Chapter 39 - Sources Of Risk Flashcards
What is systematic risk?
- Risk relating to a whole financial system or market
- Cannot be diversified away
- You get rewarded for taking extra risk
What is diversifiable risk?
- Risks relating to an individual component of a financial system or market
- Can be diversified away
- Not rewarded for taking extra risk
What are the main risk source categories?
Market Liquidity Credit Operational External Business
Give examples of credit events.
Credit rating goes down Failure to pay Insolvency/wind-up/Bankruptcy Chance in credit spread Reputation Cross default
What are the credit risks?
Credit risk = risk that a 3rd party fails to meet their obligations of a financial transaction
- Asset default
- Counterparty risk ->settlement risk
- General debtors
What is liquidity risk and market liquidity risk?
Liquidity risk = the company is solvent but does not have sufficient financial resources to meet its liability obligations or can only do so at an excessive cost
Market liquidity risk = the market does not have the capacity to handle the volumes of assets to be bought or sold without having an effect on the price
What is the difference between liquidity and marketability?
Marketability -> how quickly can you sell it
Liquidity -> how quickly can you sell it at a predictable price
How can a company manage liquidity risk?
- Hold liquid assets
- Sell illiquid assets
- Borrow money
- Allow for seasonal variations
- Allow for margins in withdrawals to be high
What is market risk?
It is the risk of a change in the investment market values, or any other factor related to the investment market for example interest rates, inflation, economic conditions or currency movements.
- Asset valuation
- Liability valuation
- A-L mismatching
What is the market risk related to A-L modelling?
- Range of assets available
- Duration of available assets
- L can include options
- L can include discretionary benefits
- Cost of matching may be too high
Mismatch = liquidity and reinvestment risk
How can you reduce credit risk?
- Security which depends on
- Nature of transaction
- Borrower covenant
- Negotiating strength
- Market conditions
- Availability - Credit ratings
- Moody’s
- Standard and Poor’s
- Fitch
What are the canons of lending?
- Is the character of borrower satisfactory?
- Known
- Competent
- Trustworthy
- References
- Defaulted before
- Depth and spread of skills and experience
- Due diligence - Is purpose valid and will money be put to good use
- Sector concerns
- Ethical and moral considerations
- Controls on application of money
- Expansion or running costs
- Other risks (country, currency, environmental, resource, technological + inherent) - Is amount reasonable
- For purpose
- Who looses if project fails
- Own contribution - Repayment
- Affordability
- Source of funds
- Asset and income cover
- How certain it is
- Credit rating
- Higher ranking debt
- Covenants or constraints
What are external risks?
Risk of losses occurring from an external event
- fire, flood, earthquake, storm, war, terrorist attack
- legislative changes, mergers of competition
What are operational risks?
Risk of failure or inadequate internal processes, people and systems Can be managed - Data erros - Admin complexity - Management actions - Dominance risk - Inadequate risk control measures - Fraud - Failure to mitigate external risk - Failure to have recovery plans - Reliance on 3rd party
Name the business risks.
Volume of business Options and guarantees Withdrawals Mix of business Underwriting cycle Reinsurance Claims Expenses Competitors Financing Exposure Underwriting risk
