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Types of Credit Risk
Types of Credit Risk
Credit Risk:
Credit risk refers to the risk that a borrower will default on any type of debt by failing
to make payments which it is obligated to do.
b) Concentration Risk:
The risk associated with any single exposure or group of exposures with the
potential to produce large enough losses to threaten a bank's core operations. It
may arise in the form of single name concentration or industry concentration.
c) Country Risk :
The risk of loss arising from a sovereign state freezing foreign currency payments
(transfer/conversion risk) or when it defaults on its obligations (sovereign risk).
Mitigating Credit Risk
Lenders mitigate credit risk using several methods:
a) Risk-based pricing:
Lenders generally charge a higher interest rate to borrowers who are more likely to
default, a practice called risk-based pricing. Lenders consider factors relating to the loan
such as loan purpose, credit rating, and loan-to-value ratio and estimates the effect on
yield (credit spread).
b) Covenants:
Lenders may write stipulations on the borrower, called covenants, into loan agreements:
Lenders and bond holders may hedge their credit risk by purchasing credit
insurance or credit derivatives. These contracts transfer the risk from the lender to the
seller (insurer) in exchange for payment. The most common credit derivative is the credit
default swap.
d) Tightening:
Lenders can reduce credit risk by reducing the amount of credit extended, either in total
or to certain borrowers. For example, a distributor selling its products to a
troubled retailer may attempt to lessen credit risk by reducing payment terms from net
30 to net 15.
e) Diversification:
Lenders to a small number of borrowers (or kinds of borrower) face a high degree
of unsystematic credit risk, called concentration risk. Lenders reduce this risk
by diversifying the borrower pool.
f) Deposit insurance:
2. Liquidity Risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded
quickly enough in the market to prevent a loss (or make the required profit).
Types of Liquidity
Market 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:
Funding liquidity:
Risk that liabilities:
3. Sovereign Risk
The risk that a foreign central bank will alter its foreign-exchange regulations thereby
significantly reducing or completely nulling the value of foreign-exchange contracts.
This is one of the many risks that an investor faces when holding forex contracts. Additionally
an investor is exposed to interest-rate risk, price risk and liquidity risk amongst others.
4. Portfolio Risk
Portfolio risk is the possibility that an investment portfolio may not achieve its objectives.
5. Foreign Exchange Risk(FOREX Risk)
Foreign exchange risk (also known as exchange rate risk or currency risk) is a financial
risk posed by an exposure to unanticipated changes in the exchange rate between
two currencies.
6. Systemic Risk
The risk inherent to the entire market or entire market segment. Interest rates,
recession and wars all represent sources of systematic risk because they affect the
entire market and cannot be avoided through diversification. Whereas this type of
risk affects a broad range of securities, unsystematic risk affects a very specific group
of securities or an individual security. Systematic risk can be mitigated only by being
hedged. Even a portfolio of well-diversified assets cannot escape all risk.
7. Unsystematic Risk
Company or industry specific risk that is inherent in each investment. The amount of
unsystematic risk can be reduced through appropriate diversification.
9. Mutual Fund
An investment vehicle that is made up of a pool of funds collected from many
investors for the purpose of investing in securities such as stocks, bonds, money
market instruments and similar assets. Mutual funds are operated by money
managers, who invest the fund's capital and attempt to produce capital gains and
income for the fund's investors. A mutual fund's portfolio is structured and
maintained to match the investment objectives stated in its prospectus.
Advantages of Mutual Fund
Increased diversification
Daily liquidity
Professional investment management
Ability to participate in investments that may be available only to larger investors
Service and convenience
Government oversight
Ease of comparison
Disadvantages of Mutual Funds
Fees
Less control over timing of recognition of gains
Less predictable income
No opportunity to customize
12.Hedge Fund
Hedge funds are private, actively managed investment funds. They invest in a diverse range
of markets, investment instruments, and strategies and are subject to the regulatory
restrictions of their country. U.S. regulations limit hedge fund participation to certain classes
of accredited investors.
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