Market Risk
ANSWER
the risk that declining prices or volatility of prices in financial markets will result in a loss.n
Credit Risk
ANSWER
the possibility of default by a counterparty in a financial transaction, and the monetary ex-
posure to credit risk is a function of the probability of default and the loss that results given
default occursn
Liquidity Risk
ANSWER
the possibility of sustaining significant losses due to the inability to sufficiently liquidate a
position at a fair pricen
Operational Risk
ANSWER
loss due to inadequate monitoring systems, management failure, defective controls, fraud
and/or human errors. Operational risk is particularly relevant to derivatives trading because
derivatives are inherently highly leveraged instruments, which enable traders to expose a
firm to enormous losses using a relatively small amount of moneyn
Absolute Risk
ANSWER
A type of market risk. Focuses on the volatility of total returns.n
1
,Relative Risk
ANSWER
A type of market risk. Referred to as tracking error because it is usually measured relative to
a benchmark index or portfolio.n
Directional Risk
ANSWER
A type of market risk. Linear risk exposures in economic or financial variables (e.g. interest
rates, stock indices)n
Non-directional Risk
ANSWER
A type of market risk. One that does have non-linear exposures or neutral exposures to
changes in economic or financial conditions.n
Basis Risk
ANSWER
A type of market risk. Risk that the price of a hedging instrument and the price of the asset
being hedged are not perfectly correlated. An example of basis risk is using a put option to
hedge an equity exposure. In this case, the option position will have to be monitored and ad-
justed appropriately because the change in the put option will likely not be exactly equal to
the change in the equity price.n
Volatility Risk
ANSWER
A type of market risk. Risk of loss from changes in actual or implied volatility of market
prices.n
Asset-liquidity Risk
ANSWER
2
,One of two types of liquidity risk. Sometimes called market (or trading) liquidity risj, results
from a large position size forcing transactions to influence the price of securities. To manage
asset-liquidity risk, limits can be established on assets that are not heavily traded.n
Funding liquidity risk
ANSWER
one of two types of liquidity risk. Sometimes called cash-flow risk. This refers to the risk that
a finacial institution will be unable to raise the cash necessary to roll over its debt; to fulfill
the cash, margin, or collateral requirements of counterparties; or to meet capital with-
drawlsn
Credit risk exposure
ANSWER
The exposure is the size or value of loss that would be realized if a credit event occurred. The
recovery rate is the percentage of assets that could be recovered from a counterparty after a
credit event occursn
Credit event
ANSWER
Relates to a change in a counterparty's ability to perform its previously agreed upon financial
obligations. Market prices incorporate changes to credit rating or changes to default proba-
bilities, which can be looked at as both market and credit risk.n
Settlement risk
ANSWER
A type of credit risk. The exchange of two payments or he exchange of an asset for payment.
The risk that the counterparty will fail to deliver its obligation after the party has made its
delivery.n
Sovereign Risk
ANSWER
3
, A type of credit risk. Risks resulting from a country's actions. A contry's willingness to repay
its obligations are often factors looked at when evaluating the soverign risk of foreign gov-
ernment debt.n
Presettlement risk is lower than settlement risk because
ANSWER
this measure, payments will offset (i.e. are netted). On the other hand, settlement risk expo-
sure deals with the full value of each payment.n
Operational, market and credit risk are
ANSWER
interrelated.n
Model Risk
ANSWER
A type of operational risk. The risk of loss due to the use of misspecified or misapplied mod-
els. An institution buying or selling collateralized mortgage obligations (CMOs) may be ex-
posed to model risk if the model used to price the CMOs does not adequately account for
the probability of default in the underlying mortgages.n
Legal Risk
ANSWER
A type of operational risk. The risk of loss in value due to legal issues including lawsuits, fines
penalties and/or damages. An example of legal risk is when a counterparty sues a bank to
avoid meeting its obligations. Legal risks are manage through corporate policies developed
by legal counsel in conjunction with the firm's financial risks managers.n
People risk
ANSWER
4
ANSWER
the risk that declining prices or volatility of prices in financial markets will result in a loss.n
Credit Risk
ANSWER
the possibility of default by a counterparty in a financial transaction, and the monetary ex-
posure to credit risk is a function of the probability of default and the loss that results given
default occursn
Liquidity Risk
ANSWER
the possibility of sustaining significant losses due to the inability to sufficiently liquidate a
position at a fair pricen
Operational Risk
ANSWER
loss due to inadequate monitoring systems, management failure, defective controls, fraud
and/or human errors. Operational risk is particularly relevant to derivatives trading because
derivatives are inherently highly leveraged instruments, which enable traders to expose a
firm to enormous losses using a relatively small amount of moneyn
Absolute Risk
ANSWER
A type of market risk. Focuses on the volatility of total returns.n
1
,Relative Risk
ANSWER
A type of market risk. Referred to as tracking error because it is usually measured relative to
a benchmark index or portfolio.n
Directional Risk
ANSWER
A type of market risk. Linear risk exposures in economic or financial variables (e.g. interest
rates, stock indices)n
Non-directional Risk
ANSWER
A type of market risk. One that does have non-linear exposures or neutral exposures to
changes in economic or financial conditions.n
Basis Risk
ANSWER
A type of market risk. Risk that the price of a hedging instrument and the price of the asset
being hedged are not perfectly correlated. An example of basis risk is using a put option to
hedge an equity exposure. In this case, the option position will have to be monitored and ad-
justed appropriately because the change in the put option will likely not be exactly equal to
the change in the equity price.n
Volatility Risk
ANSWER
A type of market risk. Risk of loss from changes in actual or implied volatility of market
prices.n
Asset-liquidity Risk
ANSWER
2
,One of two types of liquidity risk. Sometimes called market (or trading) liquidity risj, results
from a large position size forcing transactions to influence the price of securities. To manage
asset-liquidity risk, limits can be established on assets that are not heavily traded.n
Funding liquidity risk
ANSWER
one of two types of liquidity risk. Sometimes called cash-flow risk. This refers to the risk that
a finacial institution will be unable to raise the cash necessary to roll over its debt; to fulfill
the cash, margin, or collateral requirements of counterparties; or to meet capital with-
drawlsn
Credit risk exposure
ANSWER
The exposure is the size or value of loss that would be realized if a credit event occurred. The
recovery rate is the percentage of assets that could be recovered from a counterparty after a
credit event occursn
Credit event
ANSWER
Relates to a change in a counterparty's ability to perform its previously agreed upon financial
obligations. Market prices incorporate changes to credit rating or changes to default proba-
bilities, which can be looked at as both market and credit risk.n
Settlement risk
ANSWER
A type of credit risk. The exchange of two payments or he exchange of an asset for payment.
The risk that the counterparty will fail to deliver its obligation after the party has made its
delivery.n
Sovereign Risk
ANSWER
3
, A type of credit risk. Risks resulting from a country's actions. A contry's willingness to repay
its obligations are often factors looked at when evaluating the soverign risk of foreign gov-
ernment debt.n
Presettlement risk is lower than settlement risk because
ANSWER
this measure, payments will offset (i.e. are netted). On the other hand, settlement risk expo-
sure deals with the full value of each payment.n
Operational, market and credit risk are
ANSWER
interrelated.n
Model Risk
ANSWER
A type of operational risk. The risk of loss due to the use of misspecified or misapplied mod-
els. An institution buying or selling collateralized mortgage obligations (CMOs) may be ex-
posed to model risk if the model used to price the CMOs does not adequately account for
the probability of default in the underlying mortgages.n
Legal Risk
ANSWER
A type of operational risk. The risk of loss in value due to legal issues including lawsuits, fines
penalties and/or damages. An example of legal risk is when a counterparty sues a bank to
avoid meeting its obligations. Legal risks are manage through corporate policies developed
by legal counsel in conjunction with the firm's financial risks managers.n
People risk
ANSWER
4
