Types of Risk
- Systematic Risk – The overall impact of the market.
- Unsystematic Risk – Asset-specific or company-specific uncertainty.
- Political/Regulatory Risk – The impact of political decisions and changes in regulation.
- Financial Risk – The capital structure of a company (degree of financial leverage or debt burden)
Taxability risk.Refers to the risk that a security that was issued with tax-exempt status could potentially lose that status prior to maturity resulting in lower after-tax yield than originally planned.
The risk that an individual or firm will have difficulty selling an asset without incurring a loss. That is, there may be a lack of interest in the market for a particular asset, forcing the owner to sell it for less than its actual value.
Event risk refers to any unforeseen or unexpected occurrence that can cause losses for investors or other stakeholders in a company or investment. Credit events such as default or bankruptcy can be hedged against using credit default swaps or other credit derivatives.
A default risk premium is effectively the difference between a debt instrument's interest rate and the risk-free rate. The default risk premium exists to compensate investors for an entity's likelihood of defaulting on their debt.
Systematic risk refers to the risk inherent to the entire market or market segment. Systematic risk, also known as “undiversifiable risk,” “volatility” or “market risk,” affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid.
Interest rate risk is the potential for investment losses that result from a change in interest rates. If interest rates rise, for instance, the value of a bond or other fixed-income investment will decline. The change in a bond's price given a change in interest rates is known as its duration.
The Incremental Risk Charge (“IRC”) is an estimate of default and migration risk of unsecuritized credit products in the trading book. The IRC model also captures recovery risk, and assumes that average recoveries are lower when default rates are higher.
Key Takeaways. Incremental value at risk is a measure of how much risk a particular position is adding to a portfolio. It's a risk assessment used by investors who are thinking of making a change to their holdings, by either adding or removing a particular position.
The 'liquidity horizon' is defined as the time required to exit or hedge a risk position without materially affecting market prices in stressed market conditions.
The expected loss is calculated as a loan's LGD multiplied by both its probability of default (PD) and the financial institution's exposure at default (EAD). Though there are a number of ways to calculate LGD, the most favored among many analysts and accountants is gross calculation.
Companies with a default risk ratio between 1.0 and 3.0 are designated as “medium risk”, and companies with a default ratio of 3.0 and higher are classified as “low risk” because their free cash flows are 3 or more times the size of their annual principal payments).
Examples of unsystematic risk are:
- A change in regulations that impacts one industry.
- The entry of a new competitor into a market.
- A company is forced to recall one of its products.
- A company is found to have prepared fraudulent financial statements.
- A union targets a company for an employee walkout.
A downgrade is a negative change in the rating of a security. This situation occurs when analysts feel that the future prospects for the security have weakened from the original recommendation, usually due to a material and fundamental change in the company's operations, future outlook, or industry.
We evaluate the impact of commonly used indicators of bank distress on broad (i.e. sector and country) risks. We also provide strong evidence suggesting that, for listed banks, default risk tends to be systematic (i.e. non-diversifiable).
Interest rate risk directly affects the values of fixed income securities. Since interest rates and bond prices are inversely related, the risk associated with a rise in interest rates causes bond prices to fall and vice versa. Conversely, when interest rates fall, bond prices tend to rise.
Inflationary risk is the risk that inflation will undermine an investment's returns through a decline in purchasing power. Bond payments are most at inflationary risk because their payouts are generally based on fixed interest rates and an increase in inflation diminishes their purchasing power.
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial.
A default free-bond is one where the owner of the bond is assured when the bond is issued of getting the interest which was specified when the bond was issued and the principle when the bond expires. This fact though, does not eliminate all risks associated with the ownership of bonds.
A risk premium is the investment return an asset is expected to yield in excess of the risk-free rate of return. The higher interest rates these less-established companies must pay is how investors are compensated for their higher tolerance of risk.
Widely, risks can be classified into three types: Business Risk, Non-Business Risk, and Financial Risk.
Here are seven basic ways to lower the risk of not getting your money.
- Thoroughly check a new customer's credit record.
- Use that first sale to start building the customer relationship.
- Establish credit limits.
- Make sure the credit terms of your sales agreements are clear.
- Use credit and/or political risk insurance.
Some examples are poor or falling cash flow from operations (which is often needed to make the interest and principal payments), rising interest rates (if the bonds are floating-rate notes, rising interest rates increase the required interest payments), or changes in the nature of the marketplace that adversely affect
The purpose of credit analysis is to determine the creditworthiness of borrowers by quantifying the risk of loss that the lender is exposed to. The three factors that lenders use to quantify credit risk include the probability of default, loss given default, and exposure at default.
So, what do banks do then? They need to manage their credit risks. The goal of credit risk management in banks is to maintain credit risk exposure within proper and acceptable parameters. It is the practice of mitigating losses by understanding the adequacy of a bank's capital and loan loss reserves at any given time.
The main sources of credit risk that have been identified in the literature include, limited institutional capacity, inappropriate credit policies, volatile interest rates, poor management, inappropriate laws, low capital and liquidity levels, massive licensing of banks, poor loan underwriting, reckless lending, poor
