25 Temmuz 2012 Çarşamba

What is risk? What are the types of risk?

Risk can be defined in several ways. However just to summarize it we can use two definitions for this term: The first one is “The possibility of something bad happening”: This is the wide used definition of risk. If we want to give an example from insurance sector; as we have already known, the insurance companies are making life insurance policies which cover death, redundancy and/or disability. If a healthy person, with good intention wants to have life insurance coverage and the insurance company issues a policy against the concerned bad happenings, when this person passes away the insurance company has to pay whole amount on which the insurance policy has been issued. This payment to the relatives or beneficiaries of the insured person is a risk for the insurance company. The second definition is “To do something although there is a chance of a bad result”. This is the verb version of the word “risk”. It means that, if a bank lends a credit facility to a customer, in case of no repayment, this bank is risking the amount lent. The bank is monitoring the customer payment behaviors and until the payment comes, this amount is seen as the risk of the bank. [1]

We understand that risk is built on mainly two issues; uncertainty and exposure. When we think about a bank lending USD 1,000 to an individual under a 6 month repayment tenor, USD 1,000 is the exposure and the payments that are supposed to be done in 6 months show the uncertainty.

After defining risk we need to clarify the the types of risks which are listed below:
·         Systematic Risk: This is the uncontrollable risk which is originated from the market conditions. This risk can be named as market risk and it has an effect on all investments in that market.
·         Unsystematic Risk: The risk of the investment itself is defined as the unsystematic risk.
The total risk incurred by the organizations is equal to the sum of systematic and unsystematic risks. Under systematic risk the following risks are found:
·        Interest rate risk: This is the risk which arises from holding an interest bearing position. For a bank, the interest rate risk is taken if it finances a facility with fixed interest rate for a long tenor. If the borrowing cost for the banks increases the profit margin gets smaller.
·       Market risk: Market Risk is “the risk of losses in on and off-balance sheet positions arising from movements in market prices”. Another detailed definition is given by Basel Committee as “encompassing price risk, foreign exchange risk (including gold), equity risk, commodity risk and the risk of options”.
·       Political Risk: This is the risk of loss when investing in a given country caused by changes in a country's political structure or policies, such as tax laws, tariffs, etc. It can be also defined as the restrictions applied to foreign investments in the home country.
·       FX risk: It is the risk of having a short or long position for a FX currency. If the bank has more FX based assets than its liabilities, the bank will gain if FX goes up or bank will lose if FX drops.
·       Reinvestment Risk: This risk is associated with the impact of the change on the interest rates which may not give the same earning for the cash flows received from an earlier investment.
·      Equity risk: This risk arises for the holder of an equity position. An example of this risk is a bank that has purchased shares/equities in a company. A loss arises when the share/equity is fixed at a lower market value.
·      Commodity value risk: This risk that arises for the holder of a commodity position. An example of commodity risk is a bank that has purchased gold. A loss for the bank arises when the price of gold is fixed at a lower level in the commodities markets.
·       Settlement and counterparty risk: It is the risk that arises on transactions in interest rates, currency, equities or commodities that have not yet been settled.
·       Purchase power risk: This risk is related to the inflation in a country.
·       The other important risk type is credit risk. Credit risk is the probability that a borrower fails to meet its obligations according to the pre agreed conditions
·       Liquidity risk: This is the current and prospective risk to earnings or capital arising from a bank’s inability to meet its obligations when they come due without incurring unacceptable losses.
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 [1] Cambridge Dictionary

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