Speaker 1: What is financial risk? How do we classify it? What does it include? What does it exclude? So I want to answer the question, what is financial risk for a company? This is not personal finance. This is business. And one way to answer that is by classifying the risks that a firm faces. And so this classification is consistent with the financial risk manager or FRM exam that we happen to teach and is the gold standard. So this is not the only classification, but it's at least consistent with a modern perspective where the firm face lots of different risks. But we're going to see that financial risk is really defined by these set of risks that I have colored boxes as opposed to gray boxes. But at the top, I've distinguished between a business and non-business risks. Why would I do that? Well, because we're thinking here really about a non-financial firm like a manufacturer or a technology firm that makes products or a proctor and gamble for that matter. We're not really primarily thinking here about a financial services firm like Bank of America or an investment bank like Goldman Sachs, because financial services firms are primarily already in the business of managing these financial variables. All of the other companies really, they're primarily in the business of managing these risks over here, which we say are business risks. And it's a big bucket of a lot of different complex issues. But there are at least three characteristics here of these business as opposed to non-business risks. These business risks that are inevitable and the first important one is that the owners or shareholders of that business, they don't want to avoid these risks. They expect the firm or company to assume these risks, to make these decisions in this risk environment. After all, if they wanted risk-free, they would invest in U.S. Treasury bonds, for example. So that first thing is that risks are good. Shareholders and owners want the business to assume these business risks. The second is related. There's a symmetry. There's a reward, expected reward for assuming these risks. That's unlike, for example, operational risks for these companies, where it's not as if there's really a return for assuming these risks. There's really just consequences for breakdowns. So operational risk is something like, well, we really just want to get it down to zero if possible because we're not making money off of it. We just want to avoid catastrophes. And the third is that the consequences of these inevitable, necessary, and ultimately good exposure to business risks are really driven and start at the top. In theory, that's the board of directors, but definitely also includes the executive team, really the drivers, right? That's the CEO, the COO, the CFO. So that's the three, at least three characteristics over in the business side. One, owners expect it. It's good exposure. It's good risk. Two, there's a symmetry. There's a reward for the risk. And three, it's driven by, it starts by decisions driven at the top, behaviors at the top. So then we have those business risks. And then we have the non-business that I've divided into non-financial versus financial. And non-financial includes at least two big buckets, reputational and regulatory. But these are big categories of risks that tend to be fuzzy and hard to define, hard to quantify, especially reputational risk. This is huge when it breaks down, but until then, it can be difficult to manage. So then we come over to financial risks, which are for these non-financial firms. These are non-business. And then they're the colored buckets that I've got here. And they do match the sequence of the part two of the FRM, which starts at topic five. And so the sequence really goes market, then credit, then operational, then investment, five, six, seven, eight, where liquidity is actually included in operational risk. But if we start with credit risk, then it's got at least four major subclasses, including downgrade, which we can think about that as credit deterioration. And then we can have default and actually bankruptcy of the company. So these three together can also be called pre-settlement credit risk. And that credit risk is a failure of the counterparty to perform. So that could be a loan, but it can also be a counterparty in a derivative contract. So this credit risk includes counterparty credit risk. And then downgrade, default, and bankruptcy can all be considered pre-settlement risk and what we usually think of as credit risk. But then there's also settlement risk, which is also called a technical term of art, Herstadt risk. And that's really a much shorter term risk of settlement or exchange between the counterparties. So classic example there is a forward contract or foreign exchange contract. One party performs their obligation and they're just waiting maybe in the same day for the other party to pay them back. Sometimes that's minutes, hours, or even within a day. And now we're talking about settlement risk. Okay. So then we have market risk, which also breaks down into classically into these four types, interest rate, equity price, foreign exchange, and commodity price. And market risk is very different from credit risk, but they are interrelated and do play in each other. But just for example, if we think about investing in a bond, company issues a bond to investors. Credit risk is the risk that the company doesn't make those coupon payments or the principal repayment at the end, right? It's the risk of first deterioration in the credit and then default. And that includes also if the company goes bankruptcy, where do we stand in the hierarchy of claims? However, our company that issued the bond can make the coupon payments, be timely with those. And so they're in good credit standing, but the interest rate could rise. And if this is a vanilla bond and the interest rate increases, the price or value of our bond is going to decrease. Well, that's interest rate risk, which is a market risk, which can also be called price risk. So for a typical vanilla bond, we have both credit and market or price risk. Then we have liquidity, which has two major subtypes. Oh, and first, I'll just say about liquidity that at least in the FRM, it's a subclass of operational, but some would put it as a subclass of market risk. And then since the global crisis, just due to the fact that there was some benign neglect of liquidity risk and the global crisis, one of the outcomes of that was the realization of how important liquidity risk was and the realization that a lot of companies actually weren't even include modeling liquidity risk in their models. And so in some classifications, liquidity risk is really got its own seat at the table here with the other major risk buckets. But at least in terms of major subclasses here, we have market risk, market liquidity risk. Hopefully, I can get that right. And that would be that would be evidenced in the bid ask spread and how easy is it for me to sell my asset? So, for example, I happen to own. Oh, well, let's say I do own some shares in Bank of America. Those are so liquid. It's market liquidity. I can really sell them almost instantly. There's a very narrow bid ask spread. That's a real lack of market liquidity risk as opposed to funding liquidity risk. That is a phenomenon of the balance sheet. So that's when a company doesn't have enough cash on the balance sheet to meet those short term obligations. And so market is also called asset price or transaction risk and funding liquidity risk is also called balance sheet risk. So that's liquidity risk. As I mentioned in the FRM, it happens to be classified under operational risk. Operational risk is itself a huge bucket. This is the newest science art and science, so to speak. The other ones are more mature. Credit risk is very mature. Market risk is relatively mature. Operational risk. I think it's fair to say we're still figuring that out. More difficult to model, but obviously very important. But we can break it down. We can follow the Basel regulations and break it down in terms of four areas. Process, people, systems, and events or external events. And external events includes external fraud. And a great example of that would be cyber attacks. Obviously a big issue. But external events also includes natural disasters. So process, people, systems, and external events. And then notice I have in here also legal risk. I've teased that out specifically because that's important to us in financial risk. Obviously a lot of contingent liabilities. I've also teased it out because just classically in terms of the typology, legal risk always included. But traditionally reputational risk and strategy risk not included in financial risk. And then finally we have investment risk. And so this would be of interest to Treasury and what the company is doing with its investable assets. And there we have topics that overlap with the CFA, which is the Gold Standard in Portfolio Management. And I'm a CFA as well as an FRM. And we have topics such as modern topics like factor theory. How do we go beyond asset classes and look at factors, but also portfolio construction and also alternative investments, including private equity and hedge funds. And so the answer to the question, what is financial risk? Well, financial risk includes at the high level credit risk, market risk, liquidity risk, operational risk, and investment risk. And so I hope that was helpful. Thanks.