Reading 37: Risk Management －LOS b

Operations risk is the potential for failures in the firms operating systems due to personnel, technological, mechanical, or other problems. Although BigBank is sure to have exposure to operations risk, it is not explicitly described in these transactions. Credit risk is the potential for default, which is certainly a possibility in BigBanks forward contract. Herstatt risk or settlement risk is the possibility that one party could default on a contract while the other is settling. This has been a problem in foreign exchange markets due to time differences and is certainly possible in BigBanks currency swap. Liquidity risk refers to the potential for sustaining losses due to the inability to sell or buy a position quickly. BigBanks sale of the Canadian dollars is subject to liquidity risk.

Regulatory risk is due to the fact that different securities in a firms portfolio are subject to regulation by different regulatory bodies. Although the LDC Bank is sure to have exposure to regulatory risk, it is not explicitly described in these transactions. Sovereign risk refers to the willingness and ability of a country to repay its debt, which is certainly present in the loan to Tinia. Model risk refers to the risk that models may fail due to poor inputs or construction. The banks use of simulation to predict country default is subject to model risk. Herstatt risk or settlement risk is the possibility that one party could default on a contract while the other is settling. This has been a problem in foreign exchange markets due to time differences and is certainly possible in the LDC Banks currency swap.

Financial and non-financial risk factors are general terms. Financial risk factors are those associated with external capital markets and the transactions within external markets. Non-financial risk factors capture other types of risk. Financial risk factors include market risk, liquidity risk, credit risk, and sovereign risk. Market risk pertains to the factors that affect firm or portfolio values (e.g. interest rates, exchange rates, equity prices, commodity prices, etc.). Non-financial risk factors include settlement (Herstatt) risk, operations risk, model risk, sovereign risk, regulatory risk, and other miscellaneous risk factors. Note that sovereign risk has both financial and non-financial risk components.