Thursday, 29 October 2015

Risk - A pictorial description

Build Up

When first asked to define Risk, I was like, that's so easy. Risk is...a… mmm... it is... mmmm... well risk is risk. How the heck can I define risk? Risk is risk just as cat is cat, pain is pain, time is time. Isn't is that obvious? You bet...
Well, risk is not just a word, as far as this finance domain is considered. Imagine its importance when I say that numerous highly talented people dedicate their lives to provide value to this word.

Definition

Ahhh, after creating such a hype, I can finally write down a layman definition of this four letter word:
"Risk is what you take in order to achieve the return"
Higher the return desired, more is the risk one must take.
Nerdy Note: Higher the risk doesn't always mean higher the return. You only get paid for systematic risk in the real world, not for unsystematic risk that you can shoo away by diversifying.

Types of Risk

Risk is divided mainly into following categories:
  1. Credit Risk
  1. Market Risk
  1. Operational Risk
  1. Regulatory Risk
  1. Other Risks (Liquidity Risk, Sovereign Risk, Political Risk etc.)

I’ll try to explain different types of risk with the help of a silly example of an ice-cream loving boy and an ice-cream seller.
Consider an ideal world:

  • A kid wants an ice-cream.
  • Ice cream costs X INR (Indian Rupee).
  • He gives X INR to the ice-cream seller.
  • Ice-cream seller gives a delicious ice-cream to him.
  • He enjoys his ice-cream happily… End of Story
Now let’s take each categories of risk separately...

Credit Risk

Definition:“Credit risk is most simply defined as the potential that a bank borrower or counter-party will fail to meet its obligations in accordance with agreed terms”
as per bcbs54.
Basically the risk that one counter-party has if another counter-party does not fulfill its side of the agreement for the given deal (intentionally or due to adverse circumstances).

In a world exposed to credit risk:

  • A kid wants an ice-cream.
  • Ice cream costs X INR (Indian Rupee).
  • He gives X INR to the ice-cream seller.
  • Ice-cream seller refuses to give ice-cream (Counterparty failed to meet its obligation)
  • The kid not only loses money but also doesn’t get any ice-cream.

Market Risk

Definition:Market risk is the risk possessed due to change in the market conditions.
Any change in market conditions (Interest rate change, government policies, economic conditions etc.) affects the value of an asset/portfolio either in positive way or negative way. Sensitivity of one asset/portfolio to market conditions may differ from that of another, but no asset is completely isolated from market conditions.
In a world exposed to market risk:

  • A kid wants an ice-cream.
  • Ice cream costs X INR (Indian Rupee).
  • However due to sudden increase in demand, ice cream seller increases the cost to 2X INR (Change in market conditions affecting the price of ice-cream)
  • But since the kid couldn’t anticipate this sudden increase in price and has only X INR, he has to live without an ice-cream.

Operational Risk

Definition:
As per Basel II: Operational risk is defined as the risk of loss resulting from inadequate or failed processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.
This is basically the risk arising due to flaws in operational and functional activities of a firm.
In a world exposed to operational risk:

  • A kid wants an ice-cream.
  • Ice cream costs X INR (Indian Rupee).
  • He gives X INR to the ice-cream seller.
  • Ice-cream seller gives a delicious ice-cream to the kid.
  • By mistake, ice-cream falls from his hands before he could consume it (Failed to operate properly)

Regulatory Risk

Definition:
Regulatory risk is the risk that may arise due to change in regulations or law that may adversely affect the concerned industry.
It is the risk that regulatory policies may mandate the changes in how business should be carried.
In a world exposed to regulatory risk:

  • A kid wants an ice-cream.
  • Ice cream costs X INR (Indian Rupee).
  • Kid is about to purchase it but his dad (The Regulator), who is concerned about his health, stops him from doing so.

PS: I have tried to keep text as minimum as possible. This is just a high level description of different types of risk and I know that examples are bit lame, but I do believe they do a good job explaining the concepts in a simplified way possible.

References:


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