Financial risk

Financial risk is an umbrella term for any risk associated with any form of financing. Risk may be taken as downside risk, the difference between the actual return and the expected return (when the actual return is less), or the uncertainty of that return.

Risk related to an investment is often called investment risk. Risk related to a company's cash flow is called business risk.

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.

Credit risk

Main article: Credit risk

Credit risk, also called default risk, is the risk associated with a borrower going into default (not making payments as promised).

Investor losses include lost principal and interest, decreased cash flow, and increased collection costs.

Investment risk has been shown to be particularly large and particularly damaging for very large, one-off investment projects, so-called "megaprojects". 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 overruns, 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

Main article: Market risk

This is the risk that the value of a portfolio, 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 risk is the risk that stock prices and/or the implied volatility will change.
• Interest rate risk is the risk that interest rates and/or the implied volatility will change.
• Currency risk is the risk that foreign exchange rates and/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 (e.g. corn, copper, crude oil) and/or implied volatility will change.

Liquidity risk

Main article: Liquidity risk

See also: Liquidity

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 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

Operational risk

Main article: Operational risk

• Reputational risk
• Legal risk
• IT risk

Diversification

Main article: Diversification (finance)

Most of the forms of risk that we concern ourselves with, financial risk, market risk, and even inflation risk, can at least partially be moderated by forms of diversification.

For example, a person investing $10,000.00 for one year may desire a gain of $1,000.00, or a 10% return, providing a total investment of $11,000 after one year. In reality, investing, as opposed to saving, rarely provides such a neat solution. For example, the average annual compound return of the broad American stock market over the time period from 1926 to 2006 was just over 10% per year. During that eighty year period though, there were more than a few times when massive declines in market value were experienced by investors in that same stock market. From early in the year 2000 through the fall of the year 2002 for example, the broad measures of market valuation, such as the S&P 500 Stock Index fell over 50%. For an investor in 2006 to have seen that average compounded 10% return in the S&P 500 Index, he or she would have had to invest in 1994.

At least the investor in a S&P 500 index fund has some degree of assurance that if he or she waits long enough a positive return is very likely to occur. The investor who elected to invest everything in Enron is left only with the assurance that the investment was a complete loss. Enron, as a stock issue, was a part of the S&P 500, and its loss did have a temporary effect on that index, but the effect was not permanent or, in the long run, of any significance. That is the value of diversification. Further diversification away from the large capitalization stocks that make up the S&P 500 Index has historically tended to further reduce market and financial 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

See also

• Insurance
• Modern portfolio theory
• Optimism bias
• Reinvestment risk
• Risk attitude
• Risk measure
• RiskLab
• Risk premium
• Systemic risk