Risk Taxonomy

Question 1

List risks under Financial Markets.

Answer 1

1. Stock market risk (price movements, volatility)
2. Interest rate risk (affects bond prices, A/L match, consumer spending)
3. Exchange rate risk

• Transaction risk (FX movements affect settlement)
• Economic risk (importing/exporting impacts, etc.)
• Translation risk (financial statement volatility)

4. Credit Risk

• Financial market credit events
• Bond default risk (issuer may not repay)
• Credit downgrade risk (bond price falls on downgrade)
• Sovereign risk (credit risk of a country)
• Changes in credit status of a debtor or counterparty
• Credit default risk (debtor may not repay)
• Counterparty risk
• Concentration risk (increases credit risk)

5. Spread risk (changes in bond spreads) and basis risk (losses due to mismatch)
6. Systemic risk (cascading reaction across economy)
7. Liquidity risk (can be systemic or due to A/L mismatch or cash flow delay)

Question 2

List Macro-Economic risks.

Answer 2

1. Business cycle risk

• Supply/demand shifts, changes in unemployment, and changes in country growth
• Often associated with the financial market risks

2. Inflation risk

• Only causes risk if not anticipated and cash flows don’t move in parallel
• Most vulnerable: long-term fixed dollar cash flows
• Affects “developing world” countries the most

Question 3

List Political and Regulatory risks.

Answer 3

1. Political risk – adverse domestic or foreign political changes/instability

• Reduced or total shutdown of commerce and/or lower liquidity
• New regulatory hurdles (closely related to regulatory risk)

2. Regulatory risk – adverse changes in laws/regulations

• Increase in minimum wage, limits on transferring funds, changes in product licensing
• Highest for firms in socially controversial areas (e.g. cigarette companies)

Question 4

List Environmental risks.

Answer 4

1. Environmental changes (severe weather events, drought, etc.)

• May cause political risk (e.g. carbon taxes, emissions restrictions, etc.)

2. Environmental liability

• Example: inadequate disposal of hazardous waste

Environmental risk can be internal if caused by a business decision
Example: acquire a company with an existing environmental liability

Question 5

List Operational risks.

Answer 5

1. People risk – may be deliberate (theft) or not (errors, lack of training)
   * People process risk (e.g. lack of succession plan for key person)
2. IT risks (data loss/corruption, viruses, bugs, failure of IT people)
3. Project risks

• Scope risk – scope creep and gap risk
• Defect risk (hardware/software problems)
• Schedule risk (aggressive or overly conservative time budgeting)
• Resource risk (insufficient resources for project)

4. Legal risk – risk of lawsuit, defective contracts, failure to protect assets
5. Pricing risk (wrong assumptions, bad luck, adverse selection)
6. Process risk (all other risks)

• Health and safety risks (human error, flawed processes)
• Manufacturing and engineering risks (human error, defective items)
• Model risk (model itself is incorrect)
• Parameter risk (inputs to model are incorrect)

Question 6

Define Strategic risk.

Answer 6

Strategic risk – risk that senior-level decisions lead to adverse outcomes

• Not an event-driven and not a separate category
• All decisions (or not making a decision at all) involves risk-taking
• Assessment of the quality of the decisions made at the Board/executive level over time
• *Strategic risk is lowest if management has:**
  1. A full understanding of the risks
  2. A plan of action if adverse events occur as a result of the decision

Question 7

Define Reputational risk.

Answer 7

Reputational risk – risk of losses due to reputation damage with customers/stakeholders

Should separately identify the reputational impact of other risks:

• Example: people risk ñ a bond trader knowingly exceeds his trading limits
• Reputational impacts can be worse than original risk event