Financial and Non-financial Sources of Risk

Financial risks originate from financial markets and might arise from changes in share prices or interest rates. Non-financial risks emanate from outside the financial market environment and could be consequences of environmental or regulatory changes or an issue with customers or suppliers.

Financial Risk

The three primary types of financial risks are:

Market Risk

Market risk arises from movements within the financial market environment.  Such movements include shifts in share prices, interest rates, exchange rates, commodity prices, and other economic or industry market factors.

Currency risk is a form of market risk. It affects investors or companies that operate across different countries. Currency risk arises due to a change in the value of one currency relative to another. For instance, a non-US company that imports some of its raw materials from the US will be affected by currency risk, i.e., a change in the dollar relative to the company’s domestic currency will affect the quantity of raw materials imported, thereby affecting the company’s value.

Credit Risk

Credit risk is the risk of loss due to the failure of one party to pay the other an outstanding obligation. Credit risk may be defined as default risk or counterparty risk. Defaults and bankruptcies have long-term implications for borrowers and may be irrecoverable.

Liquidity Risk

Liquidity risk is the risk of a severe downward price revision when attempting to sell a particular asset. In stressed market conditions, the seller may have to accept a price well below their perception of value. Within financial markets, the typical transaction cost is measured by the bid-ask spread, where the selling price is less than the buying price. When there is uncertainty in the bid-ask spread, for example, if the spread widens significantly during a stressful market period, it means the liquidation price (selling price) is far lower than the seller believes it should be, and this creates a liquidity risk. Liquidity risk does not just pertain to illiquid assets; market liquidity varies over time for particular assets, and the size of the position and the uncertainty associated with its sale or liquidation increases simultaneously.

Non-Financial Risk

There are a number of non-financial risks that an organization may face:

Settlement Risk

Closely related to default risk, it is the risk around the timing of payments between counterparties. For example, while one party may observe the agreement of a currency swap, the other party may not.

Legal Risk

This is the risk of being sued, particularly in litigious environments, or the risk that a counterparty will not uphold a contractual obligation.

Compliance Risk

Compliance risk is made up of regulatory risk, accounting risk, and tax risk. An update of laws and regulations may create the need for financial restatements, back taxes, or other penalties.

Model Risk

This is the risk of valuation error when the valuation of a particular security is based on a misspecified price model.

Tail Risk

The likelihood or probability of a material negative outcome is often understated in financial models, and it is, in most cases, related to model risk. Financial markets do not follow a normal distribution of returns but tend to have “fat tails.” In case the internally selected model does not account for this, tail risk is introduced.

Operational Risk

This risk is related to the people and processes of an organization. The employees of an organization can make errors that are financially costly or act fraudulently due to a lack of proper oversight and control. Companies may also be subject to business interruptions attributable to natural calamities or terrorism.

Solvency Risk

A company may not survive if it runs out of cash and becomes insolvent. In times of solvency pressure, a company may be forced to liquidate assets at unfavorable prices simply to raise the necessary cash. Solvency risk can easily be mitigated by making use of less leverage, using more stable sources of funding, and incorporating solvency measures at the governance level of the business.

Interactions Between Risks

There are numerous interactions between risks – both financial and non-financial – and these interactions become more pronounced during times of market stress. The combined risk is often far more than the “sum of the parts” in the sense that risks may exacerbate one another to drive up the total enterprise risk.

An example of risk interactions may be the failure of a key counterparty to settle an obligation on time. Settlement risk creates a solvency risk for the company which was due to receive the proceeds. In turn, it may not be able to pay its suppliers, which occasions legal risk. Or, it may not meet regulatory solvency requirements, which creates compliance risk. It may also need to rapidly sell assets to raise cash hence creating a liquidity risk.

Often, risk models do not adequately account for risk interactions and understate the overall risk. The governance board, company management, and financial analysts should be aware of how consequential a combination of risks can be. This awareness should motivate them to adopt holistic approach to risk management instead of treating each risk in isolation.

Question

Which of the following are examples of financial risks?

A. Model risk, credit risk, and solvency risk

B. Tail risk, operational risk, and legal risk

C. Credit risk, market risk and, liquidity risk

Solution

The correct answer is C.

Credit risk, market risk, and liquidity risk are classified as financial risks.

Model risk, solvency risk, tail risk, operation risk, and legal risk are examples of non-financial risk.