Financial Risk

Financial risk is normally any risk associated with any form of financing. Risk is probability of unfavorable condition; in financial sector it is the probability of actual return being less than expected return. There will be uncertainty in every business; the level of uncertainty present is called risk.

Depending on the nature of the investment, the type of 'investment' risk will vary. High risk investments have greater potential rewards, but also have greater potential consequences.

A common concern with any investment is that the initial amount invested may be lost (also known as "the capital"). This risk is therefore often referred to as capital risk.

If the invested assets are being held in another currency, there is a risk that currency movements alone may affect the value. This is referred to as currency risk.

Many forms of investment may not be readily salable on the open market (e.g. commercial property) or the market has a small capacity and may therefore take time to sell. Assets that are easily sold are termed liquid: therefore this type of risk is termed liquidity risk.

Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest (coupon) or both). The default events include a delay in repayments, restructuring of borrower repayments, and bankruptcy.

Counter party risk, otherwise known as default risk, is the risk that an organization does not pay out on a credit derivative, credit default swap, credit insurance contract, or other trade or transaction when it is supposed to.

Market risk 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. The associated market risk are:

Equity risk, the risk that stock prices and/or the implied volatility will change.

Interest rate risk, the risk that interest rates and/or the implied volatility will change.

Currency risk, the risk that foreign exchange rates and/or the implied volatility will change.

Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil) and/or implied volatility will change.

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).

An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such as fraud risks, legal risks, physical or environmental risks.

Counterparty credit risk consists of both presettlement and settlement risk. Presettlement risk is the risk of loss due to the counterparty’s failure to perform on an obligation during the life of the transaction. This includes default on a loan or bond or failure to make the required payment on a derivative transaction. Presettlement risk can exist over long periods, often years, starting from the time it is contracted until settlement.

In contrast, Settlement Risk is due to the exchange of cash flows and is of a much shorter-term nature. This risk arises as soon as an institution makes the required payment until the offsetting payment is received. This risk is greatest when payments occur in different time zones, especially for foreign exchange transactions where notionals are exchanged in different currencies. Failure to perform on settlement can be caused by counterparty default, liquidity constraints, or operational problems.

Most of the time, settlement failure due to operational problems leads to minor economic losses, such as additional interest payments. In some cases, however, the loss can be quite large, extending to the full amount of the transferred payment. An example of major settlement risk is the 1974 failure of Herstatt Bank. The day it went bankrupt, it had received payments from a number of counterparties but defaulted before payments were made on the other legs of the transactions.