1. Risk

2. Risk and Uncertainty
• ISO 31000 Guide 73 defines risk as the effect of uncertainty
on objectives, which can include uncertainties arising from
events that may or may not happen or from a lack of
information
• In decision theory, risk is typically modelled as the expected
value of a loss function arising from the decision rule used to
make the decision in the face of uncertainty
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3. • In statistics, risk is typically modelled as the expected value
arising from the probability of an undesirable occurrence
• Frank Knight is widely regarded as having established the
distinction between risk and uncertainty in his book entitled
“risk, uncertainty, and profit”
• According to Knight the primary difference between risk and
uncertainty is that risk can be measured while uncertainty
cannot
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4. Financial Risk and Risk Management
• Financial risk may be defined as the risk associated with
financing and hence, can be defined as the unexpected
variability or volatility of returns
• Financial risk can include both up-side and down-side
• Downside risk occurs when the actual return is less than the
expected return while upside risk occurs when the actual
return is more than the expected return
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5. • Risk management is the discipline that clearly shows
management the risks and returns of every major strategic
decision at both the institutional level and the transaction
level
• It shows how to change strategy in order to bring the risk
return trade-off into line with the best long- and short-term
interests of the institution
• This definition knows no boundaries in terms of the nature
of the institution nor in the nature of the risk
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7. • Market risk is the risk to a financial portfolio arising from
changes in market conditions. Market risks are further
broken down into the components of equity risks, exchange
rate risks, interest rate risks and commodity price risks
• Equity risk – the risk that an investment will lose value arising
from movements in equity markets
• Exchange rate risk – the risk that an investment will lose
value arising from movements in exchange rates
• Interest rate risk – the risk that an interest-bearing
investment will lose value due to changes in interest rates
• Commodity risk - the risk that an investment will lose value
arising from movements in commodity prices
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8. • Liquidity: At company level liquidity refers to solvency, at market level
liquidity refers to the ability to trade with little or no cost, risk or
inconvenience
• Marketability refers to the ‘ease of trading an asset’ where the easier
it is to trade, the lower the liquidity risk of the asset
• Corporate liquidity refers to asset and liability liquidity
• Liquidity risk is the potential loss due to time-varying liquidity costs
• Liability liquidity risk is the risk arising from funding whereby liabilities
cannot be met when they fall due
• Asset liquidity risk is the risk that an asset cannot be sold due to lack
of liquidity in the market
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9. • Credit risk: The risk of a financial loss arising from a counter-
party default
• Sovereign risk: The risk of a government default
• Counterparty/default risk: The risk that a counter-party will
not pay out on a financial instrument or contract
• Credit event – a default that may contribute to the degree of
credit loss in credit risk models
• There are four basic types of credit events:
• A change in loss rates for a given default (LGD)
• A change in creditworthiness
• A change in the applicable credit spread
• A change in exposure to a particular credit facility
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10. • Basel II defines operational risk as the risk of loss resulting
from inadequate or failed internal processes, people and
systems, or from external events
• It is a wider category of risk as it includes aspects not
covered by market risk, liquidity risk, and credit risk
• Operational risk may consider personnel, systems, processes,
legal, physical, and environmental risks
• Strategic and reputational risks are excluded
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11. Approaches to Risk Management
• Risk Avoidance: A risk is eliminated by not taking any action
that would mean the risk could occur
• Risk Acceptance: A risk is accepted with no action taken to
mitigate it
• Risk Transference: A risk is transferred via a contract to an
external party who will assume the risk on an organization's
behalf
• Risk Reduction: A risk becomes less severe through actions
taken to prevent or minimize its impact
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