Financial Terms related to Risk This document is part of the valuable contents available at www.ftpall.com, a free online glossary with more than five thousand financial and business terms. This document can be copied and distributed freely Find thousands of financial terms at www.ftpall.com respecting its original format. It is forbidden its transcription, translation or change on its format without authorization of its author or editor. RISK Affiliate risk • If the parent company of a one-bank holding company (OBHC) or one of the affiliate banks of multi-bank holding company (MBHC) fail, there is a risk that Federal Reserve or other private claim holders will sue the non-failing bank to recover their losses. Hence, failure of an affiliate presents contingent off-balance sheet risk. Bankruptcy risk • The risk that a firm will be unable to meet its debt obligations. Also referred to as default or insolvency risk. Basis risk • Is the risk in the basis time series. This can be influenced by many variables although the total impact is less than the exposure for a naked position. When a www.ftpall.com 2|Page hedge is placed, price risk is transformed into basis risk. Basis risk is substantially less than price or inventory risk in terms of dollars. • The uncertainty about the basis at the time a hedge may be lifted. Hedging substitutes basis risk for price risk. Business and industry risk • Uncertainty of an investment's return due to a fall-off in business that is firm-related or industry-wide. Find thousands of financial terms at www.ftpall.com Business risk • The risk to the firm of being unable to cover operating costs. • The risk that the cash flow of an issuer will be impaired because of adverse economic conditions, making it difficult for the issuer to meet its operating expenses. Call risk • The combination of cash flow uncertainty and reinvestment risk introduced by a call provision. Commercial risk • The risk that a foreign debtor will be unable to pay its debts because of business events, such as bankruptcy. Company specific risk • Related: Unsystematic risk Completion risk • The risk that a project will not be brought into operation successfully. Counterparty risk • The risk that the other party to an agreement will default. In an options contract, the risk to the option buyer that the option writer will not buy or sell the underlying as www.ftpall.com 3|Page agreed. Country economic risk • Developments in a national economy that can affect the outcome of an international financial transaction. Country financial risk • The ability of the national economy to generate enough foreign exchange to meet payments of interest and principal on its foreign debt. Find thousands of financial terms at www.ftpall.com Country risk • General level of political and economic uncertainty in a country affecting the value of loans or investments in that country. • See sovereign risk. Country risk analysis models • Country Risk Analysis Models incorporate variables such as Debt Service ratio, Import Ratio, Variance of Export Revenue. Domestic Money Supply Growth Rate and others to predict the probability of debt rescheduling problems. Credit risk • The risk that an issuer of debt securities or a borrower may default on his obligations or that the payment may not be made on a negotiable instrument. Related: Default risk • Is the risk related to counterparty failure. It is a key concern for Over-the-Counter transactions. This compares to listed trades passing through a clearinghouse. • Credit risk refers to the possibility that borrowers sometimes default on their promises. The risk that an issuer of debt securities or a borrower may default on his obligations, or that payment may not be made on sale of a negotiable instrument. www.ftpall.com 4|Page (See overnight delivery risk.) Cross border risk • Refers to the volatility of returns on international investments caused by events associated with a particular country as opposed to events associated solely with a particular economic or financial agent. Currency risk • Related: Exchange rate risk Find thousands of financial terms at www.ftpall.com Currency risk sharing • An agreement by the parties to a transaction to share the currency risk associated with the transaction. The arrangement involves a customized hedge contract embedded in the underlying transaction. Default risk • The risk that a company will be unable to pay the contractual interest or Principal on its debt obligations. • Also referred to as credit risk (as gauged by commercial rating companies), the risk that an issuer of a bond may be unable to make timely principal and interest payments. • see Credit Risk Diversifiable risk • Related: unsystematic risk. • The portion of an asset's risk that is attributable to firm-specific, random causes; can be eliminated through diversification. Economic risk • In project financing, the risk that the project's output will not be salable at a price that will cover the project's operating and maintenance costs and its debt service www.ftpall.com 5|Page requirements. Equilibrium market price of risk • The slope of the capital market line (CML). Since the CML represents the return offered to compensate for a perceived level of risk, each point on the line is a balanced market condition, or equilibrium. The slope of the line determines the additional return needed to compensate for a unit change in risk. Event risk Find thousands of financial terms at www.ftpall.com • The risk that the ability of an issuer to make interest and principal payments will change because of rare, discontinuous, and very large, unanticipated changes in the market environment such as (1) a natural or industrial accident or some regulatory change or (2) a takeover or corporate restructuring. • The risk that a corporate bond will be downgraded, perhaps severely, due to some unpredictable outside event, principally a leveraged buy-out. Exchange rate risk • Also called currency risk, the risk of an investment's value changing because of currency exchange rates. • a) The danger that an unexpected change in the exchange rate between the dollar and the currency in which a project's cash flows are denominated can reduce the market value of that project's cash flow; b) The risk caused by varying exchange rates between two currencies. Exchange rate risk capital budgeting • Danger that an unexpected change in the exchange rate between the dollar and the currency in which the project's cash flows are denominated can reduce the market value of that project's cash flow. Exchange risk www.ftpall.com 6|Page • The variability of a firm's value that results from unexpected exchange rate changes or the extent to which the present value of a firm is expected to change as a result of a given currency's appreciation or depreciation. Fallout risk • A type of mortgage pipeline risk that is generally created when the terms of the loan to be originated are set at the same time as the sale terms are set. The risk is that either of the two parties, borrower or investor, fails to close and the loan falls out of the pipeline. Find thousands of financial terms at www.ftpall.com Financial risk • The risk that the cash flow of an issuer will not be adequate to meet its financial obligations. Also referred to as the additional risk that a firm's stockholder bears when the firm utilizes debt and equity. • The risk to the firm of being unable to cover required financial obligations (interest, lease payments, preferred share dividends). Firm specific risk • See: diversifiable risk or unsystematic risk. Flat price risk • Taking a position either long or short that does not involve spreading. Force majeure risk • The risk that there will be an interruption of operations for a prolonged period after a project finance project has been completed due to fire, flood, storm, or some other factor beyond the control of the project's sponsors. Forecasting risk • The possibility that the estimated cash flows are wrong (either too high or too low) and, as a result, a wrong decision made. www.ftpall.com 7|Page Foreign exchange fx risk • The risk that a long or short position in a foreign currency might, due to an adverse movement in the relevant exchange rate, have to be closed out at a loss. The long or short position may arise out of a financial or commercial transaction. Foreign exchange risk • This refers to the possibility of losing money due to changes in exchange rates. Net Foreign Exchange Exposure will create a FX risk even if the bank is perfectly hedged with respect to duration, credit risk, etc. Find thousands of financial terms at www.ftpall.com • The risk that a long or short position in a foreign currency might have to be closed out at a loss due to an adverse movement in the currency rates. Funding risk • Related: interest rate risk Geographic risk • Risk that arises when an issuer has policies concentrated within certain geographic areas, such as the risk of damage from a hurricane or an earthquake. Herstatt risk • The risk of loss in foreign exchange trading that one party will deliver foreign exchange but the counterparty financial institution will fail to deliver its end of the contract. It is also referred to as settlement risk. Idiosyncratic risk • Unsystematic risk or risk that is uncorrelated to the overall market risk. In other words, the risk that is firm specific and can be diversified through holding a portfolio of stocks. Inflation risk • Uncertainty about the future real (after-inflation) value of your investment. www.ftpall.com 8|Page • Also called purchasing-power risk, the risk that changes in the real return the investor will realize after adjusting for inflation will be negative. Insolvency risk • The risk that a firm will be unable to satisfy its debts. Also known as bankruptcy risk. Interest rate risk • The chance that interest rates will change and thereby change the required return Find thousands of financial terms at www.ftpall.com and bond value. Rising rates, which result in decreasing bond values, are of greatest concern. • The risk that a security's value changes due to a change in interest rates. For example, a bond's price drops as interest rates rise. For a depository institution, also called funding risk, the risk that spread income will suffer because of a change in interest rates. • The risk of changes in value due to changes in interest rate is called interest rate risk. Long lived assets lose more of their value when interest rates rise than short lived assets. If a bank has more long-lived assets than liabilities, then the bank worries about interest rate increases. • Is the risk associated with changes in general interest rate levels or yield curves. This compares to Prepayment Risk. Interest rate risk management • If a bank expects a rise in interest rates, it increases the maturity of its liabilities and decreases the maturity of its assets. If a bank expects the interest rates to remain the same or decline, it holds more long term assets than liabilities. Liquidity risk • In banking, risk that monies needed to fund assets may not be available in sufficient quantities at some future date. Implies an imbalance in committed www.ftpall.com 9|Page maturities of assets and liabilities. • The risk that arises from the difficulty of selling an asset. It can be thought of as the difference between the true value of the asset and the likely price, less commissions. Macro political risk • The subjection of all foreign firms to political risk (takeover) by a host country because of political change, revolution, or the adoption of new policies. Market price of risk Find thousands of financial terms at www.ftpall.com • A measure of the extra return, or risk premium, that investors demand to bear risk. The reward-to-risk ratio of the market portfolio. Market risk • Market risk is the risk that investments will change in value based on changes in general market prices. • Risk that cannot be diversified away. Related: systematic risk • The potential for an investor to experience losses owing to day-to-day fluctuations in the prices at which securities can be bought or sold. The Market Risk expresses the volatility of a stock price relative to the overall market as indicated by beta. Market risk return function • A graph of the discount rates associated with each level of project risk. Micro political risk • The subjection of an individual firm, a specific industry, or companies from a particular foreign country to political risk (takeover) by the host country. Mortality risk • The probability that the bond will default. Mortgage pipeline risk www.ftpall.com 10 | P a g e • The risk associated with taking applications from prospective mortgage borrowers who may opt to decline to accept a quoted mortgage rate within a certain grace period. Nondiversifiable risk • Risk that cannot be eliminated by diversification. • The relevant portion of an asset's risk attributable to market factors that affect all firms and cannot be eliminated through diversification. Find thousands of financial terms at www.ftpall.com Nonsystematic risk • Non market or firm-specific risk factors that can be eliminated by diversification. Also called unique risk or diversifiable risk. Systematic risk refers to risk factors common to the entire economy. Operating risk • The inherent or fundamental risk of a firm, without regard to financial risk. The risk that is created by operating leverage. Also called business risk. Operational risk • A technology-operational risk occurs when investments in new technology do not produce the estimated cost savings. Overnight delivery risk • A risk brought about because differences in time zones between settlement centers require that payment or delivery on one side of a transaction be made without knowing until the next day whether the funds have been received in an account on the other side. Particularly apparent where delivery takes place in Europe for payment in dollars in New York. • A risk brought about because differences in time zones between settlement centers require that payment or delivery on one side of a transaction be made without www.ftpall.com 11 | P a g e knowing until the next day whether funds have been received in account on the other side. Particularly apparent where delivery takes place in Europe for payment in dollars in New York. Pin risk • Is the uncertainty that an option position may be exercised into the underlying instrument. It is risky because it often refers to markets flirting with the prevailing at- the-money level. At such times, the gamma on a position is very erratic and difficult to hedge. Also, there are doubts about the exercise or assignment process. A trader Find thousands of financial terms at www.ftpall.com can experience significant changes in net positions due to option exercises. Political risk • Possibility of the expropriation of assets, changes in tax policy, restrictions on the exchange of foreign currency, or other changes in the business climate of a country. • Risk that arises from the possibility that a host government might take actions that are harmful to foreign investors or that political turmoil in a country might endanger investments made in that country by foreign nationals. The potential discontinuity or seizure of an MNC's operations in a host country due to the host's implementation of specific rules and regulations (such as nationalization, expropriation, or confiscation). Prepayment risk • The existence of prepayment options makes the cashflow of a pool of mortgages uncertain. This uncertainty creates prepayment risk. • Is the potential loss related to an early retirement of debt. The risk tends to be more common in declining interest rate environments. Price risk • The risk that the value of a security (or a portfolio) will decline in the future. Or, a type of mortgage-pipeline risk created in the production segment when loan terms www.ftpall.com 12 | P a g e are set for the borrower in advance of terms being set for secondary market sale. If the general level of rates rises during the production cycle, the lender may have to sell his originated loans at a discount. • The risk that a debt security's price may change due to a rise or fall in the going level of interest rates. Product risk • A type of mortgage-pipeline risk that occurs when a lender has an unusual loan in production or inventory but does not have a sale commitment at a prearranged price. Find thousands of financial terms at www.ftpall.com Purchasing power risk • Related: inflation risk Rate risk • In banking, the risk that profits may decline or losses occur because a rise in interest rates forces up the cost of funding fixed-rate loans or other fixed-rate assets. See interest rate risk. • In banking, the risk that profits may decline or losses occur because a rise in interest rates forces up the cost of funding fixed-rate loans or other fixed-rate assets. Regulatory pricing risk • Risk that arises when regulators restrict the premium rates that insurance companies can charge. Reinvestment risk • Is the situation whereby prepaid principal amounts will be reinvested in lower yielding securities. • The risk that proceeds received in the future will have to be reinvested at a lower potential interest rate. Residual risk www.ftpall.com 13 | P a g e • Related: unsystematic risk Reverse price risk • A type of mortgage-pipeline risk that occurs when a lender commits to sell loans to an investor at rates prevailing at application but sets the note rates when the borrowers close. The lender is thus exposed to the risk of falling rates. Risk • The chance of financial loss, or more formally, the variability of returns associated Find thousands of financial terms at www.ftpall.com with a given asset. The chance that actual outcomes may differ from those expected. • The possibility that an investment will lose or not gain value; also refers to a peril covered by an insurance contract. • Degree of uncertainty of return on an asset. • Possibility that an investment's actual return will be different than expected; includes the possibility of losing some or all of the original investment. Measured by variability of historical returns, or dispersion of historical returns around their average return. • Is the variability inherent in investment, speculative or trading activities. The greater the variability, the higher the risk. Risk can be attributed to many factors. As such, the specification of a risk can described with the use of an associated qualifying term. These terms include but are not limited to credit, counterparty, liquidity, market, fraud, currency, roll, agency, coupon, event, corporate and country. • Typically defined as the standard deviation of the return on total investment. Degree of uncertainty of return on an asset. Risk adjusted discount rate • Abbreviated RADR. The rate of return that must be earned on a given project to www.ftpall.com 14 | P a g e compensate for the risk of the project. Risk adjusted profitability • A probability used to determine a sure expected value (sometimes called a certainty equivalent) that would be equivalent to the actual risky expected value. Risk adjusted return • Return earned on an asset normalized for the amount of risk associated with that asset. Find thousands of financial terms at www.ftpall.com Risk arbitrage • Is a form of trading whereby the risk arbitrageur attempts to profit from issues involved in merger/acquisitions. The underlying rationale is that the current price after the announcement is still below the bid price. Also, the company may find itself subject to other bids for its stock in excess of the initial announced bid. These price differentials are the arbitrage part. The risk is that other bids do not materialize or the initial announcement fails due to other considerations. • Speculation on perceived mispriced securities, usually in connection with merger and acquisition deals. Mike Donatelli, John Demasi, Frank Cohane, and Scott Lewis are all hardcore arbs. They had a huge BT/MCI position in the summer of 1997, and came out smelling like roses. Risk arrays • Refer to how a specific derivative instrument will change in value, from the present to a specific point in time for a given set of market conditions. For SPAN® purposes, this time period is typically one day. Here, risk array values are calculated basis a single long position. Note that SPAN® views LONG as the purchase of a call or a put and not as market direction strategy. This contrasts to LONG usually referring to the side of the market and not the ownership of an instrument. Risk averse www.ftpall.com 15 | P a g e • The attitude toward risk in which a higher return would be required by the investor for an investment that offers greater risk. • A risk-averse investor is one who, when faced with two investments with the same expected return but two different risks, prefers the one with the lower risk. Risk capital budgeting • The chance that the inputs into the analysis of an investment project will prove to be wrong. Find thousands of financial terms at www.ftpall.com Risk classes • Groups of projects that have approximately the same amount of risk. Risk controlled arbitrage • A self-funding, self-hedged series of transactions that generally utilize mortgage securities as the primary assets. Risk free asset • An asset whose future return is known today with certainty. Risk free rate • The rate of return that one would earn on a virtually riskless investment such as a Government of Canada Treasury Bill. • The rate of return that one would earn on a virtually riskless investment such as a three-month Government of Canada Treasury bill. Such an investment offers little or no risk of default and very low interest rate (price) risk because of its short term to maturity. • The rate earned on a riskless asset. Risk indexes • Categories of risk used to calculate fundamental beta, including (1) market variability, (2) earnings variability, (3) low valuation, (4) immaturity and smallness, (5) www.ftpall.com 16 | P a g e growth orientation, and (6) financial risk. Risk indifferent • The attitude toward risk in which no change in return would be required for an increase in risk. Risk lover • A person willing to accept lower expected returns on prospects with higher amounts of risk. Find thousands of financial terms at www.ftpall.com Risk management • Is the practice of adjusting exposures for the firm's positions or portfolios. It tries to stabilize variability of returns while trimming large -dominant -net exposures as well. It can also be used to secure more favorable financing for inventories or pricing of securities or commodities. See the following features for more information: Illustrative RAMS® Graphics and Tables. How Far with VAR (Value at Risk). More about Risk Management. Risk Management and Analysis Software. RAMS® Executive Summary. Risk Management Tutor 101. • The process of identifying and evaluating risks and selecting and managing techniques to adapt to risk exposures. Risk management document • Is a formal listing of trading and hedging processes, procedures and other activities related to position taking. See Powers and Authorities for a illustrative example of the scope of this important document. Risk neutral • Insensitive to risk. Risk of technical insolvency • The probability that a firm will be unable to pay its bills as they come due. www.ftpall.com 17 | P a g e Risk premium • The amount by which the required discount rate for a project exceeds the risk-free rate; or, the additional coupon interest investors will demand based on the risk of the issuer and of the debt issue itself. • Risk Premium is the explicit amount added to the base rate to cover default and other risks. Hence, a loan might be quoted as 6-month LIBOR plus 150 basis points, which means that the interest due will start out at the current LIBOR plus 150bp. Each basis point is one-one hundredth of a percent. After 6 months, the interest rate Find thousands of financial terms at www.ftpall.com will be revised to the LIBOR in effect at that time plus 150bp. • The reward for holding the risky market portfolio rather than the risk-free asset. The spread between Treasury and non-Treasury bonds of comparable maturity. Risk premium approach • The most common approach for tactical asset allocation to determine the relative valuation of asset classes based on expected returns. Risk prone • Willing to pay money to transfer risk from others. Risk return tradeoff • The expectation that for accepting greater risk, investors must be compensated with greater returns. Risk reversal • In option trading, buy a put and sell a call. Risk seeking • The attitude toward risk in which a decreased return would be accepted for an increase in risk. Risk transformation www.ftpall.com 18 | P a g e • Is the result of an effective hedge. Here, price, interest, or currency level risk is transformed into the more manageable and less volatile, basis risk. This volatility is measured in terms of comparative dollar value swings. Risk types • Include the following: agency bankruptcy Find thousands of financial terms at www.ftpall.com basis capital restrictions commodity compliance concentration conversion convexity corporate counterparty country coupon credit credit rating currency default dilution www.ftpall.com 19 | P a g e disaster duration environmental event exercise force majeure funding Find thousands of financial terms at www.ftpall.com hazards legal liquidity market nonsystematic • obsolescence • operational • option pin political prepayment price level reinvestment residual roll rule change software, modelling, and financial assumptions www.ftpall.com 20 | P a g e spread systematic technological time value decay -theta timing volatility Find thousands of financial terms at www.ftpall.com weather yield curve: shape, shift, tilt and twist. The above risk terms relate to the capital and commodity markets. Other risk terms relate to the insurance industry. Risk/return trade off • The balance an investor must decide on between the desire for low risk and high returns; low levels of uncertainty (low risk) are associated with low potential returns, and high levels of uncertainty (high risk) are associated with high potential returns. Riskless arbitrage • The simultaneous purchase and sale of the same asset to yield a profit. Riskless or risk free asset • An asset whose future return is known today with certainty. The risk free asset is commonly defined as short-term obligations of the U.S. www.ftpall.com 21 | P a g e government. Riskless rate • The rate earned on a riskless asset. • The rate earned on a riskless investment, typically the rate earned on the 90-day U.S. Treasury Bill. Risky asset Find thousands of financial terms at www.ftpall.com • An asset whose future return is uncertain. Settlement risk • Banks and other financial intermediaries send most of their wholesale payments either through Fedwire or Clearing House InterBank Payment System (CHIPS). All claims sent on CHIPS clear at the end of the day. If a bank were to fail during the day, or send funds it does not yet have, this can create a chain of settlement problems for other banks who rely on these incoming funds. Shortfall risk • The risk of falling short of any investment target. Sovereign risk • The special risks, if any, that attach to a security (or deposit or loan) because the borrower's country of residence differs from that of the investor's. Also referred to as country risk. • Sovereign Risk refers to the fact that a foreign government can default on its promises. Moreover, a foreign government can prohibit or restrict www.ftpall.com 22 | P a g e all domestic corporations and agencies from re-paying their foreign currency denominated interest and principle payment. • The risk that a central bank will impose foreign exchange regulations that will reduce or negate the value of FX contracts. Also refers to the risk of government default on a loan made to it or guaranteed by it. Specific risk • See: unique risk. Find thousands of financial terms at www.ftpall.com Systematic risk • Also called undiversifiable risk or market risk, the minimum level of risk that can be obtained for a portfolio by means of diversification across a large number of randomly chosen assets. Related: unsystematic risk. Systematic risk principle • Only the systematic portion of risk matters in large, well-diversified portfolios. The, expected returns must be related only to systematic risks. Theta risk • Refers to the time value exposure for an option. Academic literature tends to view it on an instantaneous basis whereas practioners tend to view it on a daily basis. For the later it can calculate the time value difference between 6.7.00 and 6.8.00 all other things being held constant. Then the amounts would be expressed in dollars or other designated currency. www.ftpall.com 23 | P a g e Total risk • The combination of a security's nondiversifiable and diversifiable risk. Undiversifiable risk • Related: Systematic risk Unique risk • Also called unsystematic risk or idiosyncratic risk. Specific company Find thousands of financial terms at www.ftpall.com risk that can be eliminated through diversification. See: diversifiable risk and unsystematic risk. Unsystematic risk • Also called the diversifiable risk or residual risk. The risk that is unique to a company such as a strike, the outcome of unfavorable litigation, or a natural catastrophe that can be eliminated through diversification. Related: Systematic risk Value at risk • Is the methodology which measures the sensitivity of a portfolio or firm's position with parametric statistical techniques. It uses historical information to estimate the impact of various standard deviation events upon the value of the holdings and the associated impact on earnings. Value at risk model • Abbreviated VAR. Procedure for estimating the probability of portfolio losses exceeding some specified proportion based on a statistical analysis of historical market price trends, correlations, and volatilities. www.ftpall.com 24 | P a g e Vega risk • Refers to the monetary exposure for a change in volatility for an option. It might refer to a change from 6 to 7 or 6 to 5 percent depending on whether a party is short or long the option. Some participants breakdown the vega risks into finer gradients or decimals. Volatility risk • The risk in the value of options portfolios due to the unpredictable Find thousands of financial terms at www.ftpall.com changes in the volatility of the underlying asset.