1.1 Credit risk 1.2 Market risk 1.3 Liquidity risk 1.4 Operational risk 1.

5 Model risk
Market Risk: Risk of declining prices or volatility of prices in the finacial markets will result a loss. There are two types of market risk inculding Absolute Risk and Relative Risk. Withing the market risk following risks are of importance. - Absolute Risk - Relative Risk - Directional Risk (Linear risk exposure) - Non directional Risk (Non linear risk exposure) - Basis Risk - Volatility Risk Liquidity Risk: Risk of loss due to inadequate liqudity of position / asset at a fair price. Risks withing the liquidity risk are - Asset Liquidity Risk - Funding Liquidity Risk Credit Risk: Risk of loss due to dafaul of counterpart in a financial transaction. Important terms and further classess of risks under credit risk are - Exposure - Recovery Rate - Credit Event - Sovereign Risk - Settlement Risk Operational Risk: Risk of loss due to inadequate monitoring system, management failure, defective controls, frauds and human errors. This risk is particulary relevant to DERIVATIVE TRADING, because derivatives are inherently higly leveraged instrument, which enable tradters to expose a firm to loss using relativly small amount of capital. Following are the classes of operational risk - Model Risk - People Risk - Legal Risk

Types of Risk

Unfortunately, the concept of risk is not a simple concept in finance. There are many different types of risk identified and some types are relatively more or relatively less important in different

situations and applications. In some theoretical models of economic or financial processes, for example, some types of risks or even all risk may be entirely eliminated. For the practitioner operating in the real world, however, risk can never be entirely eliminated. It is ever-present and must be identified and dealt with. In the study of finance, there are a number of different types of risk the been identified. It is important to remember, however, that all types of risks exhibit the same positive risk-return relationship. Some of the most important types of risk are defined below.

Default Risk The uncertainty associated with the payment of financial obligations when they come due. Put simply, the risk of non-payment. Interest Rate Risk The uncertainty associated with the effects of changes in market interest rates. There are two types of interest rate risk identified; price risk and reinvestment rate risk. The price risk is sometimes referred to as maturity risk since the greater the maturity of an investment, the greater the change in price for a given change in interest rates. Both types of interest rate risks are important in banking and are addressed extensively in Bank Management classes. Price Risk The uncertainty associated with potential changes in the price of an asset caused by changes in interest rate levels and rates of return in the economy. This risk occurs because changes in interest rates affect changes in discount rates which, in turn, affect the present value of future cash flows. The relationship is an inverse relationship. If interest rates (and discount rates) rise, prices fall. The reverse is also true.

Since interest rates directly affect discount rates and present values of future cash flows represent underlying economic value, we have the following relationships.

Reinvestment Rate Risk The uncertainty associated with the impact that changing interest rates have on available rates of return when reinvesting cash flows received from an earlier investment. It is a direct or positive relationship. This type of interest rate risk is also covered extensively in the Bank Management courses.

Liquidity risk The uncertainty associated with the ability to sell an asset on short notice without loss of value. A highly liquid asset can be sold for fair value on short notice. This is because there are many interested buyers and sellers in the market. An illiquid asset is hard to sell because there there few interested buyers. This type of risk is important in some project investment decisions but is discussed extensively in Investment courses.

Inflation Risk (Purchasing Power Risk) The loss of purchasing power due to the effects of inflation. When inflation is present, the currency loses it's value due to the rising price level in the economy. The higher the inflation rate, the faster the money loses its value. Market risk Within the context of the Capital Asset Pricing Model (CAPM), the economy wide uncertainty that all assets are exposed to and cannot be diversified away. Often referred to as systematic risk, beta risk, non-diversifiable risk, or the risk of the market portfolio. This type of risk is discussed extensively in Investment courses.

Firm specific risk The uncertainty associated with the returns generated from investing in an individual firms common stock. Within the context of the Capital Asset Pricing Model (CAPM), this is the investment risk that is eliminated through the holding of a well

diversified portfolio. Often referred to as un-systematic risk or diversifiable risk. This type of risk is discussed extensively in Investment courses.

Project risk In the advanced capital budgeting topics, the total risk associated with an investment project. Sometimes referred to as stand-alone project risk. In advanced capital budgeting, project risk is partitioned into systematic and un-systematic project risk.

Financial risk The uncertainty brought about by the choice of a firms financing methods and reflected in the variability of earnings before taxes (EBT), a measure of earnings that has been adjusted for and is influenced by the cost of debt financing. This risk is often discussed within the context of the Capital Structure topics.

Business risk The uncertainty associated with a business firm's operating environment and reflected in the variability of earnings before interest and taxes (EBIT). Since this earnings measure has not had financing expenses removed, it reflect the risk associated with business operations rather than methods of debt financing. This risk is often discussed in General Business Management courses.

Foreign Exchange Risks Uncertainty that is associated with potential changes in the foreign exchange value of a currency. There are two major types: translation risk and transaction risks. Translation Risks Uncertainty associated with the translation of foreign currency denominated accounting statements into the home currency. This risk is extensively discussed in Multinational Financial Management courses.

Transactions Risks Uncertainty associated with the home currency values of transactions that may be affected by changes in foreign currency values. This risk is extensively discussed in the Multinational Financial Management courses.

Total Risk
While there are many different types of specific risk, we said earlier that in the most general sense, risk is the possibility of experiencing an outcome that is different from what is expected. If we focus on this definition of risk, we can define what is referred to as total risk. In financial terms, this total risk reflects the variability of returns from some type of financial investment.

Measures of Total Risk The standard deviation is often referred to as a "measure of total risk" because it captures the variation of possible outcomes about the expected value (or mean). In financial asset pricing theory there is a pricing model (Capital Asset Pricing Model or CAPM) that separates this "total risk" into two different types of risk (systematic risk and unsystematic risk). Another related measure of total risk is the "coefficient of variation" which is calculated as the standard deviation divided by the expected value. The following notes will discuss these concepts in more detail.