10.2 Financial Risks: Market, Credit, and Liquidity

10.2 Financial Risks: Market, Credit, and Liquidity

Financial risk arises from exposures that can change the value, cash flow, or collectability of financial positions. The Phase 1 outline emphasizes three families: market risk, credit risk, and liquidity or refinancing risk. A scenario may contain more than one, but identifying the direct driver leads to the right measurement and control.

Market risk

Market risk is the possibility of loss from adverse movements in market variables. Major forms include:

• Equity-price risk: a share or equity index moves against the position.
• Interest-rate risk: rates or yield curves change, affecting bond prices, reinvestment returns, or financing cost.
• Foreign-exchange risk: exchange rates change the peso value of foreign-currency assets, liabilities, income, or expenses.
• Commodity risk: commodity prices affect a position or an issuer's economics.
• Spread and volatility risk: credit spreads, basis relationships, or option-implied volatility move adversely.

Direction matters. A long bond generally loses market value when yields rise; a short position can lose when price rises. Market risk can be measured with sensitivity, duration, scenario analysis, stress tests, position limits, or value-at-risk models. Every measure has assumptions. A historical model can understate a new regime, and a normal-day measure does not replace stress testing.

Credit and counterparty risk

Credit risk is the possibility that an obligor will not perform fully and on time, or that deterioration in credit quality reduces a claim's value. A bond issuer may miss interest or principal, a margin client may fail to cure a deficit, or a settlement counterparty may not deliver cash or securities.

Useful components are probability of default, exposure at default, and loss given default. Expected loss is conceptually related to all three, but precise estimation requires data and judgment. Credit-spread widening can create a market-value loss before an actual default. That price effect is related to credit quality but observed through the market.

Controls include credit approval, counterparty limits, collateral and haircuts, margin, diversification, netting where legally enforceable, covenants, ongoing monitoring, and settlement arrangements such as delivery versus payment. Collateral reduces loss severity but brings valuation, liquidity, custody, and legal-enforceability risk.

Liquidity and refinancing risk

Liquidity has two distinct meanings:

1. Market liquidity risk is inability to sell or close a position promptly at a price close to fair value. Warning signs include wide bid-offer spreads, shallow order books, low turnover, price gaps, and a position large relative to normal volume.
2. Funding liquidity risk is inability to obtain cash to meet obligations when due at reasonable cost. Margin calls, redemptions, settlement payments, operating expenses, and maturing borrowings can create funding needs.

Refinancing risk is the danger that maturing debt cannot be renewed, or can be renewed only at a much higher cost or on restrictive terms. A firm can be solvent on a balance-sheet basis yet fail because assets cannot be monetized before payments fall due. Liquidity management therefore uses cash-flow ladders, liquid-asset buffers, committed facilities, diversified funding sources, maturity limits, and contingency funding plans.

Concentration, leverage, and interaction

Concentration risk arises when exposure is heavily dependent on one issuer, counterparty, sector, currency, product, funding provider, or correlated group. Diversification works only when exposures do not all fail under the same condition. Leverage magnifies both gains and losses and may create forced sales through margin or collateral calls.

Risk interaction is common. A price decline (market risk) produces a margin call (funding liquidity risk); forced sales into a thin market deepen the price decline (market liquidity risk); counterparties then question the firm's ability to pay (credit risk). A good analysis names that sequence instead of assigning the entire case to one silo.

Classification examples

Exam method

Ask what changed first. If a market variable moved, start with market risk. If a party may not perform, start with credit risk. If the problem is selling an asset, think market liquidity; if it is finding cash, think funding liquidity. Then identify concentration, leverage, or operational failures that amplify the primary exposure.

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Interaction and Measurement Discipline

Financial risks frequently compound. A credit downgrade can lower a bond's price, widen its bid-offer spread, trigger collateral calls, and force a sale into an illiquid market. That single scenario contains credit, market, liquidity, and funding effects. Measures must match the exposure: duration and scenario loss help explain rate sensitivity; concentration and expected loss support credit analysis; maturity gaps and liquidation horizons support liquidity analysis. A model output is not the risk itself. Assumptions, data quality, stressed conditions, limits, and exceptions must accompany the number so management can decide whether the exposure is within appetite.