Describe the main classes of risk and set them apart, showing how each arises and judging what effect each could have on an organization.
The idea
The main classes of risk differ in where they come from. Market risk is loss from changes in prices and rates such as equities, interest rates, currencies and commodities. Credit risk is loss from a borrower or counterparty failing to pay, including a downgrade. Liquidity risk has two forms. Market liquidity risk is being unable to sell an asset without a large price concession. Funding liquidity risk is being unable to raise cash to meet obligations when due. Operational risk is loss from inadequate or failed processes, people, systems or external events. Under Basel it includes legal risk but excludes strategic and reputational risk. Business or strategic risk is the erosion of revenue from competition or regulation. Reputational risk is loss of trust. Funding liquidity failure can be fatal within days, while business risk acts slowly. On the exam, classify by the root cause.
A practice question
Market risk is the risk of:
- losses from changes in market prices and rates, such as equity prices or interest rates. - correct
- losses because a counterparty fails to meet its contractual obligations.Why not: That describes credit risk, loss from counterparty failure, not market risk.
- losses from inadequate or failed internal processes, people and systems.Why not: That is the definition of operational risk.
- losses because positions cannot be sold or funded without significant cost to the institution.Why not: That is liquidity risk, arising from market depth or funding access rather than from price level changes.
Market risk arises from movements in the prices of traded or marked-to-market positions. Credit, operational and liquidity risks arise from default, failed processes and inability to trade or fund.
A harder one
A fund must sell a large block of thinly traded corporate bonds and can do so only at a price 6% below the last quote. Which risk does this illustrate?
- Funding liquidity risk: the fund cannot raise enough cash to meet its obligations as they fall due.Why not: Funding liquidity is the inability to raise cash or refinance; here the issue is the price impact of selling an asset.
- Credit risk: the issuer's creditworthiness has deteriorated.Why not: Nothing indicates a change in credit quality; the discount reflects thin trading.
- Market liquidity risk: the position cannot be sold without a big price concession. - correct
- Operational risk: the trading system failed to execute the sale.Why not: No process failed; the trade executed, but at a price reflecting shallow market depth.
The concession reflects market depth, which is market liquidity risk. Funding liquidity concerns cash raising ability, and the two can interact but are different.
The hardest tier
A fintech suffers a cyber attack that exposes customer data. As the news spreads, customers leave and some lenders cut credit lines. Which description is most accurate?
- Both the attack and the loss of trust are operational risk, since Basel's definition of operational risk includes reputational loss.Why not: Basel's definition includes legal risk but excludes strategic and reputational risk.
- The attack is a market risk event, because the firm's value fell when the news became public.Why not: Market risk comes from changes in market prices on positions; a cyber incident arises from failed systems and controls.
- The attack is legal risk only, because data protection law is what makes the incident costly.Why not: The root cause is a failure of systems and controls, which is operational risk; legal costs are a consequence.
- The attack is an operational risk event; the loss of trust is reputational risk, which can feed business and funding problems. - correct
Classify by root cause: failed systems and security are operational risk. The consequences, such as loss of trust, customer attrition and funding withdrawal, are reputational, business and liquidity effects.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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