Subject 3. Identification of Risks

There are two general categorizations of risks.

Financial Risks

Financial risks originate from the financial markets.

  • Market risk arises from movements in stock prices, interest rates, exchange rates, and commodity prices.
  • Credit risk is the risk that a counterparty will not pay an amount owed.
  • Liquidity risk is the widening of the bid-ask spread on an asset. It is usually caused by degradation in market conditions or a lack of market participants.

Non-Financial Risks

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:

  • Settlement risk: one party fails to deliver the terms of a contract with another party at the time of settlement.
  • Legal risk: the risk of being sued, or of the terms of a contract not being upheld by the legal system.
  • Compliance risk: regulatory risk, accounting risk and tax risk. Companies may fail to respond quickly when laws and regulations are updated.
  • Model risk: the risk of improperly using a model. An example is tail risk which suggests that distribution is not normal, but skewed, with fatter tails.
  • Operational risk: the risk that arises from within the operations of an organization and includes both human and system or process errors.
  • Solvency risk: the risk that the entity does not survive or succeed because it runs out of cash to meet its financial obligations.

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).

User Contributed Comments 7

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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.