LOS F requires us to:
identify financial and non-financial sources of risk and describe how they may interact
Some of the major sources of financial risk are:
1. Market Risk
Market risk is the risk of the value of a firm’s investments going down as a result of market movements. It is also referred to as price risk. It may be due to changes in interest rates, stock prices, foreign exchange rates, commodity prices, etc.
The main drivers of market risk are fundamental economic conditions, industry or company events, etc.
2. Credit Risk
This risk is also called the default or counterparty risk. When there is counterparty failure in performing the repayment obligation on the due date, it gives rise to the low-quality assets, which in turn leads to credit risk.
The main drivers of the credit risk are an economic weakness, drop in demand, etc.
3. Liquidity Risk
Liquidity risk refers to the risk of possible bankruptcy arising due to the inability of the firm to meet its financial obligations. Due to the liquidity risk, the firm may have to sell its assets below the fair price.
The main drivers of the liquidity risk are:
a. widening bid-ask spread in times of market strain,
b. changes in market conditions or the market for specific assets,
c. the size of the position, etc.
Some of the sources of non-financial risk are:
1. Settlement Risk
This risk is also known as Herstatt Risk. This risk arises as a result of a party failing to deliver, even though it has been paid for.
2. Legal Risk
The legal risk mainly arises due to two reasons:
a. the risk that the enterprise may be sued due to non-legal compliance or any default, and
b. not being able to make a fair legal argument.
3. Compliance Risk
It is the risk arising due to the inability of the enterprise to meet the regulatory, accounting, or tax compliance. This includes ‘injurious reliance’.
4. Model Risk
A major technology risk faced by financial institutions and firms is that the prices, risk management, and hedges produced by their models (mark-to-model) may be different from the actual market prices (mark-to-market).
The differences are caused by the fact that all models and assumptions are the best estimates of an unpredictable market and these models and assumptions may be invalid during periods of market stresses and the economy in turmoil.
One important type of model risk is the tail risk, where the events in the tail are occurring more frequently than expected by the model.
5. Operational Risk
It is the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. The definition includes legal risk, which is the risk of loss, resulting from the failure to comply with the laws as well as the prudent ethical standards and contractual obligations.
6. Solvency Risk
It is the risk of running out of cash or being unable to secure financing, or of rolling over debt.
Apart from the financial and the non-financial risks, there are individual risks also. These individual risks may result from the risk of:
a. Theft
b. Health
c. Mortality
d. Accident
e. Wealth
Interactions Between Financial & Non-Financial Risks
There may be different from of interactions between the financial and non-financial risks, some of the risks may intensify the other risk and others may counter the other risk. Some of the examples of interactions between the financial and non-financial risks are:
a. The credit risk may be made worse by the market risk, as the market conditions deteriorate.
b. There may be a concentration of risk resulting from owning a home in a one-factory town while being employed in that factory and holding the company stock in the pension plan. The risk gets so intensified in the event of the factory going out of business.