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Old Friday, May 13, 2016
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Default Advance Risk Management

A hazard is a situation that poses a level of threat to life, health, property, or environment. Most hazards are dormant or potential, with only a theoretical risk of harm; however, once a hazard becomes "active", it can create an emergency situation. A hazard does not exist when it is not happening. A hazardous situation that has come to pass is called an incident. Hazard and vulnerability interact together to create risk.
There are several methods of classifying a hazard, but most systems use some variation on the factors of "likelihood" of the hazard turning into an incident and the "seriousness" of the incident if it were to occur. (This discussion moved away from hazard to a discussion of risk.)
A common method is to score both likelihood and seriousness on a numerical scale (with the most likely and most serious scoring highest) and multiplying one by the other in order to reach a comparative score.
Risk = Hazard x Vulnerability(-)Capacity
This score can then be used to identify which hazards may need to be mitigated. A low score on likelihood of occurrence may mean that the hazard is dormant, whereas a high score would indicate that it may be an "active" hazard.
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment. In simple language, Hedge (Hedging Technique) is used to reduce any substantial losses suffered by an individual or an organization. Hedging is the practice of taking a position in one market to offset and balance against the risk adopted by assuming a position in a contrary or opposing market or investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts.
In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents.[1] Therefore, any risk-averse investor will diversify to at least some extent, with more risk-averse investors diversifying more completely than less risk-averse investors.
Diversification is one of two general techniques for reducing investment risk. The other is hedging. Diversification relies on the lack of a tight positive relationship among the assets' returns, and works even when correlations are near zero or somewhat positive. Hedging relies on negative correlation among assets, or shorting assets with positive correlation.
It is important to remember that diversification only works because investment in each individual asset is reduced. If someone starts with $10,000 in one stock and then puts $10,000 in another stock, they would have more risk, not less. Diversification would require the sale of $5,000 of the first stock to be put into the second. There would then be less risk. Hedging, by contrast, reduces risk without selling any of the original position.[2]
The risk reduction from diversification does not mean anyone else has to take more risk. If person A owns $10,000 of one stock and person B owns $10,000 of another, both A and B will reduce their risk if they exchange $5,000 of the two stocks, so each now has a more diversified portfolio
The simplest example of diversification is provided by the proverb "Don't put all your eggs in one basket". Dropping the basket will break all the eggs. Placing each egg in a different basket is more diversified. There is more risk of losing one egg, but less risk of losing all of them. In finance, an example of an undiversified portfolio is to hold only one stock. This is risky; it is not unusual for a single stock to go down 50% in one year. It is much less common for a portfolio of 20 stocks to go down that much, even if they are selected at random. If the stocks are selected from a variety of industries, company sizes and types (such as some growth stocks and some value stocks) it is still less likely.
Further diversification can be obtained by investing in stocks from different countries, and in different asset classes such as bonds, real estate, private equity, infrastructure and commodities such as heating oil or gold.[4]
Since the mid-1970s, it has also been argued that geographic diversification would generate superior risk-adjusted returns for large institutional investors by reducing overall portfolio risk while capturing some of the higher rates of return offered by the emerging markets of Asia and Latin America.[5][6]
Return expectations while diversifying
If the prior expectations of the returns on all assets in the portfolio are identical, the expected return on a diversified portfolio will be identical to that on an undiversified portfolio. Ex post, some assets will do better than others; but since one does not know in advance which assets will perform better, this fact cannot be exploited in advance. The ex post return on a diversified portfolio can never exceed that of the top-performing investment, and indeed will always be lower than the highest return (unless all returns are ex post identical). Conversely, the diversified portfolio's return will always be higher than that of the worst-performing investment. So by diversifying, one loses the chance of having invested solely in the single asset that comes out best, but one also avoids having invested solely in the asset that comes out worst. That is the role of diversification: it narrows the range of possible outcomes. Diversification need not either help or hurt expected returns, unless the alternative non-diversified portfolio has a higher expected return.[7] But risk averse investors may find it beneficial to diversify into assets with lower expected returns, thereby lowering the expected return on the portfolio, when the risk-reduction benefit of doing so exceeds the cost in terms of diminished expected return.
Maximum diversification
Given the advantages of diversification, many experts recommend maximum diversification, also known as “buying the market portfolio.” Unfortunately, identifying that portfolio is not straightforward. The earliest definition comes from the capital asset pricing model which argues the maximum diversification comes from buying a pro rata share of all available assets. This is the idea underlying index funds.
One objection to that is it means avoiding investments like futures that exist in zero net supply. Another is that the portfolio is determined by what securities come to market, rather than underlying economic value. Finally, buying pro rata shares means that the portfolio overweights any assets that are overvalued, and underweights any assets that are undervalued. This line of argument leads to portfolios that are weighted according to some definition of “economic footprint,” such as total underlying assets or annual cash flow. “Risk parity” is an alternative idea. This weights assets in inverse proportion to risk, so the portfolio has equal risk in all asset classes. This is justified both on theoretical grounds, and with the pragmatic argument that future risk is much easier to forecast than either future market value or future economic footprint.
Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities.[1] These commodities may be grains, metals, gas, electricity etc. A commodity enterprise needs to deal with the following kinds of risks:
• Price risk (Risk arising out of adverse movements in the world prices, exchange rates, basis between local and world prices)
• Quantity risk
• Cost risk (Input price risk)
• Political risk
Groups at Risk
There are broadly four categories of agents who face the commodities risk:
• Producers (farmers, plantation companies, and mining companies) face price risk, cost risk (on the prices of their inputs) and quantity risk
• Buyers (cooperatives, commercial traders and trait ants) face price risk between the time of up-country purchase buying and sale, typically at the port, to an exporter.
• Exporters face the same risk between purchase at the port and sale in the destination market; and may also face political risks with regard to export licenses or foreign exchange conversion.
• Governments face price and quantity risk with regard to tax revenues, particularly where tax rates rise as commodity prices rise (generally the case with metals and energy exports) or if support or other payments depend on the level of commodity prices.
Concentration risk is a banking term denoting the overall spread of a bank's outstanding accounts over the number or variety of debtors to whom the bank has lent money. This risk is calculated using a "concentration ratio" which explains what percentage of the outstanding accounts each bank loan represents. For example, if a bank has 5 outstanding loans of equal value each loan would have a concentration ratio of .2; if it had 3, it would be .333.
Various other factors enter into this equation in real world applications, where loans are not evenly distributed or are heavily concentrated in certain economic sectors. A bank with 10 loans, valued at 10 dollars a piece would have a concentration ratio of .10; but if 9 of the loans were for 1 dollar, and the last was for 50, the concentration risk would be considerably higher. Also, loans weighted towards a specific economic sector would create a higher ratio than a set of evenly distributed loans because the evenly spread loans would serve to offset the risk of economic downturn and default in any one specific industry damaging the bank's outstanding accounts.
Risk of default is an important factor in concentration risk. The basic issue raised by the concept of default risk is: does the risk of default on a bank's outstanding loans match the overall risk posed by the entire economy or are the bank's loans concentrated in areas of higher or lower than average risk based on their volume, type, amount, and industry.
There are two types of concentration risk. These types are based on the sources of the risk. Concentration risk can arise from uneven distribution of exposures (or loan) to its borrowers. Such a risk is called Name Concentration risk. Another type is Sectoral Concentration risk which can arise from uneven distribution of exposures to particular sectors, regions, industries or products.
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Investor losses include lost principal and interest, decreased cash flow, and increased collection costs, which arise in a number of circumstances
• A consumer does not make a payment due on a mortgage loan, credit card, line of credit, or other loan
• A business does not make a payment due on a mortgage, credit card, line of credit, or other loan
• A business or consumer does not pay a trade invoice when due
• A business does not pay an employee's earned wages when due
• A business or government bond issuer does not make a payment on a coupon or principal payment when due
• An insolvent insurance company does not pay a policy obligation
• An insolvent bank won't return funds to a depositor
• A government grants bankruptcy protection to an insolvent consumer or business
Types of credit risk
Credit risk can be classified in the following way:[3]
• Credit Default Risk - The risk of loss when the bank considers that the obligor is unlikely to pay its credit obligations in full or the obligor is more than 90 days past due on any material credit obligation; default risk may impact all credit-sensitive transactions, including loans, securities and derivatives.
• Concentration Risk - The risk associated with any single exposure or group of exposures with the potential to produce large enough losses to threaten a bank's core operations. It may arise in the form of single name concentration or industry concentration.
• Country Risk - The risk of loss arising when a sovereign state freezes foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk).
Assessing credit risk
Main articles: Credit analysis and Consumer credit risk
Significant resources and sophisticated programs are used to analyze and manage risk.[4] Some companies run a credit risk department whose job is to assess the financial health of their customers, and extend credit (or not) accordingly. They may use in house programs to advise on avoiding, reducing and transferring risk. They also use third party provided intelligence. Companies like Standard & Poor's, Moody's Analytics, Fitch Ratings, and Dun and Bradstreet provide such information for a fee.
Most lenders employ their own models (credit scorecards) to rank potential and existing customers according to risk, and then apply appropriate strategies.[5] With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa.[6][7] With revolving products such as credit cards and overdrafts, risk is controlled through the setting of credit limits. Some products also require security, most commonly in the form of property.
Credit scoring models also form part of the framework used by banks or lending institutions grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively. Once this information has been fully reviewed by credit officers and credit committees, the lender provides the funds subject to the terms and conditions presented within the contract (as outlined above).
Credit risk has been shown to be particularly large and particularly damaging for very large investment projects, so-called megaprojects. This is because such projects are especially prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost overruns, schedule delays, etc. – the costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the debt.[8]
Sovereign risk
Sovereign risk is the risk of a government becoming unwilling or unable to meet its loan obligations, or reneging on loans it guarantees Many countries have faced sovereign risk in the late-2000s global recession.[10] The existence of such risk means that creditors should take a two-stage decision process when deciding to lend to a firm based in a foreign country. Firstly one should consider the sovereign risk quality of the country and then consider the firm's credit quality.[11]
Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:[12]
• Debt service ratio
• Import ratio
• Investment ratio
• Variance of export revenue
• Domestic money supply growth
The probability of rescheduling is an increasing function of debt service ratio, import ratio, variance of export revenue and domestic money supply growth. Frenkel, Karmann and Scholtens also argue that the likelihood of rescheduling is a decreasing function of investment ratio due to future economic productivity gains. Saunders argues that rescheduling can become more likely if the investment ratio rises as the foreign country could become less dependent on its external creditors and so be less concerned about receiving credit from these countries/investors.
Counterparty risk
Counterparty risk, known as default risk, is the risk that an organization does not pay out on a bond, credit derivative, trade credit insurance or payment protection insurance contract, or other trade or transaction when it is supposed to. Even organizations who think that they have hedged their bets by buying credit insurance of some sort still face the risk that the insurer will be unable to pay, either due to temporary liquidity issues or longer term systemic issues.[
Large insurers are counterparties to many transactions, and thus this is the kind of risk that prompts financial regulators to act, e.g., the bailout of insurer AIG.
On the methodological side, counterparty risk can be affected by wrong way risk, namely the risk that different risk factors be correlated in the most harmful direction. Including correlation between the portfolio risk factors and the counterparty default into the methodology is not trivial,
Mitigating credit risk
Lenders mitigate credit risk using several methods:
• Risk-based pricing: Lenders generally charge a higher interest rate to borrowers who are more likely to default, a practice called risk-based pricing. Lenders consider factors relating to the loan such as loan purpose, credit rating, and loan-to-value ratio and estimates the effect on yield (credit spread).
• Covenants: Lenders may write stipulations on the borrower, called covenants, into loan agreements:
o Periodically report its financial condition
o Refrain from paying dividends, repurchasing shares, borrowing further, or other specific, voluntary actions that negatively affect the company's financial position
o Repay the loan in full, at the lender's request, in certain events such as changes in the borrower's debt-to-equity ratio or interest coverage ratio
• Credit insurance and credit derivatives: Lenders and bond holders may hedge their credit risk by purchasing credit insurance or credit derivatives. These contracts transfer the risk from the lender to the seller (insurer) in exchange for payment. The most common credit derivative is the credit default swap.
• Tightening: Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30 to net 15.
• Diversification:[19] Lenders to a small number of borrowers (or kinds of borrower) face a high degree of unsystematic credit risk, called concentration risk. Lenders reduce this risk by diversifying the borrower pool.
• Deposit insurance: Many governments establish deposit insurance to guarantee bank deposits of insolvent banks. Such protection discourages consumers from withdrawing money when a bank is becoming insolvent, to avoid a bank run, and encourages consumers to hold their savings in the banking system instead of in cash.
Currency risk or exchange rate risk is a form of financial risk that arises from the potential change in the exchange rate of one currency against another. Investors or businesses face an exchange rate risk when they have assets or operations across national borders or if they have loans or borrowings in a foreign currency.
An exchange rate risk can result in an exchange gain as well as a loss. Great concern occurs when there is possibility that currency depreciation will negatively affect the value of one's assets, investments, and their related interest and dividend payment streams, especially those securities denominated in foreign currency. To neutralize the risk of a loss (but at the same time forgoing any potential exchange gain), some businesses hedge all their foreign exchange exposure or exposure beyond some predetermined comfort level, which is a way of transferring the risk to another business prepared to carry the risk or has a reverse risk exposure. Hedging can involve the use of a forward contract.
There are two basic types of currency risk:
Transaction risk is the risk that an exchange rate will change unfavourably over time. It is associated with the time delay between entering into a contract and settling it. The greater the time differential between the entrance and settlement of the contract, the greater the transaction risk, because there is more time for the two exchange rates to fluctuate. [1]
Translation risk is an accounting concept. It is proportional to the amount of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency.
A currency risk exists regardless of whether investors invest domestically or abroad. If they invest in the home country, and the home currency devalues, investors have lost money. All stock market investments are subject to a currency risk, regardless of the nationality of the investor or the investment, and whether they are in the same or different currency. Some people argue that the only way to avoid currency risk is to invest in commodities (such as gold) which hold value independently of the monetary system.[citation needed]
Consequences of risk
The currency risk associated with a foreign denominated instrument is a significant consideration in foreign investment. Corporations with operations in overseas markets are exposed to currency risk since their foreign financial results must be consolidated into the company's home currency.For example, if a U.S. investor owns stocks in Canada, the return that will be realized is affected by both the change in the price of the stocks and the change of the Canadian dollar against the US dollar. Suppose that the investor realized a return on the stocks of 15% but if the Canadian dollar depreciated 15% against the US dollar, then the movement in the exchange rate would cancel out the realized profit on sale of the stocks.
If a business buys or sells in another currency, then revenue and costs can move upwards or downwards as exchange rates between the transaction currency changes in relation to the home currency. Similarly, if a business borrows funds in another currency, the repayments on the debt could change in terms of the home currency; and if the business has invested overseas, the returns on investment may alter with exchange rate movements.
Currency risk has been shown to be particularly significant and particularly damaging for very large, one-off investment projects, so-called megaprojects. This is because such projects are typically financed by very large debts nominated in currencies different from the currency of the home country of the owner of the debt. Megaprojects have been shown to be prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost overruns, schedule delays, unforeseen foreign currency and interest rate increases, etc. – the costs of servicing debt becomes larger than the revenues available to do so. Financial restructuring is typically the consequence and is common for megaprojects.
Equity risk is the risk that one's investments will depreciate because of stock market dynamics causing one to lose money
Interest rate risk is the risk (variability in value) borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond's duration.
Asset liability management is a common name for the complete set of techniques used to manage risk within a general enterprise risk management framework.
Banks and interest rate risk
Banks face many types of interest rate risk:
Basis risk
the risk presented when yields on assets and costs on liabilities are based on different bases, such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate. In some circumstances different bases will move at different rates or in different directions, which can cause erratic changes in revenues and expenses.
Yield curve risk
the risk presented by differences between short-term and long-term interest rates. Short-term rates are normally lower than long-term rates, and banks earn profits by borrowing short-term money (at lower rates) and investing in long-term assets (at higher rates). But the relationship between short-term and long-term rates can shift quickly and dramatically, which can cause erratic changes in revenues and expenses.
Repricing risk
the risk presented by assets and liabilities that reprice at different times and rates. For instance, a loan with a variable rate will generate more interest income when rates rise and less interest income when rates fall. If the loan is funded with fixed rated deposits, the bank's interest margin will fluctuate.
Option risk
the risk presented by optionalities embedded in some assets and liabilities. For instance, mortgage loans present significant option risk due to prepayment speeds that change dramatically when interest rates rise and fall. Falling interest rates will cause many borrowers to refinance and repay their loans, leaving the bank with uninvested cash when interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to repay slower, leaving the bank with more loans based on prior, lower interest rates. Option risk is difficult to measure and control.
Model risk
the risk presented by mathematical models used to price asset and liabilities not directly quoted on the market. Interest rate pricing models are based on reasonable assumptions about the behaviour of interest rates that may fail in particular market conditions.
Most banks are asset sensitive, meaning interest rate changes impact asset yields more than they impact liability costs. This is because substantial amounts of bank funding are not affected, or are just minimally affected, by changes in interest rates. The average checking account pays no interest, or very little interest, so changes in interest rates do not produce notable changes in interest expense. However, banks have large concentrations of short-term and/or variable rate loans, so changes in interest rates significantly impact interest income. In general, banks earn more money when interest rates are high, and they earn less money when interest rates are low. This relationship often breaks down in very large banks that rely significantly on funding sources other than traditional bank deposits. Large banks are often liability sensitive because they depend on large concentrations of funding that are highly interest rate sensitive. Large banks also tend to maintain large concentrations of fixed rate loans, which further increases liability sensitivity. Therefore, large banks will often earn more net interest income when interest rates are low.
Megaprojects and interest rate risk
Interest rate risk has been shown to be particularly significant and particularly damaging for very large, one-off investment projects, so-called megaprojects. This is because such projects are typically debt-financed and are prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost overruns, schedule delays, unforeseen interest rate increases, etc. – the costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the debt.
Hedging interest rate risk
Interest rate risks can be reduced (hedged) using bonds, fixed income instruments or fixed-for-floating interest rate swaps.
Legal risk is risks that counterparty are not legally able to enter into a contract. Another legal risk relates to regulatory risk, i.e., that a transaction could conflict with a regulator's policy or, more generally, that legislation might change during the life of a financial contract.The Risk Principle is an area of law closely tied to legal causation in negligence. It provides limits on negligence for harm caused unforeseeably.
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices. The associated market risks are:
• Equity risk, the risk that stock or stock indexes (e.g. Euro Stoxx 50, etc. ) prices and/or their implied volatility will change.
• Interest rate risk, the risk that interest rates (e.g. Libor, Euribor, inflation, etc.) and/or their implied volatility will change.
• Currency risk, the risk that foreign exchange rates (e.g. EUR/USD, EUR/GBP, etc.) and/or their implied volatility will change.
• Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil, etc.) and/or their implied volatility will change.
Measuring the potential loss amount due to market risk
As with other forms of risk, the potential loss amount due to market risk may be measured in a number of ways or conventions. Traditionally, one convention is to use Value at Risk. The conventions of using Value at risk is well established and accepted in the short-term risk management practice.
However, it contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the specified period. Over short time horizons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the positions in the portfolio may have been changed. The Value at Risk of the unchanged portfolio is no longer relevant.
The Variance Covariance and Historical Simulation approach to calculating Value at Risk also assumes that historical correlations are stable and will not change in the future or breakdown under times of market stress.
In addition, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.
All businesses take risks based on two factors: the probability an adverse circumstance will come about and the cost of such adverse circumstance.
In banking and finance, refinancing risk is the possibility that a borrower cannot refinance by borrowing to repay existing debt. Many types of commercial lending incorporate balloon payments at the point of final maturity; often, the intention or assumption is that the borrower will take out a new loan to pay the existing lenders.
A borrower that cannot refinance their existing debt and does not have sufficient funds on hand to pay their lenders may have a liquidity problem. The borrower may be considered technically insolvent: even though their assets are greater than their liabilities, they cannot raise the liquid funds to pay their creditors. Insolvency may lead to bankruptcy, even when the borrower has a positive net worth.
In order to repay the debt at maturity, the borrower that cannot refinance may be forced into a fire sale of assets at a low price, including the borrower's own home and productive assets such as factories and plants.
Most large corporations and banks face this risk to some degree, as they may constantly borrow and repay loans. Refinancing risk increases in periods of rising interest rates, when the borrower may not have sufficient income to afford the interest rate on a new loan.[citation needed]
Most commercial banks provide long term loans, and fund this operation by taking shorter term deposits. In general, refinancing risk is only considered to be substantial for banks in cases of financial crisis, when borrowing funds, such as inter-bank deposits, may be extremely difficult.
Refinancing is also known as “rolling over” debt of various maturities, and so refinancing risk may be referred to as rollover risk.
Reputational risk, often called reputation risk, is a type of risk related to the trustworthiness of business. Damage to a firm's reputation can result in lost revenue or destruction of shareholder value, even if the company is not found guilty of a crime. Reputational risk can be a matter of corporate trust, but serves also as a tool in crisis prevention
Settlement risk is the risk that a counterparty does not deliver a security or its value in cash as per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value as per the trade agreement.
Volatility risk is the risk of a change of price of a portfolio as a result of changes in the volatility of a risk factor. It usually applies to portfolios of derivatives instruments, where the volatility of its underlyings is a major influencer of prices.
Sensitivity to Volatility
A measure for the sensitivity of a price of a portfolio (or asset) to changes in volatility is vega, the rate of change of the value of the portfolio with respect to the volatility of the underlying asset[1].
Risk Management
This kind of risk can be managed using appropriate financial instruments whose price depends on the volatility of a given financial asset (a stock, a commodity, an interest rate, etc.). Examples are Futures contracts such as ViX[2] for equities, or caps, floors and swaptions for interest rates.
Political risk is a type of risk faced by investors, corporations, and governments. It is a risk that can be understood and managed with reasoned foresight and investment.
Broadly, political risk refers to the complications businesses and governments may face as a result of what are commonly referred to as political decisions—or “any political change that alters the expected outcome and value of a given economic action by changing the probability of achieving business objectives.”.[1] Political risk faced by firms can be defined as “the risk of a strategic, financial, or personnel loss for a firm because of such nonmarket factors as macroeconomic and social policies (fiscal, monetary, trade, investment, industrial, income, labour, and developmental), or events related to political instability (terrorism, riots, coups, civil war, and insurrection).”[2] Portfolio investors may face similar financial losses. Moreover, governments may face complications in their ability to execute diplomatic, military or other initiatives as a result of political risk.
A low level of political risk in a given country does not necessarily correspond to a high degree of political freedom. Indeed, some of the more stable states are also the most authoritarian. Long-term assessments of political risk must account for the danger that a politically oppressive environment is only stable as long as top-down control is maintained and citizens prevented from a free exchange of ideas and goods with the outside world.[3]
Understanding risk as part probability and part impact provides insight into political risk. For a business, the implication for political risk is that there is a measure of likelihood that political events may complicate its pursuit of earnings through direct impacts (such as taxes or fees) or indirect impacts (such as opportunity cost forgone). As a result, political risk is similar to an expected value such that the likelihood of a political event occurring may reduce the desirability of that investment by reducing its anticipated returns.
There are both macro- and micro-level political risks. Macro-level political risks have similar impacts across all foreign actors in a given location. While these are included in country risk analysis, it would be incorrect to equate macro-level political risk analysis with country risk as country risk only looks at national-level risks and also includes financial and economic risks. Micro-level risks focus on sector, firm, or project specific risk.[4]
Macro-level political risk
Macro-level political risk looks at non-project specific risks. Macro political risks affect all participants in a given country.[5] A common misconception is that macro-level political risk only looks at country-level political risk; however, the coupling of local, national, and regional political events often means that events at the local level may have follow-on effects for stakeholders on a macro-level. Other types of risk include government currency actions, regulatory changes, sovereign credit defaults, endemic corruption, war declarations and government composition changes. These events pose both portfolio investment and foreign direct investment risks that can change the overall suitability of a destination for investment. Moreover, these events pose risks that can alter the way a foreign government must conduct its affairs as well.Macro political risks also affect the organizations operating in the nations and the result of macro level political risks are like confiscation, causing the seize of the businesses' property.
Research has shown that macro-level indicators can be quantified and modeled like other types of risk. For example, Eurasia Group produces a political risk index which incorporates four distinct categories of sub-risk into a calculation of macro-level political stability. This Global Political Risk Index can be found in publications like The Economist.[6] Other companies which offer publications on macro-level political risk include Economist Intelligence Unit and The PRS Group, Inc.
Micro-level political risk
Micro-level political risks are project-specific risks. In addition to the macro political risks, companies have to pay attention to the industry and relative contribution of their firms to the local economy.[7] An examination of these types of political risks might look at how the local political climate in a given region may impact a business endeavor. Micropolitical risks are more in the favour of local businesses rather than international organizations operating in the nation. This type of risk process includes the project-specific government review Committee on Foreign Investment in the United States (CFIUS), the selection of dangerous local partners with political power, and expropriation/nationalization of projects and assets.
To extend the CFIUS example above, imagine a Chinese company wished to purchase a US weapons component producer. A micro-level political risk report might include a full analysis of the CFIUS regulatory climate as it directly relates to project components and structuring, as well as analysis of congressional climate and public opinion in the US toward such a deal. This type of analysis can prove crucial in the decision-making process of a company assessing whether to pursue such a deal. For instance, Dubai Ports World suffered significant public relations damage from its attempt to purchase the US port operations of P&O, which might have been avoided with more clear understanding of the US climate at the time.
Political risk is also relevant for government project decision-making, whereby government initiatives (be they diplomatic or military or other) may be complicated as a result of political risk. Whereas political risk for business may involve understanding the host government and how its actions and attitudes can impact a business initiative, government political risk analysis requires a keen understanding of politics and policy that includes both the client government as well as the host government of the activity.
Political risk and megaprojects
Political risk has been shown to be particularly large for very big investment projects, so-called megaprojects. This is because such projects are especially visible and are often used for political purposes, e.g., monument building, in addition to the functional demands the projects are designed to meet. Moreover, megaprojects have been shown to be prone to controversy because of widespread cost overrun, schedule delays, and benefit shortfalls for such projects. Controversy often translates into improvised political decisions, which translate into political risk.[8]
Companies may have a Chief Risk Officer who is charged with managing political risk or, in many cases, this job falls to the Chief Financial Officer.
At the macro-level, largely involves understanding political uncertainties of the operating environment and the risks faced by all business operations in individual countries. Such information can come in the form of customized analysis or in-depth subject matter reporting; information that can enable an investor or firm to calibrate their risk appetite. Mitigation tactics involve both macro- and micro-level strategies. A recent article on the subject suggested that political risk mitigation should not simply revolve around the decision to enter or avoid a given country’s marketplace, but should rather center on the pragmatic usage of contingency planning, intellectual property safeguards, risk diversification, and sound exit planning to guard against uncertainty.[9]
At the micro-level, political risk insurance and hedges play a larger role. MIGA and OPIC, both public sector insurers, provide project-specific political risk insurance while private market insurers can provide cover for projects as well as a portfolio of investments. This type of insurance usually outlines specific triggers, such as expropriation or breach of contract by a local party, which entitle the insured entity to a pay-out after relinquishing control of the insured project to the insurer. Political risk insurance, however, often involves premiums which must factor in considerable uncertainty and the threat that arbitrary decisions will affect the value of insured property. Policies therefore can be expensive and are manuscripted after extensive negotiations. An experienced and specialist broker can assess the availability of appropriate cover from private and public insurers and then, based on their experience and expertise, negotiate appropriate policies. Businesses can also purchase hedges, which could be derivative instruments, which allow them to reduce risk by selecting a level of return based on a given set of outcomes.
Political risk mitigation takes place before, during, and after an investment. Prior to investment, businesses can perform due diligence related to local partners and carefully word and structure their contracts. While a project is on-going, the investor may benefit from building local political leverage through community activities. After a risk has been realized, its effects may be mitigated through post-hoc litigation and retaliation, as well as the implementation of a previously developed contingency plan, or exit from the market.
Generally, systemic risk can be described as a risk caused by an event at the firm level that is severe enough to cause instability in the financial system.

On the other hand, systematic risk does have a more recognized and universal definition. Sometimes plainly called market risk, systematic risk is the risk inherent in the aggregate market that cannot be solved by diversification. Some common sources of market risk are recessions, wars, interest rates and others that cannot be avoided through a diversified portfolio. Though systematic risk cannot be fixed with diversification, it can be hedged. Also, the risk that is specific to a firm or industry and can be solved by diversification is called unsystematic.

Systemic “refers to an event having effects on the entire banking, financial, or economic system rather than just one or a few institutions”
Financial risk and financial risk management
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Old Friday, September 22, 2017
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Any one appearing in Advance Risk paper?
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Kinldy provide past paper of advance risk managment and corporate law if your have or any study materiel for above mentioned subjects. i m going to appear AIBP exame
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