Lesson 5 of 8 · All lessons in this module
- Risk, risk exposure and what risk management is
- The risk management framework
- Risk governance and the enterprise view
- Risk tolerance and risk budgetingVideo lesson
- Financial and non-financial risks, and how they interact
- Risk drivers and risk metrics
- Modifying risk: avoid, accept, transfer or shiftVideo lesson
- Integrated case: hedging the currency of a foreign bond holding
Lesson 5 of 8 · 15 min
Financial and non-financial risks, and how they interact
Financial risks come from the financial markets (market, credit and liquidity risk); non-financial risks come from inside the organisation or from its environment; and in practice risks feed on one another, so the combined damage is usually worse than the sum of the parts.
In short
- Financial risks arise from events in the financial markets: market risk (interest rates, stock prices, exchange rates, commodity prices), credit risk (a counterparty fails to pay) and liquidity risk (having to sell at a significant price concession).
- Liquidity risk is the uncertainty of the transaction cost, not the known bid-ask spread itself.
- Non-financial risks: settlement, legal, compliance (regulatory, accounting, tax), model, tail, operational and solvency risk.
- Solvency risk is running out of cash even if otherwise solvent; practitioners often call it liquidity risk, but the reading keeps the terms separate.
- Individuals also face health, mortality (dying young), longevity (outliving resources) and property and casualty risks.
- Risks interact: market risk begets credit risk, which begets operational and settlement risk. Wrong-way risk and leverage meeting illiquidity are classic examples. Interactions are non-linear; systemic risk is the extreme case.
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