Financial risk

The four standard market risk factors are equity risk, interest rate risk, currency risk, and commodity risk:

Equity risk is the risk that stock prices in general (not related to a particular company or industry) or the implied volatility will change. When it comes to long-term investing, equities provide a return that will hopefully exceed the risk free rate of return[6] The difference between return and the risk free rate is known as the equity risk premium. When investing in equity, it is said that higher risk provides higher returns. Hypothetically, an investor will be compensated for bearing more risk and thus will have more incentive to invest in riskier stock. A significant portion of high risk/ high return investments come from emerging markets that are perceived as volatile.

Interest rate risk is the risk that interest rates or the implied volatility will change. The change in market rates and their impact on the probability of a bank, lead to interest rate risk.[7] Interest rate risk can affect the financial position of a bank and may create unfavorable financial results.[7] The potential for the interest rate to change at any given time can have either positive or negative effects for the bank and the consumer. If a bank gives out a 30-year mortgage at a rate of 4% and the interest rate rises to 6%, the bank loses and the consumer wins. This is an opportunity cost for the bank and a reason why the bank could be affected financially.

Currency risk is the risk that foreign exchange rates or the implied volatility will change, which affects, for example, the value of an asset held in that currency. Currency fluctuations in the marketplace can have a drastic impact on an international firm's value because of the price effect on domestic and foreign goods, as well as the value of foreign currency denominate assets and liabilities.[8] When a currency appreciates or depreciates, a firm can be at risk depending on where they are operating and what currency denominations they are holding. The fluctuation in currency markets can have effects on both the imports and exports of an international firm. For example, if the euro depreciates against the dollar, the U.S. exporters take a loss while the U.S. importers gain. This is because it takes less dollars to buy a euro and vice versa, meaning the U.S. wants to buy goods and the EU is willing to sell them; it's to expensive for the EU to import from U.S. at this time.

Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) or implied volatility will change. There is too much variation between the amount of risks producers and consumers of commodities face in order to have a helpful framework or guide.[9]

Financial risk measurement, pricing of financial instruments, and portfolio selection are all based on statistical models. If the model is wrong, risk numbers, prices, or optimal portfolios are wrong. Model risk quantifies the consequences of using the wrong models in risk measurement, pricing, or portfolio selection.

The main element of a statistical model in finance is a risk factor distribution. Recent papers treat the factor distribution as unknown random variable and measuring risk of model misspecification. Jokhadze and Schmidt (2018) propose practical model risk measurement framework.[10] They introduce superposed risk measures that incorporate model risk and enables consistent market and model risk management. Further, they provide axioms of model risk measures and define several practical examples of superposed model risk measures in the context of financial risk management and contingent claim pricing.

Credit risk management is a profession that focuses on reducing and preventing losses by understanding and measuring the probability of those losses. Credit risk management is used by banks, credit lenders, and other financial institutions to mitigate losses primarily associates with nonpayment of loans. A credit risk occurs when there is potential that a borrower may default or miss on an obligation as stated in a contract between the financial institution and the borrower.

Attaining good customer data is an essential factor for managing credit risk. Gathering the right information and building the right relationships with the selected customer base is crucial for business risk strategy. In order to identify potential issues and risks that may arise in the future, analyzing financial and nonfinancial information pertaining to the customer is critical. Risks such as that in business, industry of investment, and management risks are to be evaluated. Credit risk management evaluates the company's financial statements and analyzes the company's decision making when it comes to financial choices. Furthermore, credit risks management analyzes where and how the loan will be utilized and when the expected repayment of the loan is as well as the reason behind the company's need to borrow the loan.

Expected Loss (EL) is a concept used for Credit Risk Management to measure the average potential rate of losses that a company accounts for over a specific period of time. The expected credit loss is formulated using the formula:

Expected Loss = Expected Exposure X Expected Default X Expected Severity

Expected Exposure refers to exposure expected during the credit event. Some factors impacting expected exposure include expected future events and the type of credit transaction. Expected Default is a risk calculated for the number of times a default will likely occur from the borrower. Expected Severity refers to the total cost incurred in the event a default occurs. This total loss includes loan principle and interests. Unlike Expected Loss, organizations have to hold capital for Unexpected Losses. Unexpected Losses represent losses where an organization will need to predict an average rate of loss. It is considered the most critical type of losses as it represents the instability and unpredictability of true losses that may be encountered at a given timeframe.[11][12][13][14]

This is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). There are two types of liquidity risk:

• Asset liquidity – An asset cannot be sold due to lack of liquidity in the market – essentially a sub-set of market risk. This can be accounted for by:
  • Widening bid-offer spread
  • Making explicit liquidity reserves
  • Lengthening holding period for VaR calculations
• Funding liquidity – Risk that liabilities:
  • Cannot be met when they fall due
  • Can only be met at an uneconomic price
  • Can be name-specific or systemic

Operational risk means the risk that a company or individual has to face due their own operation and decisions made for the investment. Unlike Market risk, Liquidity risk and Credit risk. As long as the personnels, internal systems and processes are not perfect, there is no way could completely eliminate the operational risks.[15]

Non-financial risks summarize all other possible risks

• Reputational risk
• Legal risk
• IT risk