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MBA – PM0012 : Describe various types of financial risks.

Posted on: March 2, 2012

 MBA – PM0012 : Describe various types of financial risks.

Answer: The risks associated with finance are:

Liquidity Risk: The possibility that the cash available to a bank exceed by customer’s calls on it, or the income generated by a corporation, along with the funds raise through equity or debt issuance and/or borrowing, are insufficient to cover operating commitment forcing the corporation to stop operations. It can also be through thin markets sometimes resulting from distractions, which result in the unavailability of hedging instruments at economic prices.

Most institutions generally face two types of liquidity risk, the first relates to the depth of markets for definite products and the second to funding the financial-trading activities of the firm. For example, some firms have contract limits for every futures contract based on the volume of turnover and outstanding. Senior managers have to develop methods to identify and monitor the firm’s liquidity sources to ensure it can meet the funding demands of its activities. This is achieved by examining the differences in maturities between assets and liabilities and by analysing future funding requirements based on various assumptions, including the firm’s ability to settle down positions quickly in adverse conditions.

Credit Risk (Counterparty Risk): This risk may occur due to the non-payment by the borrower or counterparty such that loans, bonds or leases will not be repaid on time or in full or the counterparty will fail to perform on an obligation to the institution. The likelihood of this happening is calculated through the repayment record or default rate of the borrowing entity, determination of market conditions, and default rate of a loan portfolio of similar borrowers.

Sovereign Risk: This is the risk that a government action will interfere with repayment of a loan or security. This is measured, by the past performance of the nation and present default rate and situation such as political, social and economic. It is controlled by severe credit analysis, limiting exposure as a percentage of portfolios, and incorporating covenants into the loan documents.

Market Risk: This deals with unfavourable price or volatility that affects the assets contained in a firm’s or fund’s portfolio. It can be defined as the doubt of a financial institution’s earnings which results from changes in market conditions such as the price of an asset, interest rates, market volatility and market liquidity.

Settlement Risk: This refers to the risk that an expected settlement payment on a commitment will not be made on time due to bankruptcy, inability or time zone differential and it is related to credit risk but not identical. For example, a bilateral obligation in which one party makes a required settlement payment and the counterparty does not. Settlement risk provides an important inspiration to develop netting arrangements and other safeguards and is also called Delivery Risk.

Interest Rate Risk: The risk due to changes in interest rates results in financial losses related to asset or liability management. It is measured by past and present market instability and the profile of the asset or liabilities of the bank and its possible exposure through gap management.

Foreign Exchange Risk: The risk caused due to the rate change in the foreign exchange that cause foreign exchange denominated assets to fall in value or foreign exchange denominated liabilities to rise in expense. It is measured by marking-to-market the importance of the asset, or raise of the liability, by the actual movement of the exchange rate between the currency of the asset or liability and the currency of the booked or pending asset or liability, or country of earnings return.

Capital Risk: The risk may incur if the institution has insufficient capital for losses, which can result in bankruptcy or regulatory closure. It has a sub-optimal equity-debt capital profile which negatively impacts the market price of its stock. It is controlled by conditions and reserves from past earnings sufficient enough to cover operating losses; and by evaluating the loan, securities and trading operations accurately for any pending losses or deterioration.

Fraud Risk: The risk may occur if the banks own employees or its customers will defraud the bank. This is one of the most complicated situations to measure or control. It is controlled by dividing trading and settlement functions, periodic internal and external audits, and a centralised computer system to track and quickly or accurately resolve the bank’s position, portfolio and operations.

Legal Risk: This risk is caused because of claims from dissatisfied employees, clients, improper documentation; criminal or negligent conduct, workplace regulations or environmental defect will severely disrupt the company’s operations.

Operations Risk: The risk that human or machine, error or failure will result in financial losses due to documentation scarcity, securities processing, clearing issues, and systems failure. It is difficult to measure errors but the loss can be substantial related to settlement problems or customer liability suits. It is controlled through back-up data processing systems, computerised accounting or audit system that can flag a problem, and reserves for related losses.

Overhead Risk: The risk that overhead expenses excessively saddle the company’s capability. It is measured by the ratio of total expenses or net interest income and total of other income; other expenses tend to rise faster than income in a time of inflation.
Regulatory Risk: The risk that changes in regulations will negatively affect. It is measured by the way a change affect an established operation or restricts entry into a new operation, or affects capital reserve requirements, or operating requirements of the respective national banking regulator.

Economic Conditions Risk: The risk, that an undesirable change in economic conditions can unduly put the bank at risk. It is measured by how the loan portfolio will perform, what interest rates will do, how the securities portfolio may refuse in market value, how liabilities may raise, deposit withdrawals increase resulting in liquidity problems.

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