the timing, frequency and severity of insured events, relative to the expectations of the firm at the time of underwriting and pricing.
This will include:
- mortality
- morbidity
- property
- casualty risks