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RISK
Affiliate 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
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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.
• 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.
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
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agreed.
• The ability of the national economy to generate enough foreign exchange to meet
payments of interest and principal on its foreign debt.
• General level of political and economic uncertainty in a country affecting the value
of loans or investments in that country.
• 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
• 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.
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Currency risk
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.
Diversifiable risk
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
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requirements.
• 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
• The risk that a corporate bond will be downgraded, perhaps severely, due to some
unpredictable outside event, principally a leveraged buy-out.
• 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.
• 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
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• 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.
• 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).
• Taking a position either long or short that does not involve spreading.
• 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.
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• 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.
• 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.
Funding 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
• 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.
• The chance that interest rates will change and thereby change the required return
• 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.
• 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
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• 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.
• 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 risk
• Market risk is the risk that investments will change in value based on changes in
general market prices.
• A graph of the discount rates associated with each level of project risk.
Mortality risk
• 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
• The relevant portion of an asset's risk attributable to market factors that affect all
firms and cannot be eliminated through diversification.
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 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
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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
Political risk
• 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
• 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
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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.
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.
• Risk that arises when regulators restrict the premium rates that insurance
companies can charge.
Reinvestment risk
• The risk that proceeds received in the future will have to be reinvested at a lower
potential interest rate.
Residual risk
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• 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
• The possibility that an investment will lose or not gain value; also refers to a peril
covered by an insurance contract.
• Abbreviated RADR. The rate of return that must be earned on a given project to
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• Return earned on an asset normalized for the amount of risk associated with that
asset.
• 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.
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
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• 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.
• The chance that the inputs into the analysis of an investment project will prove to
be wrong.
• 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.
Risk indexes
Risk indifferent
• The attitude toward risk in which no change in return would be required for an
increase in risk.
Risk lover
• 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.
• 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.
• The probability that a firm will be unable to pay its bills as they come due.
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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
• 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.
• The most common approach for tactical asset allocation to determine the relative
valuation of asset classes based on expected returns.
Risk prone
• The expectation that for accepting greater risk, investors must be compensated
with greater returns.
Risk reversal
Risk seeking
• The attitude toward risk in which a decreased return would be accepted for an
increase in risk.
Risk transformation
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• 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
agency
bankruptcy
capital restrictions
commodity
compliance
concentration
conversion
convexity
corporate
counterparty
country
coupon
credit
credit rating
currency
default
dilution
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disaster
duration
environmental
event
exercise
force majeure
funding
legal
liquidity
market
pin
political
prepayment
price level
reinvestment
residual
roll
rule change
spread
systematic
technological
timing
volatility
The above risk terms relate to the capital and commodity markets. Other
risk terms relate to the insurance industry.
• 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
• 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.
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government.
Riskless rate
Risky asset
Settlement risk
Shortfall risk
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
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• 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
• 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.
Theta risk
Total risk
Undiversifiable risk
Unique 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
Vega risk
Volatility risk