What is a risk?

Risk means when there could be a possibility that the returns expected from a particular project or investment may or may not match the investor's expectations. In other words, the uncertainty of an income arising from a source that would either be lower than expected or result in losses in risk exposure of the project. The higher the risk involved, the higher is the return expected by the investor as the investor is exposed to a high level of risk. There are various methods by which different types of risk can be assessed and avoided or mitigated.

Systematic and unsystematic risk

Systematic risk refers to the risk associated with the market as a whole. Economic, geographic, political, and financial factors affect systematic risk. Unsystematic risk is the risk associated with a particular organization or industry. Unsystematic risk can be mitigated, and preventive measures can be taken.

Classification of risk

Financial products are classified into two risks:

• Market Risk
• Credit Risk

Market risk

Market risk is further classified into the following classes:

Interest rate risk

Whenever there is a change in the yield curve, the interest rate risk arises. Returns on investment and the cost of lending and borrowing are dictated by the interest that affects the financial statements of the financial institutions.

The following sources generate the interest rate risk:

• Yield Curve Risk: This risk arises due to a change in fixed-income securities' interest rate. This risk is the most vital risk that sometimes the organization's existence is at stake.
• Basis Risk: This risk arises due to the change in the spreads. That is why it is also known as the spread risk. When there is a relationship change between interest rates and benchmarks, spread risk arises.
• Repricing Risk: This is the risk that arises on the reset date. This risk greatly impacts those fixed-income securities that are about to mature or whose interest rates will be rest soon. This risk changes the interest rate on the date on the financial contract.
• Optionality Risk: This risk arises in embedded contracts, giving one party an option to call or repay the borrowed money. This risk generally arises when there is a change in the interest rate at which money was borrowed.

Foreign exchange risk

Foreign exchange risk significantly impacts the organizations involved in foreign exchange or those organizations whose assets and liabilities are denominated in foreign currency.

Commodity risk

Commodity risk is a type of risk that arises due to change in the prices of commodities, commodity index, etc. The impact of this risk is mainly on those financial institutions whose customers mostly trade in the commodity market.

Equity Risk

When equity indices fall for most of the equity shares, equity risk arises. The reason behind equity risk is unprecedented events such as sovereign default, any default in payment by the country's government, etc.

Credit risk

Credit risk refers to the risk of default that might arise due to the borrower failing to repay the debt. Banks grant credits daily, and hence they are always at high risk. Bank serves both wholesale and retail segments. Now, the question arises what the optimal credit risk is? So, in the banking business, the greater the credit lend by the bank, the higher the risk it holds. However, the optimal credit decision will maximize the return. The decision of optimal risk depends on how much credit risk should be accepted? How much compensation should be added? What will be the credit cap limit? On what basis customer's request will be accepted or rejected?

Following is the credit risk classification:

• Default risk: This risk is associated with the default in payment. Every bank or even insurance company estimates the probability of default depending upon the borrower's creditworthiness, which can be determined by the factors like size of business, reputation, brand value, etc.
• Exposure risk: This risk is associated with the future level or amount of risk. This risk mainly arises when there is an uncertain event, for example, prepayment of the loan.
• Recovery risk: This risk is associated with default in the recovery of loans or insurance premiums. However, this risk can be minimized by collateral or a third-party guarantee.
• Collateral risk: This risk arises only when the collateral is sold at a significant value. The loan is provided for an amount less than the collateral value, but even if the collateral value reduces, there may be a collateral risk.

Factors affecting the credit risk:

There are two factors that can affect the credit risk classification:

• Internal factors
• External factors

Internal factors: These factors are internal to the bank. Internal factors like the concentration of credit in a few bank branches, excessive lending to a particular industry sector or organization, ignoring the intention of customers behind taking the loan, liberal credit appraisal, absence of efficient recovery mechanism, etc.

External factors: These are the factors that are beyond the bank's control. External factors like fluctuation in the exchange rate, loss to people in business, change in standard interest rates, standard government policies, etc. Loss to a particular industry due to a change in stock indices also falls under external factors.

Credit Risk management in banks

In order to implement an appropriate credit risk management system in banks, the regulatory authorities expect every bak to take appropriate actions such as policy framework, Credit rating framework, credit risk models, Portfolio management, managing credit risk in inter-bank exposure, country risk, loan review mechanism, new capital accord.

Problems faced during risk classification

Effective risk management starts with the risk identification and understanding of various types of risk. It involves the establishment of risk limits, monitoring mechanisms, and the adoption of risk mitigation measures. Following are the few signals of risk management and risk classification.

1. The level of risks is calculated using various methods. It is possible that the method used to assess the risk was not appropriate and best suited for the risk classification.
2. Sometimes, the risk management team is inefficient in assessing the risk and doing the risk classification in such a manner results in a loss to the organization.
3. Those involved in hedging and speculative activity have a habit to hedge their risk, but their speculative attitude makes them fall for losses.
4. It is human nature to desire huge profits quickly, but the impact can be negative due to the high risk involved, resulting in a loss.

Challenges in risk management

Effective risk monitoring requires the following practices:

(a) Physical and functional segregation of the trading room and the back office, including segregation of reporting lines.

(b) Well-documented operating procedures to ensure, among other things.

(c) Proper deal capture-transactions are rightly captured such that risk positions can be compiled in an accurate and timely manner for monitoring purposes;

(d) An effective and efficient reporting mechanism, which spells out, among other things, the circumstances under which exceptional reports have to be made to senior management.

(e) Independent verification of prices, rates, and yield curves used for risk management and accounting purposes.

Insurance risk

Apart from the two main risk classifications of market risk and credit risk, there is one more risk associated with the individuals called insurance risk. Insurance companies calculate their risk by determining the new policies and premiums thereon. If an insurance company finds that the group of individuals to be insured is risky with less credibility, the premium on the policy is set as higher as the risk. The risk insurance also depends on the age, health, and prior driving record.

Context and Applications

This topic is significant in the professional exams for both undergraduate courses & postgraduate courses and competitive exams, especially for:

• Certified Risk Management
• Chartered Financial Analyst
• Financial Risk Management
• Associate in Risk Management

Practice problems

Common Mistakes

The biggest mistake done by students is not classifying risk appropriately. A thorough understanding of market risk and credit risk is important to become a pro player in the stock market.

Related Concepts

While studying this topic, it is important to read the following topics to get a better knowledge:

• Credit policy
• Treasury operations
• Credit derivatives
• Credit rating
• Money markets