Financial risk is an umbrella term for multiple types of risk associated with financing, including
financial transactions that include company loans in risk of default.
Risk is a term often used to imply downside risk, meaning the uncertainty of a return
and the potential for financial loss.
In addition to financial risks, there are five broad categories of investment risks
known as five risks.
A science has evolved around managing market and financial risk under the general title
of modern portfolio theory initiated by Dr. Harry Markowitz in 1952 with his article,
"Portfolio Selection".
In modern portfolio theory, the variance of a portfolio is used as the definition of risk.
Types of risk Asset-backed risk
Risk that the changes in one or more assets that support an asset-backed security will
significantly impact the value of the supported security.
Risks include interest rate, term modification, and prepayment risk.
Credit risk
Credit risk, also called default risk, is the risk associated with a borrower going
into default.
Investor losses include lost principal and interest, decreased cash flow, and increased
collection costs.
An investor can also assume credit risk through direct or indirect use of leverage.
For example, an investor may purchase an investment using margin.
Or an investment may directly or indirectly use or rely on repo, forward commitment, or
derivative instruments.
Foreign investment risk Risk of rapid and extreme changes in value
due to: smaller markets; differing accounting, reporting, or auditing standards; nationalization,
expropriation or confiscatory taxation; economic conflict; or political or diplomatic changes.
Valuation, liquidity, and regulatory issues may also add to foreign investment risk.
Liquidity risk
This is the risk that a given security or asset cannot be traded quickly enough in the
market to prevent a loss.
There are two types of liquidity risk: Asset liquidity - An asset cannot be sold
due to lack of liquidity in the market - essentially a sub-set of market risk.
This can be accounted for by: Widening bid-offer spread
Making explicit liquidity reserves Lengthening holding period for VaR calculations
Funding liquidity - Risk that liabilities: Cannot be met when they fall due
Can only be met at an uneconomic price Can be name-specific or systemic
Market risk
The four standard market risk factors are equity risk, interest rate risk, currency
risk, and commodity risk: Equity risk is the risk that stock prices
in general or the implied volatility will change.
Interest rate risk is the risk that interest rates or the implied volatility will change.
Currency risk is the risk that foreign exchange rates or the implied volatility will change,
which affects, for example, the value of an asset held in that currency.
Commodity risk is the risk that commodity prices or implied volatility will change.
Operational risk
Other risks Reputational risk
Legal risk IT risk
Model risk
Diversification
Financial risk, market risk, and even inflation risk, can at least partially be moderated
by forms of diversification.
The returns from different assets are highly unlikely to be perfectly correlated and the
correlation may sometimes be negative.
For instance, an increase in the price of oil will often favour a company that produces
it, but negatively impact the business of a firm such an airline whose variable costs
are heavily based upon fuel.
However, share prices are driven by many factors, such as the general health of the economy
which will increase the correlation and reduce the benefit of diversification.
If one constructs a portfolio by including a wide variety of equities, it will tend to
exhibit the same risk and return characteristics as the market as a whole, which many investors
see as an attractive prospect, so that index funds have been developed that invest in equities
in proportion to the weighting they have in some well known index such as the FTSE.
However, history shows that even over substantial periods of time there is a wide range of returns
that an index fund may experience; so an index fund by itself is not "fully diversified".
Greater diversification can be obtained by diversifying across asset classes; for instance
a portfolio of many bonds and many equities can be constructed in order to further narrow
the dispersion of possible portfolio outcomes.
A key issue in diversification is the correlation between assets, the benefits increasing with
lower correlation.
However this is not an observable quantity, since the future return on any asset can never
be known with complete certainty.
This was a serious issue in the Late-2000s recession when assets that had previously
had small or even negative correlations suddenly starting moving in the same direction causing
severe financial stress to market participants who had believed that their diversification
would protect them against any plausible market conditions, including funds that had been
explicitly set up to avoid being affected in this way
Diversification has costs.
Correlations must be identified and understood, and since they are not constant it may be
necessary to rebalance the portfolio which incurs transaction costs due to buying and
selling assets.
There is also the risk that as an investor or fund manager diversifies their ability
to monitor and understand the assets may decline leading to the possibility of losses due to
poor decisions or unforeseen correlations.
Hedging Hedging is a method for reducing risk where
a combination of assets are selected to offset the movements of each other.
For instance when investing in a stock it is possible to buy an option to sell that
stock at a defined price at some point in the future.
The combined portfolio of stock and option is now much less likely to move below a given
value.
As in diversification there is a cost, this time in buying the option for which there
is a premium.
Derivatives are used extensively to mitigate many types of risk.
Financial / Credit risk related acronyms ACPM Active credit portfolio management
EAD Exposure at default EL Expected loss
ERM Enterprise risk management LGD Loss given default
PD Probability of default KMV quantitative credit analysis solution
developed by credit rating agency Moody's VaR value at risk, a common methodology for
measuring risk due to market movements See also
Beta Capital asset pricing model
Cost of capital Downside beta
Downside risk Insurance
Macro risk Modern portfolio theory
Optimism bias Reinvestment risk
Risk attitude Risk measure
RiskLab Risk premium
Systemic risk Upside beta
Upside risk Value at risk
References
External links Bartram, Söhnke M.; Brown, Gregory W.; Waller,
William.
"How Important is Financial Risk?".
Journal of Financial and Quantitative Analysis.
forthcoming.
Risk.net "Financial Risk Management News & Analysis MacroRisk Analytics “Patented and proprietary
macro risk measurements and tools for investors since 1999”.
Elements of Financial Risk Management, 2nd Edition
Quantitative Risk Management: A Practical Guide to Financial Risk
Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial
Markets Group