There are two general categorizations of risks.
Financial risks originate from the financial markets.
Non-financial risks arise from actions within an entity or from external origins, such as the environment, the community, regulators, politicians, suppliers, and customers. They include:
Individuals face many of the same organizational risks outlined here, as well as health risks, mortality or longevity risks, and property and casualty risks.
Risks are not necessarily independent. because many risks arise as a result of other risks; risk interactions can be extremely non-linear and harmful. For example, fluctuations in the interest rate cause changes in the value of the derivative transactions but could also impact the creditworthiness of the counterparty. Another example might occur with an emerging-market counterparty, where there is country and possibly currency risk associated with the counterparty (however creditworthy it might otherwise be).
|wlh123: a firm can fail to deliver on a contract standalone but need not go bankrupt. so failure to settle a contract is not the same as default.|
|robkaz: The counterparty may not be the same as the instrument. For instance, Lehman Brothers sells you a Goldman Sachs bond. Your credit risk is GS. Your settlement risk is LEH.|
|corarale: Still why would Settlement risk be non-financial risk while credit risk be financial risk? How to really distinguish whether it is financial or non-financial risk?|
|canteen: You cannot model Settlement risk, no one will sell you an instrument to cover this risk. For credit risk there are all kinds of vehicles from derivatives to collateral postings which are all forms of financial instruments.|
|leachim: Just need clarification, because to me settlement risk has an element of credit risk. Example, I terminate a derivative contract with a derivative counterparty. Assume that I am owed money and it takes two days for the contract to be settled. Wouldn't I still have to account for risk of the counterparty failing/not being able to deliver in the next two days?|
|fishjenny: I think you're describing the credit risk part of the contract. but I am not sure who settles such a contract. If it is exchange traded there is little to zero credit risk, if it is with a AAA bank you probably have recourse of some kind ( maybe a bailout? )|
| jimishg: I think settlement risk comprises both credit risk and liquidity risk ( but with a focus on liquidity ).|
Credit event ALONE by itself denotes that one party is insolvent and is not likely to ever be able to settle. In settlement risk event, they may miss a payment or two but are otherwise solvent.
settlement risk event can happen due to liquidity without credit event happening, due to temporary liquidity crisis. But can happen due to other horrible or shady circumstances as well:
CFAI points to Hertstatt when a German bank was told to stop business at the end of the current day, but had already taken in payments from various counterparties. At the end of the day, these counterparties did not get their dues in foreign currencies or whatever instrument they had paid for ( cash flows ). They became fully exposed even when they were almost fully hedged against this bank on their books.
This kind of problem is impossible for a default model to capture.