Kinds of Risk

 

Figure 2.2 Kinds of risk refers to the commonly used terms that describe “risk.”

We selected a number of different kinds of risk to describe in this  chapter, but as we describe in the section titled “Other Definitions of Risk,” there are many different types of risk that we do not cover. We selected risk types that are strongly related to the trading markets or that are critical to understanding the regulatory   initiatives described here.

In understanding the kinds of risk, one needs to realize that there is sometimes overlap among labels in this section in terms of the exposures to which the categories refer. Differences can come from perspective. When those engaged in operations describe risks, they are generally talking in terms of what can happen  during the settlement process, and those things are often mechanical or procedural in nature.

ENVIRONMENTAL, SOCIETAL, AND GOVERNMENTAL RIS

Traders and investors more frequently think about market events, and yet some of the same potential problems are common to both the market and  operations. Also, every new risk-induced event of significance usually results in the description of new, previously undiagnosed risk. Often these risks can be reduced to a variation or new attribute of previously defined kinds of risk, but sometimes they are indeed new.

The risks described in this chapter are in rough sequence from the broadest to more narrow kinds of risk. Business risk is common to all types of commercial enterprises. Successive categories are more specific, except for the category of systemic risk, which is the last specific kind of risk described. Systemic risk can be thought of as the result of all or most of the other types of risk occurring at the same time, resulting in a single, large, cataclysmic event.

BUSINESS RISK

Business risk occurs for all economic entities as a result of the overall services they perform and the customers they serve (see Figure 2.2.1). For a firm in the financial   markets, this kind of risk includes both the lines of business in which the firm engages (not because they are financial or market activities) and the fact that the firm is a commercial enterprise operating in a national and global economy.

Possible causesPossible results

s Normal business and commercial s Inability to pay obligations eventss Stunted growth

  • Inadequate cash flows Revenue decline             – Adverse competitives Litigation liabilities

                                       activitiess Loss of customers

  • Negative economics Possible bankruptcy              conditions           – Customer discontent
  • Product liability Business Risk

Figure 2.2.1      Business risks affect all commercial enterprises, and entities on the Street are subject to problems that affect all such organizations.

ENVIRONMENTAL, SOCIETAL, AND GOVERNMENTAL RISK

A kind of risk that is growing in importance relates to environmental concerns, shifts in the beliefs or mood of society at large, and the actions of governments (see Figure 2.2.2). Each of these components can have a large impact on individual instruments and on entire portfolios or positions. Environmental, societal, and  governmental risk is sometimes referred to as ESG.

Possible causesPossible results s             Environmental problemss Lower profits

  • Opposition to investment s Reduced flexibility  decisionss Litigation liabilities
  • Expensive demandss Loss of customers

              * Office requirements      * Recycling s             Social pressures           – Demands for equality               – Opposition to actions s            Governmental requirements

(separate from regulation)

  • Hiring practices Environmental
  • Taxation Societal, and

Governmental

Risk

Figure 2.2.2      Environmental, societal, and governmental risk occurs because all firms operate in an environment that is affected by public and political pressures that often seem unrelated or even antithetical to normal business activities.

FINANCIAL RISK

Financial risk includes the problems that an investment firm creates for itself or  others as a result of its financial condition (see Figure 2.2.3). In particular, this kind of risk occurs when a firm has insufficient financial strength to sustain its activities in the trading markets given the commitments it undertakes for itself or for its customers.

When a firm creates financial risk for itself, it creates counterparty risk for the other participants in the markets, as described next. When a firm experiences the effects of financial risk, it frequently needs to generate liquidity quickly, which can result in trading under duress, as described in Book 2, Part 1.

Possible causesPossible results

s Inadequate capitals Reduced trading capacity s Excessive trading losss Forced sale of positions s Counterparty failure(trading under duress)

s Sale of divisions or other

assets

s Bankruptcy

Financial Risk

Figure 2.2.3      Financial risk occurs when a firm lacks the financial strength or resources to absorb dramatic events without threats to its assets or even its existence.

OPERATIONAL RIS

MARKET RISK

Market risk is the potential for events in the markets—usually adverse price movements for one or more instruments—to have a negative impact on a portfolio or on a market participant (see Figure 2.2.4). Leveraged positions can cause extreme losses. An instrument that is sold short may have to be covered under extremely adverse conditions. Speculators may profit on this situation in what is known as a short squeeze. Market risk in many ways corresponds to the notion of diversifiable risk that we considered when describing Modern Portfolio Theory in Book 2, Part 1.

Possible causesPossible results

s                               Dramatic (adverse) swings in s Forced sale of positions

instruments, sectors, or entire (trading under duress)

marketss        Short squeeze

s   Leveraged positions squeeze s              Sale of assets to fund liquidity            positions

s                                                                      Bankruptcy

Market Risk

Figure 2.2.4 Market risk occurs when prices move in an adverse direction from the perspective of a trader or investor.

OPERATIONAL RISK

Operational risk is the exposure of an organization to losses because it lacks  adequate staff (or trained staff), procedures, and systems to protect the organiza tion from the other normal risks to which the organization is subjected (see Figure 2.2.5).

Possible causesPossible results

s Firm’s own backoffice is not s Processing errors effectives Trade breaks

s Counterparty’s backoffice s High processing costs ineffectives Resulting financial risk s Support entities ineffectives Bankruptcy

Operational Risk

Figure 2.2.5      Operational risk occurs when middle and backoffice failures create losses and potentially put firms and support entities at risk.

CREDIT RISK

Credit risk is the problem that occurs when credit is extended to others who may not be able to repay as promised (see Figure 2.2.6). Credit risk is most frequently described in terms of bank loans and securitized debt, but also occurs in correspondent and prime broker relationships when credit is extended to support customers’ trading activities.

Also, during settlement, there are periods when different participants are extending de facto credit pending resolution at settlement, as occurs when an intermediary may post funds or instruments in anticipation of repayment by the customer before settlement. Typically, credit risk in the trading markets goes by other names. This is an example of different types of risk going by various names depending on the perspective of the participant or group assessing the risk.

When credit risk is high, a converse problem sometimes labeled “credit risk” occurs when those who need credit are unable to obtain necessary loans to fund operations.

Possible causesPossible results

s           Firms unable to pay loanss             Credit defaults s  Firms unable to obtain credits Creditors force bankruptcy

s  Business curtailed due to           lack of credit

Credit Risk

Figure 2.2.6      Credit risk results from firms being unable to repay debts and/or firms being unable to obtain needed credit.

LIQUIDITY RISK

Liquidity risk occurs when a participant or group of participants may have assets with sufficient value to cover its obligations, but the assets are not in liquid form and/or normal sources of credit such as commercial paper or traditional lenders are unable or unwilling to provide liquid funds that the participant needs to meet obligations (see Figure 2.2.7). (Note the overlap with credit risk in the preceding section.)

During the financial crisis in 2007–2008, many firms got into trouble because traditional sources of financing were withdrawn at critical times in the market. Liquidity risk also refers to the inability of traders and investors to liquidate assets at something approaching a fair price in periods of stress. In many cases, falling markets result in many sellers and few buyers. Conversely, in a rising market, a short seller trying to cover a short position finds many sellers, but the prices result in huge, often  destructive losses.

COUNTERPARTY RIS

Possible causesPossible results

s Firms unable to access s Business curtailed due to liquidity      lack of credit

s Firms unable to liquidate s Trading under duress

assetss Firms forced into panic

  sales at huge losses s Bankruptcy

Liquidity Risk

Figure 2.2.7      Liquidity risk involves firms being unable to convert assets to cash at reasonable prices or to borrow against assets at reasonable rates.

When liquidity problems occur, firms are often forced to raise funds, frequently selling assets at distressed prices. Again, this is what we meant in Book 2 when we described duress as a type of trading.

COUNTERPARTY RISK

Counterparty risk is the exposure a firm is subjected to when the other market  participants fail or are unable to perform on the contracts and transactions in the markets (see Figure 2.2.8). In markets that are not well developed, firms must vet every counterparty independently and evaluate every transaction based on the  ability of the other party(ies) to perform. In developed markets, clearing corporations and clearing funds serve as a protection for market participants against problems with counterparties. In less developed markets, participants are required to perform an independent credit analysis for each counterparty.

Possible causesPossible results

s Trading and/or settlements A firm suffers serious damage                 partners unable to performand/or loss

s Trading and/or settlements A firm is itself unable to perform             partners collapse while      for other counterparties           controlling a firm’s assetss Bankruptcy

    or before completing settlement s Daisy-chain fails obligations    Counterparty Risk           s Damage to support entities

s Systemic threats

Figure 2.2.8      Counterparty risk involves a trading or settlement partner that is unable to perform as expected, resulting in losses and a possible survival threat to the damaged party.

REGULATORY RISK

Although most regulation is intended to protect the markets and reduce risks, market  participants may sometimes be at risk from regulations (i.e., regulatory risk) that limit a firm’s  ability to engage in desired activities (see Figure 2.2.9). In some cases, the activity is proscribed because of r egulatory ineptitude, but often the interests of a market  participant or group may run counter to the best interests as a whole.

Whether the purposes are inept or beneficial, market participants must monitor  impending regulatory changes, influence them if possible, and prepare for them in any case. Often industry groups monitor regulation for their members and work as agents to influence the details and implementation of regulations.

Possible causesPossible results

s Regulator takes unexpected s A firm suffers a threatening

action threatening a firm or regulatory or enforcement

its activities                                                          action

s A regulator takes actionss A firm’s business is diminished     that make a firm’s activitiesor made unlawful  less attractives A firm is liquidated by a

                                                                    regulator

Regulatory Risk

Figure 2.2.9      Regulatory risk is created when pending regulations put traditional activities at risk and potentially threaten participants with liabilities because those activities are to be reclassified as wrong or problematic.

SYSTEMIC RISK

Systemic risk is described as the risk that individual firms create for the system (e.g., the banking system) of which they are a part as a result of the actions they undertake (see Figure 2.2.10). By contrast, a firm that is part of a system can be put at risk because of the actions of others even if the firm itself has not engaged in risky behavior.

OTHER DEFINITIONS OF RIS

Possible causesPossible results

s Failure of a major market s National markets at risk participant or support s Global market at risk

entitys A collapse of global

s Multiple cumulative failures             confidence and trading

Systemic Risk

Figure 2.2.10      Systemic risks are those that threaten the entire financial system in a country or globally.

OTHER DEFINITIONS OF RISK

Beyond the risk categories presented here, there are many other examples. In his book Operations Risk: Managing a Key Component of Operational Risk, David Loader  provides a glossary of risk with 48 different components. Even that list does not include systemic risk, which we have included. This suggests four important facts related to risk:

s 4HERE ARE MANY DIFFERENT KINDS OF RISK AND ALTHOUGH THERE IS OVERLAP among categories, each category has understandable differences from other categories.

s 2ISK DEFINITIONS TEND TO BE PREDICATED ON THE PERSPECTIVE OF THE INDIVIDUAL

or group making the definition.

s 4HERE ARE NO ABSOLUTE DEFINITIONS OF RISK s -UCH OF THE DISCUSSION THAT OCCURS ABOUT RISK SUFFERS WHEN DIFFERENT

commentators use the same or similar words to mean different things.

Therefore, discussions of risk require care in explaining and understanding the implicit definitions being used.