Level 1 CFA® Exam:
Financial Risks vs Non-Financial Risks
Market risk is the risk that stock prices, commodity prices, interest rates, or exchange rates change in an adverse direction.
Credit risk is the risk that the counterparty will not be able to fulfill its financial obligations.
Liquidity Risk (Transaction Cost Risk)
Liquidity risk is the risk of the bid-ask spread getting wider or the risk that there will be no counterparty willing to buy the financial asset from the company for a price that is not below the perceived fundamental value of the asset.
Settlement risk is the risk that one party of the contract defaults just before settling the payments.
Regulatory Risk, Accounting Risk, Tax Risk (Also Collectively Called Compliance Risk)
An update of laws and regulations may result in unexpected costs and losses for an organization.
Model risk is the risk that an error occurs in a valuation model or that a correct model is used incorrectly, which may lead to incorrect investment decisions.
Tail risk occurs for example if we assume normal distribution in modeling but the distribution of data is in fact characterized by fatter tails than the normal distribution. In such a case, the probability of extreme results is higher than expected from the model.
Operational Risk (Internal Risk)
Operational risk is the risk that can affect the company’s day-to-day operations and that results from errors of staff, systems, procedures, and processes. Also, the risk of external events, such as natural disasters, is included in this category, as well as other risks that can affect the company’s operations and that could be mitigated if proper processes and procedures were in place. Additionally, in the category of operational risk, cyber risk (e.g. hackers attack) is included.
Solvency risk is the risk that a company becomes insolvent because it runs out of cash.
The examples of risks borne by individuals include:
- identity theft,
- health risk,
- mortality risk,
- property and casualty risks.
It’s very important to factor in that different risks can interact with each other and adverse events can trigger other adverse events, so the risk may increase by an order of magnitude (wrong-way risk). Potential risk interactions should be carefully assessed during the risk management process.
market risk >> credit risk >> settlement risk >> operational risk
credit risk >> legal risk
- Financial risks include: market risk, credit risk, and liquidity risk.
- Non-financial risks include: settlement risk, compliance risk, model risk, tail risk, operational risk, and solvency risk.
- The examples of risks borne by individuals include: identity theft, health risk, mortality risk, and property and casualty risks.
- Potential risk interactions should be carefully assessed during the risk management process.