Identifying and Understanding Risks | CFA Level I Portfolio Management

Today, we’ll dive into the various types of risks faced by organizations and individuals. We’ll explore financial risks, non-financial risks, and how these risks interact with one another.

Financial Risks

Financial risks originate from financial markets and can be divided into three main categories:

1. Market risk – Risk arising from movements in asset prices, exchange rates, and market interest rates.
2. Credit risk – Risk of loss if a counterparty fails to fulfill its contractual obligations.
3. Liquidity risk – Risk of loss when selling an asset at a price that is less than its underlying fair value.

Non-Financial Risks

Non-financial risks originate from sources other than financial markets, such as the company itself, the environment, regulators, suppliers, and customers.

• Settlement risk – Risk due to the timing of the payment process.
• Legal risk – Risk that the terms of a contract may not be upheld by the legal system.
• Regulatory, accounting, and tax risk – Uncertainties regarding policies, laws, and regulations set by regulators, accounting standards boards, and tax authorities.
• Model risk – Risk that asset valuations are incorrect due to using the wrong model or using the right model incorrectly.
• Tail risk – Risk that extreme events are more likely than the probability models suggest.
• Operational risk – Risk arising from people and processes that combine to produce the output of an organization.
• Solvency risk – Risk that an organization will be unable to continue to operate because it has run out of cash.

Risks Specific to Individuals

Individuals face similar risks as organizations but also encounter unique non-financial risks:

• Health risk – Risk of direct health care expenses, reduced income due to disability, and reduced lifespan or quality of life.
• Mortality risk – Risk of death prior to providing for family’s future needs.
• Longevity risk – Risk of living longer than anticipated, causing assets to run out.

Interactions of Risks

Risks don’t usually arise in isolation; they often interact with one another. For example, a company exposed to market risk might hedge its risk with a counterparty, creating credit risk. Legal risks might also arise if the counterparty attempts to avoid payment through contract loopholes. Interactions among risks are essential to consider, especially during periods of stress in financial markets.

And that concludes our lesson on identifying risks and understanding their interactions. In our next lesson, we’ll learn methods for measuring risks.