Financial risk
Encyclopedia
Financial risk an umbrella term for multiple types of risk
associated with financing
, including financial transaction
s 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.
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".
(not making payments as promised).
Investor losses include lost principal and interest
, decreased cash flow
, and increased collection cost
s.
Investment risk has been shown to be particularly large and particularly damaging for very large, one-off investment projects, so-called "megaproject
s". This is because such projects are especially prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost overrun
s, schedule delays, etc. – the costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the debt.
, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices:
.
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 Fund
s 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.
The 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.
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.
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
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
associated with financing
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, including financial transaction
Financial transaction
A financial transaction is an event or condition under the contract between a buyer and a seller to exchange an asset for payment. It involves a change in the status of the finances of two or more businesses or individuals.-History:...
s that include company loans in risk of default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
. Risk is a term often used to imply downside risk
Downside risk
Downside risk is the financial risk associated with losses. That is, the risk of difference between the actual return and the expected return , or the uncertainty of that return....
, meaning the uncertainty of a return and the potential for financial loss.
A science has evolved around managing market and financial risk
Financial risk management
Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc...
under the general title of modern portfolio theory
Modern portfolio theory
Modern portfolio theory is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets...
initiated by Dr. Harry Markowitz
Harry Markowitz
Harry Max Markowitz is an American economist and a recipient of the John von Neumann Theory Prize and the Nobel Memorial Prize in Economic Sciences....
in 1952 with his article, "Portfolio Selection".
Credit risk
Credit risk, also called default risk, is the risk associated with a borrower going into defaultDefault
Default may refer to:*Default , the failure to do something required by law**Default judgment*Default , failure to satisfy the terms of a loan obligation or to pay back a loan*Default , a preset setting or value...
(not making payments as promised).
Investor losses include lost principal and interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
, decreased cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
, and increased collection cost
Collection cost
A collection cost is incurred to collect debt that is owed. This could include expenditures for hiring a collection agency. Some contracts and regulations prescribe liquidated damages for collection costs. When collection costs occur, the debtor has pay off debt to get the collector out of...
s.
Investment risk has been shown to be particularly large and particularly damaging for very large, one-off investment projects, so-called "megaproject
Megaproject
A megaproject is an extremely large-scale investment project. Megaprojects are typically defined as costing more than US$1 billion and attracting a lot of public attention because of substantial impacts on communities, environment, and budgets. Megaprojects can also be defined as "initiatives that...
s". This is because such projects are especially prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost overrun
Cost overrun
A cost overrun, also known as a cost increase or budget overrun, is an unexpected cost incurred in excess of a budgeted amount due to an under-estimation of the actual cost during budgeting...
s, schedule delays, etc. – the costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the debt.
Market risk
This is the risk that the value of a portfolioPortfolio (finance)
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices:
- Equity riskEquity riskEquity risk is the risk that one's investments will depreciate because of stock market dynamics causing one to lose money.The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods...
is the risk that stock pricesShare priceA share price is the price of a single share of a number of saleable stocks of a company. Once the stock is purchased, the owner becomes a shareholder of the company that issued the share.-Behavior of share prices:...
and/or the implied volatilityImplied volatilityIn financial mathematics, the implied volatility of an option contract is the volatility of the price of the underlying security that is implied by the market price of the option based on an option pricing model. In other words, it is the volatility that, when used in a particular pricing model,...
will change. - Interest rate riskInterest rate riskInterest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
is the risk that interest rateInterest rateAn interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s and/or the implied volatility will change. - Currency riskCurrency riskCurrency risk or exchange rate risk is a form of financial risk that arises from the potential change in the exchange rate of one currency in relation to another...
is the risk that foreign exchange ratesExchange rateIn finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
and/or the implied volatility will change, which affects, for example, the value of an asset held in that currency. - Commodity riskCommodity riskCommodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc...
is the risk that commodityCommodityIn economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
prices (e.g. corn, copper, crude oil) and/or implied volatility will change.
Liquidity risk
This 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). 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 spreadBid-offer spreadThe bid–offer spread for securities is the difference between the prices quoted for an immediate sale and an immediate purchase...
- Making explicit liquidity reserves
- Lengthening holding period for VaRValue at riskIn financial mathematics and financial risk management, Value at Risk is a widely used risk measure of the risk of loss on a specific portfolio of financial assets...
calculations
- Widening bid-offer spread
- 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 systemicSystemic riskIn finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...
Operational risk
- Reputational riskReputational riskReputational risk, often called reputation risk, is a type of risk related to the trustworthiness of business. Damage to a firm's reputation can result in lost revenue or destruction of shareholder value, even if the company is not found guilty of a crime...
- Legal riskLegal riskLegal risk is risks that counterparty are not legally able to enter into a contract. Another legal risk relates to regulatory risk, i.e., that a transaction could conflict with a regulator's policy or, more generally, that legislation might change during the life of a financial contract.-The Risk...
- IT riskIT riskInformation technology risk, or IT risk, IT-related risk, is a risk related to information technology. This relatively new term due to an increasing awareness that information security is simply one facet of a multitude of risks that are relevant to IT and the real world processes it...
Diversification
Financial risk, market risk, and even inflation risk, can at least partially be moderated by forms of diversificationDiversification (finance)
In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of...
.
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 Fund
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
s 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
Correlation
In statistics, dependence refers to any statistical relationship between two random variables or two sets of data. Correlation refers to any of a broad class of statistical relationships involving dependence....
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.
The 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.
Financial / Credit risk related acronyms
ACPM Active credit portfolio managementEAD 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
Var
Var, VAR, VAr, VaR or var can mean:VAR* Varna Airport IATA airport code* Vacuum arc remelting, a process for production of steel and special alloys...
value at risk, a common methodology for measuring risk due to market movements
See also
- InsuranceInsuranceIn law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
- Modern portfolio theoryModern portfolio theoryModern portfolio theory is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets...
- Optimism biasOptimism biasOptimism bias is the demonstrated systematic tendency for people to be overly optimistic about the outcome of planned actions. This includes over-estimating the likelihood of positive events and under-estimating the likelihood of negative events. Along with the illusion of control and illusory...
- Reinvestment riskReinvestment riskReinvestment risk is one of the main genres of financial risk. The term describes the risk that a particular investment might be canceled or stopped somehow, that one may have to find a new place to invest that money with the risk being there might not be a similarly attractive investment available...
- Risk attitude
- Risk measureRisk measureA Risk measure is used to determine the amount of an asset or set of assets to be kept in reserve. The purpose of this reserve is to make the risks taken by financial institutions, such as banks and insurance companies, acceptable to the regulator...
- RiskLabRiskLabRiskLab is a laboratory that conducts research in financial risk management. The first was created in 1994 at Eidgenössische Technische Hochschule Zürich in Zurich, Switzerland. In 1996, another one was created independently at the University of Toronto, this time sponsored by the private company...
- Risk premiumRisk premiumA risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, in order to induce an individual to hold the risky asset rather than the risk-free asset...
- Systemic riskSystemic riskIn finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...