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Types of Financial Risks

Types of Financial Risks

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Published by: Shaharyar Qayum on Nov 08, 2011
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05/01/2012

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1.1 Credit risk 1.2 Market risk 1.3 Liquidity risk 1.4 Operational risk 1.

5 Model risk
Market Risk: Risk of declining prices or volatility of prices in the finacial markets will result a loss. There are two types of market risk inculding Absolute Risk and Relative Risk. Withing the market risk following risks are of importance. - Absolute Risk - Relative Risk - Directional Risk (Linear risk exposure) - Non directional Risk (Non linear risk exposure) - Basis Risk - Volatility Risk Liquidity Risk: Risk of loss due to inadequate liqudity of position / asset at a fair price. Risks withing the liquidity risk are - Asset Liquidity Risk - Funding Liquidity Risk Credit Risk: Risk of loss due to dafaul of counterpart in a financial transaction. Important terms and further classess of risks under credit risk are - Exposure - Recovery Rate - Credit Event - Sovereign Risk - Settlement Risk Operational Risk: Risk of loss due to inadequate monitoring system, management failure, defective controls, frauds and human errors. This risk is particulary relevant to DERIVATIVE TRADING, because derivatives are inherently higly leveraged instrument, which enable tradters to expose a firm to loss using relativly small amount of capital. Following are the classes of operational risk - Model Risk - People Risk - Legal Risk

Types of Risk

Unfortunately, the concept of risk is not a simple concept in finance. There are many different types of risk identified and some types are relatively more or relatively less important in different

for example. some types of risks or even all risk may be entirely eliminated. The reverse is also true. In some theoretical models of economic or financial processes. If interest rates (and discount rates) rise. Interest Rate Risk The uncertainty associated with the effects of changes in market interest rates. prices fall. there are a number of different types of risk the been identified. Price Risk The uncertainty associated with potential changes in the price of an asset caused by changes in interest rate levels and rates of return in the economy. price risk and reinvestment rate risk. This risk occurs because changes in interest rates affect changes in discount rates which. It is ever-present and must be identified and dealt with.situations and applications. the risk of non-payment. in turn. affect the present value of future cash flows. that all types of risks exhibit the same positive risk-return relationship. the greater the change in price for a given change in interest rates. . we have the following relationships. Both types of interest rate risks are important in banking and are addressed extensively in Bank Management classes. however. The price risk is sometimes referred to as maturity risk since the greater the maturity of an investment. There are two types of interest rate risk identified. In the study of finance. For the practitioner operating in the real world. however. It is important to remember. Some of the most important types of risk are defined below. risk can never be entirely eliminated. Since interest rates directly affect discount rates and present values of future cash flows represent underlying economic value. Put simply. The relationship is an inverse relationship. Default Risk The uncertainty associated with the payment of financial obligations when they come due.

Inflation Risk (Purchasing Power Risk) The loss of purchasing power due to the effects of inflation. This type of risk is important in some project investment decisions but is discussed extensively in Investment courses. The higher the inflation rate. When inflation is present. Often referred to as systematic risk. this is the investment risk that is eliminated through the holding of a well . A highly liquid asset can be sold for fair value on short notice. This is because there are many interested buyers and sellers in the market.Reinvestment Rate Risk The uncertainty associated with the impact that changing interest rates have on available rates of return when reinvesting cash flows received from an earlier investment. the faster the money loses its value. It is a direct or positive relationship. This type of risk is discussed extensively in Investment courses. or the risk of the market portfolio. the economy wide uncertainty that all assets are exposed to and cannot be diversified away. Market risk Within the context of the Capital Asset Pricing Model (CAPM). the currency loses it's value due to the rising price level in the economy. This type of interest rate risk is also covered extensively in the Bank Management courses. Firm specific risk The uncertainty associated with the returns generated from investing in an individual firm’s common stock. An illiquid asset is hard to sell because there there few interested buyers. Within the context of the Capital Asset Pricing Model (CAPM). non-diversifiable risk. beta risk. Liquidity risk The uncertainty associated with the ability to sell an asset on short notice without loss of value.

There are two major types: translation risk and transaction risks. This risk is often discussed in General Business Management courses. it reflect the risk associated with business operations rather than methods of debt financing. Since this earnings measure has not had financing expenses removed. the total risk associated with an investment project. Business risk The uncertainty associated with a business firm's operating environment and reflected in the variability of earnings before interest and taxes (EBIT). Foreign Exchange Risks Uncertainty that is associated with potential changes in the foreign exchange value of a currency. a measure of earnings that has been adjusted for and is influenced by the cost of debt financing. project risk is partitioned into systematic and un-systematic project risk. In advanced capital budgeting. Sometimes referred to as stand-alone project risk. Financial risk The uncertainty brought about by the choice of a firm’s financing methods and reflected in the variability of earnings before taxes (EBT). .diversified portfolio. Often referred to as un-systematic risk or diversifiable risk. This risk is often discussed within the context of the Capital Structure topics. This risk is extensively discussed in Multinational Financial Management courses. This type of risk is discussed extensively in Investment courses. Translation Risks Uncertainty associated with the translation of foreign currency denominated accounting statements into the home currency. Project risk In the advanced capital budgeting topics.

we said earlier that in the most general sense. . The following notes will discuss these concepts in more detail. this total risk reflects the variability of returns from some type of financial investment. Total Risk While there are many different types of specific risk. risk is the possibility of experiencing an outcome that is different from what is expected. we can define what is referred to as total risk. If we focus on this definition of risk. In financial terms.Transactions Risks Uncertainty associated with the home currency values of transactions that may be affected by changes in foreign currency values. This risk is extensively discussed in the Multinational Financial Management courses. In financial asset pricing theory there is a pricing model (Capital Asset Pricing Model or CAPM) that separates this "total risk" into two different types of risk (systematic risk and unsystematic risk). Measures of Total Risk The standard deviation is often referred to as a "measure of total risk" because it captures the variation of possible outcomes about the expected value (or mean). Another related measure of total risk is the "coefficient of variation" which is calculated as the standard deviation divided by the expected value.

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