Financial risks originate from financial markets and might arise from changes in share price or interest rates. Non-financial risks are from outside of the financial market environment and could be as a result of environmental or regulatory changes or an issue with customers or suppliers.
The three primary types of financial risk are:
- Market risk
- Market risk arises from movements within the financial market environment like share prices, interest rates, exchange rates, commodity prices and other economic or industry market factors.
- Credit risk
- Credit risk is the risk of loss due to the failure of one party to pay another 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 as the size of the position increases, the cost, and uncertainty associated with selling or liquidating the position increases.
There are a number of non-financial risks that an organization may face:
- Settlement risk
- Closely related to default risk and is the risk around the timing of payments between counterparties
- Legal risk
- The risk of being sued, particularly in litigious environments
- The risk that a counterparty will not uphold a contractual obligation
- Compliance risk made up of regulatory risk, accounting risk, and tax risk
- When laws and regulations are updated, this may create the need for financial restatements, back-taxes or other penalties
- Model risk
- The risk of valuation error when the valuation of a particular security is based on a misspecified price model
- Tail risk
- This is often related to model risk, the likelihood or probability of a material negative outcome is often understated in financial models. Financial markets do not follow a normal distribution of returns but tend to have “fat tails” and if 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 which are financially costly or act fraudulently due to a lack of proper oversight and control. Companies may also be subject to business interruptions due to weather 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 be easily 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 risk may exacerbate each to drive up the total enterprise risk.
An example of risk interactions may be the failure of a key counterparty is settle an obligation in a timely manner. The settle risk creates a solvency risk for the company which was due to receive the proceeds. In turn, they may not be able to pay their suppliers which leads to legal risk. Or, they may not meet regulatory solvency requirements which creates compliance risk. They may need to rapidly sell assets to raise the cash 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 the potential for combined risks and try to incorporate a more holistic risk view rather than treating different risk categories in isolation.
Which of the following are examples of financial risk?
A. Model risk, credit risk, and solvency risk
B. Tail risk, operational risk, and legal risk
C. Credit risk, market risk and, liquidity risk
The correct answer is C.
Credit risk, market risk, and liquidity risk are classified as financial risk. Model risk, solvency risk, tail risk, operation risk and legal risk are examples of non-financial risk.
Reading 40 LOS 40f:
Identify financial and non-financial sources of risk and describe how they may interact