Types of Risk

There are three main forms of risk that a financial institution is subject to; market risk, credit risk, and operational risk. 

Market Risk

Market risk refers to the possibility of loss on investments or trading operations.  There are a few key macro events which could increase the risk to a trading portfolio.  The most obvious is the devaluation in the equity markets.  In the last 10 years, the equity markets have experienced two substantial crashes.  In March of 2000, the equity markets topped which subsequently led to a major crash in the markets, namely in technology shares.  In 2007 to 2008, the equity markets crashed once again as the credit markets became unstable due to the reckless amount of leverage that individuals and businesses were allowed to take.  These events bankrupted hundreds of companies, small to very large.  In both cases, leverage was the name of the game and bank assets and liabilities were grossly mismatched.  Money was cheap and when the party ended, interest rates moved higher and banks imploded.

Other important market risks to consider are interest rate risk, exchange rate risk, and commodity price risk.

Credit Risk

Credit risk and market risk are closely tied together.  You can view credit risk as the risk of default on a debt payment.  Market risk premiums and prices increase as the perceived credit risk increases.  There are many forms of credit risk; counterparty risk affects trading operations if the counterparty fails to take delivery on a security or fails to pay at settlement of a derivatives contract.  Banks issuing loans to other business also face default risk in the event that the borrower does not repay the loan.  Conversely, the issuing bank also carries a credit risk and a credit rating downgrade will send the bond price spiraling lower, thereby affecting the bond investors.

Operational Risk

Operating risk defines the risk that originates from an organizations people and processes.  This type of risk accounts for fraudulent activity, mistakes by employees, and even legal risks.  Since the implementation of Basel II, creates international standards that regulators can use to mandate capital reserves that banks must set aside to protect against various operational risks that exist for banks.  There are three common types of calculations that Basel II calls for in order to calculate operational risk:  Basic indicator approach, standardized approach, and the advanced measurement approach.  The basic and standardized approaches are relatively straight forward; they calculate capital requirements based on revenue.  The basic indicator approach is based on annual revenues while the standardized approach is based on annual revenues by business segments.  The advanced measurement technique is a customized approach using a home grown risk measurement platform which adheres to industry standards.

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Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...

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