A Vocabulary of Risk
Basic Primer on the Vocabulary of Risk
Risk can be defined as any source of randomness that may have an adverse impact on the market value of a corporation’s assets net of liabilities, on its earnings, and/or on its raw cash flows.
? Financial risk: a financial event that can give rise to unexpected reductions in a firm’s cash flows, value, or earnings, the amount of which is determined by the movement in one or more financial asset prices
? Peril: a natural, man-made, or economic situation that may cause a personal or property loss
? Accident: an unexpected loss of resources arising from a peril
? Hazard: something that increases the probability of a loss arising from a peril
A) Financial Risks
A financial risk is a source of potential unexpected losses for a firm that will arise because of some adverse change in market conditions, the financial condition of an obligor to the firm, or the financial condition of the firm itself. Financial risk can impact a company’s cash flows, accounting earnings, and/or value (i.e., asset and liability market values). Importantly, the amount of money a firm loses from financial risks that are realized usually depends on the behavior of one or more “market-determined” prices. Five specific types of financial risk are discussed below[2]:
1. Market risk
2. Funding risk
3. Market liquidity risk
4. Credit risk
5. Legal risk
Market Risk
Market risk arises from the event of a change in some market-determined asset price, reference rate (e.g., LIBOR), or index, usually classified based on the asset class whose price changes are impacting the exposure in question. Common forms of asset class-based market risk include interest rate risk, exchange rate risk, commodity price risk (through input purchases or output sales), and equity price risk.
Delta is the risk that the value of an exposure will deteriorate as the price or value of some underlying risk factor changes, all else being equal. A bond is affected by changes in interest rates, so the interest rate is the risk factor. When interest rates rise, bond prices fall. In the bond world, this delta is called “duration.” Other examples of delta include the sensitivity of a forward purchase/sale of foreign exchange to a small change in the exchange rate, the sensitivity of a commodity delivery contract to the change in the underlying commodity price, and the variability of a futures or options contract on the S&P 500 stock index to a small change in the prices of any S&P 500 stocks.
Gamma is the risk that delta will change when the value of an underlying risk factor changes. It is sometimes referred to as “convexity risk” or “rate of change” risk. Returning to the bond example, bond prices fall as interest rates rise, but the amount of the price change depends on the level of interest rates. Large interest rate increases may cause larger bond price declines than small interest rate increases.
The risk that volatility changes in the underlying risk factor will cause a change in the value of an exposure goes by many names. Vega, lambda, kappa, and tau are among them. For purchased options (longs), declines in volatility pose the risk. Less volatility means there is a smaller chance that the option held will expire profitably. For options written (short), lower volatility increases the odds for profits by reducing the opportunities for unprofitable exercise against the short to occur.
Theta measures the risk to certain exposures due only to the passage of time. Insurance, for example, is an asset that “decays” or “wastes” over time. For every day that passes on an unused insurance policy, there is one less day for the insurance contract to become valuable.
Finally, rho is the risk that the interest rates which are used to discount future cash flows in present value calculations will change and impose unexpected losses on the firm. For many exposures, the discount rate is the borrowing or lending rate that corresponds to the maturity of the contract. For other contracts, such as swaps, a yield curve is used to discount cash flows, and hence any shifts in the level of any of several interest rates may affect cash flows.
Yet another market risk—correlation risk—is the risk of an unexpected change in the correlation of two factors affecting the value of a contract. We must be careful here to distinguish between basis risk, or correlation risk arising from the combination of a derivatives contract with another asset or portfolio, and correlation risk affecting a single asset held in isolation or in a portfolio.
Funding Risk
Funding risk occurs in the event that cash inflows and current balances are insufficient to cover cash outflow requirements, often necessitating costly asset liquidation to generate temporary cash inflows. Most firms, both financial and nonfinancial, have liquidity plans designed to manage funding risks.
The distinctions between pure funding risk and market risk are subtle, as the two are clearly related. Market risk can be viewed as the risk of changes in the value of a bundle of cash flows when adverse market events occur. But value is just defined as the discounted NPV of future cash flows. Funding risk is based on the risk of cash flows when they occur in time. For the purpose of comparing liquidity risk at one time to liquidity risk at another, discounting to an NPV serves no purpose. On the contrary, all that is relevant is cash balances per period. Market risk, by contrast, deals with cash flow risks in any period, because all future cash flows ultimately affect the current NPV of the asset or liability in question.
Market Liquidity Risk
Market liquidity risk is the risk that volatile markets will inhibit the liquidation of losing transactions and/or the establishment of new transactions to hedge existing market risk exposures. Suppose a firm has negotiated an agreement with a bank to purchase British pounds for Deutsche marks (Dmark) three months from now. If the British pound experiences a massive and rapid depreciation vis-Ã -vis the Dmark—as happened in September 1992 when the European Monetary System’s exchange rate mechanism imploded on “Black Wednesday”—the currency purchase agreement will decline rapidly in value.
The firm in this case may attempt to neutralize its original agreement or enter into an offsetting contract. If the agreement is left unhedged or the counterparty to any offsetting contract defaults, volatility may be so high that a new hedge cannot be initiated at a favorable price, even using liquid exchange-traded futures on pounds and Dmarks. The firm’s market risk is thus exacerbated by market liquidity risk.
Credit Risk
Credit risk is the risk of the actual or possible nonperformance by an obligor to the firm. Credit risk usually comes in four forms:
1. Presettlement credit risk arises from the potential for an obligor to default on a transaction prior to the initiation of the settlement of that transaction.
2. Settlement risk is specifically associated with the failure of a firm during the settlement window, or the time period between the confirmation of a transaction and the final settlement of that transaction.
3. Migration or downgrade risk is the risk that the increase in the market’s perception of a default at a firm causes a decline in the value of the claims issued by that firm.
4. Spread risk is the risk that deteriorations in general corporate credit quality will affect the claim issued by a given firm.
Settlement risk, by contrast, arises after the transaction has entered the settlement process and one party defaults.
Legal Risk
Legal risk is the risk that a firm will incur a loss if a contract it thought was enforceable actually is not. The Global Derivatives Study Group (1993) identified several sources of legal risk for innovative financial instruments that often are associated with risk management, including conflicts between oral contract formation and the statutes of frauds in certain countries and jurisdictions, the capacity of certain entities (e.g., municipalities) to enter into certain types of transactions, the enforceability of “close-out netting,” and the legality of financial instruments. In addition, unexpected changes in laws and regulations can expose firms to potential losses as well.
Legal risk is classified here as a financial risk because this particular incarnation of risk results in losses that usually are driven in size and economic importance by changes in market prices. A netting agreement that is unenforceable in insolvency, for example, could lead to cherry-picking losses whose total amounts are based on market price movements.
Perils, Accidents, and Hazards
A peril is a natural, man-made, or economic “situation” that can cause an unexpected loss for a firm, the size of which is usually not based on the realization of one or more financial variables. A peril thus is essentially a nonfinancial risk.
An accident is a specific negative event arising from a peril that gives rise to a loss and is usually considered “unintentional.”
A hazard is something that increases the probability of a peril-related loss occurring, whether intentional or not.
Consider the peril to a firm of having its employees sustain on-the-job injuries. A related accident would be the unintended opening of a valve on some storage tank at a firm. A hazard could be alcohol or drugs that make an employee more likely to open the value, the presence of corrosive chemicals in the tank that dissolve the valve seals, and the like.
Different types of perils that firms typically face in their business operations include the following[4]:
? Production—unexpected changes in the demand for products sold, increases in input costs, failures of marketing
? Operational—failures in processes, people, or systems
? Social—adverse changes in social policy (e.g., political incorrectness of a product sold), strained labor relations, changes in fashions and tastes, etc.
? Political—unexpected changes in government, nationalization of resources, war, etc.
? Legal—tort and product liability and other liabilities whose exposures are not driven by financial variables
? Physical—destruction or theft of assets in place, impairment of asset functionality, equipment or mechanical failure, chemical-related perils, energy-related perils
? Environmental—flood, fire, windstorm, hailstorm, earthquake, cyclone, etc.
Outreville (1998) provides some examples of hazards that increase the probability of loss for different perils:
? Human—fatigue, ingnorance, carelessness, smoking
? Environmental—weather, noise
? Mechanical—weight, stability, speed
? Energy—electrical, radiation
? Chemical—toxicity, flammability, combustability
Production Perils
Production-related perils cover any perils that threaten a firm’s ability to carry out its normal business activities as expected, usually resulting from changes to the supply or demand for the firm’s product or to the physical production process. Shocks to a firm’s cost or demand functions, for example, can precipitate a loss of value owing to production risks. Three other production-related perils include customer loss risk, supply chain risk, and reputation risk.
At the core of risks facing a business is the risk that the business loses its customers, either because a competitor attracts them away or because they no longer demand the products and services the firm is selling at the prices it is quoting. Customer loss risk thus encompasses pricing risk, or the risk that firms misestimate either the level or the structure of prices for their customers.
Many nonfinancial firms also face risks from adverse events that may occur at any point along a physical “supply chain” (the chain that connects inputs to the firm’s production process to its outputs). Problems may arise at any juncture. Consider, for example, a firm that grows wheat, mills it into flour, and exports the flour to bread makers around the world. Problems could arise at origination from disease, bad weather, insects, vandalism, or any number of other factors that prevent the crop from being grown and brought in according to schedule (both time and quantity). At the transformation stage, equipment breakdowns could occur, contamination of the grain is a possibility, and losses of product during transportation are a consideration. And so on. In short, the firm faces some form of inventory or product risk at every stage here.
A third major production-related peril faced by virtually all firms is the risk of a loss to their brand name capital or reputation that can translate into reduced revenues, increased expenses, and fewer customers—hence its classification as a type of production peril. Reputation risk can arise when a firm acts negligently or is simply perceived to act negligently—as Exxon was perceived following the Valdez, Alaska, oil disaster.
Reputation risk also can arise from poor public relations management of external crises, whether or not the crises are the direct fault of the company. A plane crash due to bad weather, for example, can still impose major adverse reputation effects on both the airline and the aircraft manufacturer if the public relations dimension of the disaster is not handled properly.
Finally, reputation risk can arise when a firm simply fails to honor its commitments. An insurance company that regularly tries to avoid paying out claims even when the claims are unambiguous and legitimate, for example, will quickly find itself short of customers.
Operational Perils
“the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events.”
Examples of losses that can be attributed to operational risk include failed securities trades, settlement errors in funds transfers, stolen or damaged physical assets, damages awarded in court proceedings against the firm, penalties and fines assessed by member associations or regulators, irrecoverable or erroneous funds and asset transfers, unbudgeted personnel costs, and negligence or fraud.
Operational perils also can sometimes be considered as a type of financial risk if the operational losses are driven by market, credit, or liquidity risks. The failure of Barings to catch the huge position buildup by rogue trader Nick Leeson was in some sense an operational risk management failure. It was a failure of processes (internal audit and control), people (Leeson was defrauding the firm and others), and systems (a consolidated global position-keeping system would have revealed Leeson’s rogue positions). But in the end, Barings went bust because Leeson’s positions went underwater as a result of their market risk. Operational risk management may have failed to catch the process, personnel, and systems problem, but market risk sank the firm.
Core versus Noncore Risks
The core risks facing a firm may be defined as those risks that the firm is in business to bear and manage so that it can earn returns in excess of the risk-free rate.
Noncore risks, by contrast, are risks to which a firm’s primary business exposes it but that the firm does not necessarily need to retain in order to engage in its primary business line.
The firm may well be exposed to noncore risks, but it may not wish to remain exposed to those risks. Core risks, by contrast, are those risks the firm is literally in business not to get rid of.
Core and noncore risks are sometimes today called “business” and “financial” risks, respectively.
Knight defined noncore risks as “risks,” or situations in which the randomness facing a firm can be expressed in terms of specific, numerical probabilities. These probabilities may be objective (as in a lottery) or subjective (as in a horse race), but they must be quantifiable. Because they can be quantified, they can be managed.
Unlike risk, Knight defined “uncertainty” as situations when a firm faces some randomness that cannot be expressed in terms of the probabilities of alternative outcomes. This was “core risk” in Knight’s eyes, or the risks about which only the firm in question had some perceived special insight. To Knight, uncertainty was the source of all major profits and losses to businesses. Lord J.M. Keynes agreed, choosing the term “animal spirits” to describe essentially the same phenomenon.
A major distinction between core and noncore risk—Knightian uncertainty and risk—is driven purely by information. Those factors about which a firm perceives itself as having some comparative informational advantage will be those factors on which the business concentrates for its core business cash flows. Risks about which the firm has comparatively less information will be those risks more likely to be hedged, diversified away, insured, or controlled in some other fashion.
The distinction between core and noncore risk clearly rests on a slippery slope. Not only does it vary from one firm to the next, but it also depends not on the quality of information the firm actually has but rather on the firm’s perceived comparative advantage in digesting that information. Perceptions, of course, can be wrong. Businesses fail, after all, with an almost comforting degree of regularity. Without business failures, one might tend to suspect the market is not working quite right. Accordingly, the preponderance of actual business failures clearly means that some firms thought they had a better handle on information than they did, whether that information concerns market demand for their products, their competitors, or their costs.
Retained versus Transferred Risks
A major purpose of distinguishing between risk—especially core versus noncore risks—is to help a firm make its retention decision.
The retained risk or retention of a firm is the agglomeration of risks—core and noncore—to which the firm is naturally exposed in the conduct of its business that the firm decides to bear rather than to shift to another market participant.
Transferred risk, by contrast, is any risk to which a firm is exposed that a firm decides it is not in the business of bearing and decides to transfer to another market participant.
The decision whether to retain or transfer a given risk is essentially a determination by the firm’s shareholders of whether they want to absorb any realized losses arising from the risk in question or whether they would prefer to have the equity holders of another firm absorb those losses. A core factor to firms in making this determination will, of course, be the benefit/cost trade-off—whether the benefit of transferring the risk is above the cost at the margin. The cost of risk transfer can include both the opportunity cost of forgone profits or positive returns, the pure transaction costs of the risk transfer, and/or the price that the firm may have to pay to induce the equity holders of another corporation to assume the risk the firm is trying to transfer away.
For more Information:
Risk Management, Risk Transfer, Financial Risks, Business Risks, Legal Risk
Basic Primer on the Vocabulary of Risk
Risk can be defined as any source of randomness that may have an adverse impact on the market value of a corporation’s assets net of liabilities, on its earnings, and/or on its raw cash flows.
? Financial risk: a financial event that can give rise to unexpected reductions in a firm’s cash flows, value, or earnings, the amount of which is determined by the movement in one or more financial asset prices
? Peril: a natural, man-made, or economic situation that may cause a personal or property loss
? Accident: an unexpected loss of resources arising from a peril
? Hazard: something that increases the probability of a loss arising from a peril
A) Financial Risks
A financial risk is a source of potential unexpected losses for a firm that will arise because of some adverse change in market conditions, the financial condition of an obligor to the firm, or the financial condition of the firm itself. Financial risk can impact a company’s cash flows, accounting earnings, and/or value (i.e., asset and liability market values). Importantly, the amount of money a firm loses from financial risks that are realized usually depends on the behavior of one or more “market-determined” prices. Five specific types of financial risk are discussed below[2]:
1. Market risk
2. Funding risk
3. Market liquidity risk
4. Credit risk
5. Legal risk
Market Risk
Market risk arises from the event of a change in some market-determined asset price, reference rate (e.g., LIBOR), or index, usually classified based on the asset class whose price changes are impacting the exposure in question. Common forms of asset class-based market risk include interest rate risk, exchange rate risk, commodity price risk (through input purchases or output sales), and equity price risk.
Delta is the risk that the value of an exposure will deteriorate as the price or value of some underlying risk factor changes, all else being equal. A bond is affected by changes in interest rates, so the interest rate is the risk factor. When interest rates rise, bond prices fall. In the bond world, this delta is called “duration.” Other examples of delta include the sensitivity of a forward purchase/sale of foreign exchange to a small change in the exchange rate, the sensitivity of a commodity delivery contract to the change in the underlying commodity price, and the variability of a futures or options contract on the S&P 500 stock index to a small change in the prices of any S&P 500 stocks.
Gamma is the risk that delta will change when the value of an underlying risk factor changes. It is sometimes referred to as “convexity risk” or “rate of change” risk. Returning to the bond example, bond prices fall as interest rates rise, but the amount of the price change depends on the level of interest rates. Large interest rate increases may cause larger bond price declines than small interest rate increases.
The risk that volatility changes in the underlying risk factor will cause a change in the value of an exposure goes by many names. Vega, lambda, kappa, and tau are among them. For purchased options (longs), declines in volatility pose the risk. Less volatility means there is a smaller chance that the option held will expire profitably. For options written (short), lower volatility increases the odds for profits by reducing the opportunities for unprofitable exercise against the short to occur.
Theta measures the risk to certain exposures due only to the passage of time. Insurance, for example, is an asset that “decays” or “wastes” over time. For every day that passes on an unused insurance policy, there is one less day for the insurance contract to become valuable.
Finally, rho is the risk that the interest rates which are used to discount future cash flows in present value calculations will change and impose unexpected losses on the firm. For many exposures, the discount rate is the borrowing or lending rate that corresponds to the maturity of the contract. For other contracts, such as swaps, a yield curve is used to discount cash flows, and hence any shifts in the level of any of several interest rates may affect cash flows.
Yet another market risk—correlation risk—is the risk of an unexpected change in the correlation of two factors affecting the value of a contract. We must be careful here to distinguish between basis risk, or correlation risk arising from the combination of a derivatives contract with another asset or portfolio, and correlation risk affecting a single asset held in isolation or in a portfolio.
Funding Risk
Funding risk occurs in the event that cash inflows and current balances are insufficient to cover cash outflow requirements, often necessitating costly asset liquidation to generate temporary cash inflows. Most firms, both financial and nonfinancial, have liquidity plans designed to manage funding risks.
The distinctions between pure funding risk and market risk are subtle, as the two are clearly related. Market risk can be viewed as the risk of changes in the value of a bundle of cash flows when adverse market events occur. But value is just defined as the discounted NPV of future cash flows. Funding risk is based on the risk of cash flows when they occur in time. For the purpose of comparing liquidity risk at one time to liquidity risk at another, discounting to an NPV serves no purpose. On the contrary, all that is relevant is cash balances per period. Market risk, by contrast, deals with cash flow risks in any period, because all future cash flows ultimately affect the current NPV of the asset or liability in question.
Market Liquidity Risk
Market liquidity risk is the risk that volatile markets will inhibit the liquidation of losing transactions and/or the establishment of new transactions to hedge existing market risk exposures. Suppose a firm has negotiated an agreement with a bank to purchase British pounds for Deutsche marks (Dmark) three months from now. If the British pound experiences a massive and rapid depreciation vis-Ã -vis the Dmark—as happened in September 1992 when the European Monetary System’s exchange rate mechanism imploded on “Black Wednesday”—the currency purchase agreement will decline rapidly in value.
The firm in this case may attempt to neutralize its original agreement or enter into an offsetting contract. If the agreement is left unhedged or the counterparty to any offsetting contract defaults, volatility may be so high that a new hedge cannot be initiated at a favorable price, even using liquid exchange-traded futures on pounds and Dmarks. The firm’s market risk is thus exacerbated by market liquidity risk.
Credit Risk
Credit risk is the risk of the actual or possible nonperformance by an obligor to the firm. Credit risk usually comes in four forms:
1. Presettlement credit risk arises from the potential for an obligor to default on a transaction prior to the initiation of the settlement of that transaction.
2. Settlement risk is specifically associated with the failure of a firm during the settlement window, or the time period between the confirmation of a transaction and the final settlement of that transaction.
3. Migration or downgrade risk is the risk that the increase in the market’s perception of a default at a firm causes a decline in the value of the claims issued by that firm.
4. Spread risk is the risk that deteriorations in general corporate credit quality will affect the claim issued by a given firm.
Settlement risk, by contrast, arises after the transaction has entered the settlement process and one party defaults.
Legal Risk
Legal risk is the risk that a firm will incur a loss if a contract it thought was enforceable actually is not. The Global Derivatives Study Group (1993) identified several sources of legal risk for innovative financial instruments that often are associated with risk management, including conflicts between oral contract formation and the statutes of frauds in certain countries and jurisdictions, the capacity of certain entities (e.g., municipalities) to enter into certain types of transactions, the enforceability of “close-out netting,” and the legality of financial instruments. In addition, unexpected changes in laws and regulations can expose firms to potential losses as well.
Legal risk is classified here as a financial risk because this particular incarnation of risk results in losses that usually are driven in size and economic importance by changes in market prices. A netting agreement that is unenforceable in insolvency, for example, could lead to cherry-picking losses whose total amounts are based on market price movements.
Perils, Accidents, and Hazards
A peril is a natural, man-made, or economic “situation” that can cause an unexpected loss for a firm, the size of which is usually not based on the realization of one or more financial variables. A peril thus is essentially a nonfinancial risk.
An accident is a specific negative event arising from a peril that gives rise to a loss and is usually considered “unintentional.”
A hazard is something that increases the probability of a peril-related loss occurring, whether intentional or not.
Consider the peril to a firm of having its employees sustain on-the-job injuries. A related accident would be the unintended opening of a valve on some storage tank at a firm. A hazard could be alcohol or drugs that make an employee more likely to open the value, the presence of corrosive chemicals in the tank that dissolve the valve seals, and the like.
Different types of perils that firms typically face in their business operations include the following[4]:
? Production—unexpected changes in the demand for products sold, increases in input costs, failures of marketing
? Operational—failures in processes, people, or systems
? Social—adverse changes in social policy (e.g., political incorrectness of a product sold), strained labor relations, changes in fashions and tastes, etc.
? Political—unexpected changes in government, nationalization of resources, war, etc.
? Legal—tort and product liability and other liabilities whose exposures are not driven by financial variables
? Physical—destruction or theft of assets in place, impairment of asset functionality, equipment or mechanical failure, chemical-related perils, energy-related perils
? Environmental—flood, fire, windstorm, hailstorm, earthquake, cyclone, etc.
Outreville (1998) provides some examples of hazards that increase the probability of loss for different perils:
? Human—fatigue, ingnorance, carelessness, smoking
? Environmental—weather, noise
? Mechanical—weight, stability, speed
? Energy—electrical, radiation
? Chemical—toxicity, flammability, combustability
Production Perils
Production-related perils cover any perils that threaten a firm’s ability to carry out its normal business activities as expected, usually resulting from changes to the supply or demand for the firm’s product or to the physical production process. Shocks to a firm’s cost or demand functions, for example, can precipitate a loss of value owing to production risks. Three other production-related perils include customer loss risk, supply chain risk, and reputation risk.
At the core of risks facing a business is the risk that the business loses its customers, either because a competitor attracts them away or because they no longer demand the products and services the firm is selling at the prices it is quoting. Customer loss risk thus encompasses pricing risk, or the risk that firms misestimate either the level or the structure of prices for their customers.
Many nonfinancial firms also face risks from adverse events that may occur at any point along a physical “supply chain” (the chain that connects inputs to the firm’s production process to its outputs). Problems may arise at any juncture. Consider, for example, a firm that grows wheat, mills it into flour, and exports the flour to bread makers around the world. Problems could arise at origination from disease, bad weather, insects, vandalism, or any number of other factors that prevent the crop from being grown and brought in according to schedule (both time and quantity). At the transformation stage, equipment breakdowns could occur, contamination of the grain is a possibility, and losses of product during transportation are a consideration. And so on. In short, the firm faces some form of inventory or product risk at every stage here.
A third major production-related peril faced by virtually all firms is the risk of a loss to their brand name capital or reputation that can translate into reduced revenues, increased expenses, and fewer customers—hence its classification as a type of production peril. Reputation risk can arise when a firm acts negligently or is simply perceived to act negligently—as Exxon was perceived following the Valdez, Alaska, oil disaster.
Reputation risk also can arise from poor public relations management of external crises, whether or not the crises are the direct fault of the company. A plane crash due to bad weather, for example, can still impose major adverse reputation effects on both the airline and the aircraft manufacturer if the public relations dimension of the disaster is not handled properly.
Finally, reputation risk can arise when a firm simply fails to honor its commitments. An insurance company that regularly tries to avoid paying out claims even when the claims are unambiguous and legitimate, for example, will quickly find itself short of customers.
Operational Perils
“the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events.”
Examples of losses that can be attributed to operational risk include failed securities trades, settlement errors in funds transfers, stolen or damaged physical assets, damages awarded in court proceedings against the firm, penalties and fines assessed by member associations or regulators, irrecoverable or erroneous funds and asset transfers, unbudgeted personnel costs, and negligence or fraud.
Operational perils also can sometimes be considered as a type of financial risk if the operational losses are driven by market, credit, or liquidity risks. The failure of Barings to catch the huge position buildup by rogue trader Nick Leeson was in some sense an operational risk management failure. It was a failure of processes (internal audit and control), people (Leeson was defrauding the firm and others), and systems (a consolidated global position-keeping system would have revealed Leeson’s rogue positions). But in the end, Barings went bust because Leeson’s positions went underwater as a result of their market risk. Operational risk management may have failed to catch the process, personnel, and systems problem, but market risk sank the firm.
Core versus Noncore Risks
The core risks facing a firm may be defined as those risks that the firm is in business to bear and manage so that it can earn returns in excess of the risk-free rate.
Noncore risks, by contrast, are risks to which a firm’s primary business exposes it but that the firm does not necessarily need to retain in order to engage in its primary business line.
The firm may well be exposed to noncore risks, but it may not wish to remain exposed to those risks. Core risks, by contrast, are those risks the firm is literally in business not to get rid of.
Core and noncore risks are sometimes today called “business” and “financial” risks, respectively.
Knight defined noncore risks as “risks,” or situations in which the randomness facing a firm can be expressed in terms of specific, numerical probabilities. These probabilities may be objective (as in a lottery) or subjective (as in a horse race), but they must be quantifiable. Because they can be quantified, they can be managed.
Unlike risk, Knight defined “uncertainty” as situations when a firm faces some randomness that cannot be expressed in terms of the probabilities of alternative outcomes. This was “core risk” in Knight’s eyes, or the risks about which only the firm in question had some perceived special insight. To Knight, uncertainty was the source of all major profits and losses to businesses. Lord J.M. Keynes agreed, choosing the term “animal spirits” to describe essentially the same phenomenon.
A major distinction between core and noncore risk—Knightian uncertainty and risk—is driven purely by information. Those factors about which a firm perceives itself as having some comparative informational advantage will be those factors on which the business concentrates for its core business cash flows. Risks about which the firm has comparatively less information will be those risks more likely to be hedged, diversified away, insured, or controlled in some other fashion.
The distinction between core and noncore risk clearly rests on a slippery slope. Not only does it vary from one firm to the next, but it also depends not on the quality of information the firm actually has but rather on the firm’s perceived comparative advantage in digesting that information. Perceptions, of course, can be wrong. Businesses fail, after all, with an almost comforting degree of regularity. Without business failures, one might tend to suspect the market is not working quite right. Accordingly, the preponderance of actual business failures clearly means that some firms thought they had a better handle on information than they did, whether that information concerns market demand for their products, their competitors, or their costs.
Retained versus Transferred Risks
A major purpose of distinguishing between risk—especially core versus noncore risks—is to help a firm make its retention decision.
The retained risk or retention of a firm is the agglomeration of risks—core and noncore—to which the firm is naturally exposed in the conduct of its business that the firm decides to bear rather than to shift to another market participant.
Transferred risk, by contrast, is any risk to which a firm is exposed that a firm decides it is not in the business of bearing and decides to transfer to another market participant.
The decision whether to retain or transfer a given risk is essentially a determination by the firm’s shareholders of whether they want to absorb any realized losses arising from the risk in question or whether they would prefer to have the equity holders of another firm absorb those losses. A core factor to firms in making this determination will, of course, be the benefit/cost trade-off—whether the benefit of transferring the risk is above the cost at the margin. The cost of risk transfer can include both the opportunity cost of forgone profits or positive returns, the pure transaction costs of the risk transfer, and/or the price that the firm may have to pay to induce the equity holders of another corporation to assume the risk the firm is trying to transfer away.
For more Information:
Risk Management, Risk Transfer, Financial Risks, Business Risks, Legal Risk
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