Financial risk is often divided into four principal types of risk: market risk, credit risk, liquidity risk, and operational risk. To varying degrees, most financial transactions involve aspects of all four types of risk. Within financial institutions, risk management groups are often organized along these lines. Because instruments with the greatest market risk tend to have the most variable liquidity risk. Market risk and liquidity risk are often managed by a single group within financial firms. In addition to market risk, credit risk, liquidity risk, and operational risk. Many firms will also have an enterprise risk management group, giving us a total of five principal areas of risk management. We consider each in turn.
The Market risk is risk associated with changing asset values. Market risk is most often associated with assets that trade in liquid financial markets, such as stocks and bonds. During trading hours, the prices of stocks and bonds constantly fluctuate. An asset’s price will change as new information becomes available and investors reassess the value of that asset. An asset’s value can also change due to changes in supply and demand.
All financial assets have a market risk. Even if an asset is not traded on an exchange, its value can change over time. Firms that use mark-to-market accounting recognize this change explicitly. For these firms, the change in the value of exchange-traded assets will be based on market prices. Other assets will either be marked to model—that is, their prices will be determined based on financial models with inputs that may include market prices. Or their prices will be based on broker quotes—that is, their prices will be based on the price at which another party expresses their willingness to buy or sell the assets.
Firms that use historical cost accounting, or book value accounting, will normally only realize a profit or a loss when an asset is sold. Even if the value of the asset is not being updated on a regular basis, the asset still has market risk. For this reason, most firms that employ historical cost accounting will reassess the value of their portfolios when they have reason to believe that there has been a significant change in the value of their assets.
For most financial instruments, we expect price changes to be relatively smooth and continuous most of the time, and large and discontinuous rarely. Because of this, market risk models often involve continuous distribution. Market risk models can also have a relatively high frequency (i.e., daily or even intraday). For many financial instruments, we will have a large amount of historical market data that we can use to evaluate market risk.
The Credit risk is the risk that one party in a financial transaction will fail to pay the other party. Credit risk can arise in a number of different settings. Firms may extend credit to suppliers and customers. Credit card debt and home mortgages create credit risk. One of the most common forms of credit risk is the risk that a corporation or government will fail to make interest payments or to fully repay the principal on bonds they have issued. This type of risk is known as default risk and in the case of national governments. It is also referred to as sovereign risk. Defaults occur infrequently, and the simplest models of default risk are based on discrete distributions.
Although bond markets are large and credit rating agencies have been in existence for a long time, default events are rare. Because of this, we have much less historical data to work with when developing credit models, compared to market risk models.
For financial firms, counterparty credit risk is another important source of credit risk. While credit risk always involves two counterparties, when risk managers talk about counterparty credit risk they are usually talking about the risk arising from a significant long-term relationship between two counterparties. Prime brokers will often provide loans to investment firms. Provide them with access to emergency credit lines, and allow them to purchase securities on margin.
Assessing the credit risk of a financial firm can be difficult, time-consuming, and costly. Because of this, when credit risk is involved, financial firms often enter into long-term relationships based on complex legal contracts. Counterparty risk specialists help design these contracts and play a lead role in assessing and monitoring the risk of counterparties.
Derivatives contracts can also lead to credit risk. A derivative is essentially a contract between two parties, that specifies that certain payments be made based on the value of an underlying security or securities. Derivatives include futures, forwards, swaps, and options. As the value of the underlying asset changes, so too will the value of the derivative. As the value of the derivative changes, so too will the amount of money that the counterparties owe each other. This leads to credit risk.
Another very common form of credit risk in financial markets is settlement risk. Typically, when you buy a financial asset you do not have to pay for the asset immediately. Settlement terms vary by market, but typical settlement periods are one to three days. Practitioners would describe settlement as being T+2, when payment is due two days after a trade has happened.
Liquidity risk is the risk that you will either not be able to buy or sell an asset. Or that you will not be able to buy or sell an asset in the desired quantity at the current market price. We often talk about certain markets being more or less liquid. Even in relatively liquid markets, liquidity risk can be a problem for large financial firms.
Liquidity risk can be difficult to describe mathematically, and the data needed to model liquidity risk can be difficult to obtain even under the best circumstances. Though its importance is widely recognized, liquidity risk modeling has traditionally received much less attention than market or credit risk modeling. Current approaches to liquidity risk management are often primitive. The more complex approaches that do exist are far from standard.
Operational risk is risk arising from all aspects of a firm’s business activities. Put simply, it is the risk that people will make mistakes and that systems will fail. Operational risk is a risk that all financial firms must deal with.
Just as the number of activities that businesses carry out is extremely large, so too are the potential sources of operational risk. That said, there are broad categories on which risk managers tend to focus. These include legal risk (most often risk arising from contracts. Which may be poorly specified or misinterpreted), systems risk (risk arising from computer systems) and model risk (risk arising from pricing and risk models. Which may contain errors or may be used inappropriately).
As with credit risk, operational risk tends to be concerned with rare but significant events. Operational risk presents additional challenges in that the sources of operational risk are often difficult to identify, define, and quantify.
The enterprise risk management group of a firm, as the name suggests, is responsible for the risk of the entire firm. At large financial firms, this often means overseeing market, credit, liquidity, and operations risk groups, and combining information from those groups into summary reports. In addition to this aggregation role, enterprise risk management tends to look at overall business risk. Large financial companies will often have a number of business units. (e.g., capital markets, corporate finance, commercial banking, retail banking, asset management, etc.).
Some of these business units will work very closely with risk management. (e.g. capital markets, asset management), while others may have very little day-to-day interaction with risk (e.g. corporate finance). Regardless, enterprise risk management would assess how each business unit contributes to the overall profitability of the firm in order to assess the overall risk to the firm’s revenue, income, and capital.