Subject 3. Identification of risks
#cfa #cfa-level-1 #portfolio-management #risk-management-introduction
There are two general categorizations of risks.
Financial risks originate from the financial markets.
- Market risk arises from movements in stock prices, interest rates, exchange rates, and commodity prices.
- Credit risk is the risk that a counterparty will not pay an amount owed.
- Liquidity risk is the widening of the bid-ask spread on an asset. It is usually caused by degradation in market conditions or a lack of market participants.
Non-financial risks arise from actions within an entity or from external origins, such as the environment, the community, regulators, politicians, suppliers, and customers. They include:
- Settlement risk: one party fails to deliver the terms of a contract with another party at the time of settlement.
- Legal risk: the risk of being sued, or of the terms of a contract not being upheld by the legal system.
- Compliance risk: regulatory risk, accounting risk and tax risk. Companies may fail to respond quickly when laws and regulations are updated.
- Model risk: the risk of improperly using a model. An example is tail risk which suggests that distribution is not normal, but skewed, with fatter tails.
- Operational risk: the risk that arises from within the operations of an organization and includes both human and system or process errors.
- Solvency risk: the risk that the entity does not survive or succeed because it runs out of cash to meet its financial obligations.
Individuals face many of the same organizational risks outlined here, as well as health risks, mortality or longevity risks, and property and casualty risks.
Risks are not necessarily independent. because many risks arise as a result of other risks; risk interactions can be extremely non-linear and harmful. For example, fluctuations in the interest rate cause changes in the value of the derivative transactions but could also impact the creditworthiness of the counterparty. Another example might occur with an emerging-market counterparty, where there is country and possibly currency risk associated with the counterparty (however creditworthy it might otherwise be).
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