Types of Risks — CFA Level I (Risk Management)

"Risk is the price you pay for being in the game — and knowing which risk you’re paying for means you stop getting fleeced."

---

Opening: Why this matters (and why you should care)

You already understand how financial markets work, from trading floors to sovereign bond auctions — and you've seen what happens when things go sideways (hello, Financial Crisis Analysis). Now we zoom in: what can go wrong for a portfolio, a bank, or a whole economy? Types of risks are the taxonomy that lets us name the monsters so we can fight them (or at least avoid tripping over them).

This isn’t just theory. After studying Emerging Markets and the Impact of Economic Policy on Markets, you've seen how policy shocks, liquidity dry-ups, and sovereign defaults aren't abstract headlines — they're real risk categories that affect returns, pricing, and valuation.

---

The Big Picture: Two meta-categories

• Systematic (market) risk — affects many assets at once; cannot be diversified away. Example: global recession, interest-rate shock.
• Unsystematic (idiosyncratic) risk — specific to a company or issuer; can be reduced through diversification. Example: CEO scandal, factory fire.

Ask yourself: is this risk something that macro policy, markets, or the entire sector will move with — or is it just one firm’s tragic sitcom episode?

---

Main types of risks (with tasty examples and how you handle them)

1) Market risk (a.k.a. systematic risk)

• Interest rate risk — bond values move when yields move. Duration tells you sensitivity. Example: Central bank hikes — bond portfolio loses value.
• Equity price risk — stock prices fall with economic contractions or sentiment shocks. Measured by beta.
• Currency (FX) risk — exchange-rate moves affect foreign earnings. Emerging market currencies often add spicy volatility.
• Commodity price risk — oil, metals, agricultural goods — crucial for commodity producers/consumers.

How to manage: hedging (forwards, futures, options), asset allocation, duration matching, beta targeting.

---

2) Credit risk

• Default risk — borrower fails to pay. Measured by probability of default (PD), exposure at default (EAD), and loss given default (LGD).
• Credit spread risk — spreads widen in stress (remember Financial Crisis Analysis — spreads blew out).
• Sovereign risk — government default or restructuring; higher in some emerging markets.

How to manage: credit analysis, diversification across issuers, credit derivatives (CDS), covenants, limits on exposure.

---

3) Liquidity risk

• Market liquidity risk — you can’t sell an asset without big price concessions. Think thin emerging market bonds during a sell-off.
• Funding liquidity risk — you can’t raise cash to meet obligations (margin calls, deposit outflows).

Real-world flashback: 2008 — assets were fine-ish on paper but nobody would buy them. Funding dried up. Lesson: liquidity is the silent killer.

Manage with: liquidity buffers, stress tests, contingent funding plans, market-making commitments.

---

4) Operational risk

• Failures in systems, people, processes. Includes fraud, cyberattacks, failed controls.
• Example: a trading desk accidentally submits a massive order that crashes a stock.

Manage with: strong controls, audits, redundancy, insurance, incident response plans.

---

5) Legal & regulatory risk

• Changes in laws, fines, contract enforceability. Policy shifts (we covered Impact of Economic Policy on Markets) can create regulatory risk overnight.

Manage with: compliance programs, legal review, scenario planning.

---

6) Model risk

• Your valuation or risk model is wrong or misused. “The model said it was safe” — the most famous liar.

Manage with: model validation, conservative assumptions, backtesting, multiple models.

---

7) Event (tail) risk

• Rare but catastrophic: geopolitical events, pandemics, corporate collapses.
• Black swans love exploiting tiny weak links.

Manage by: stress testing, tail-hedging, insurance, strategic allocation to uncorrelated assets.

---

8) Reputational & strategic risk

• Damage to brand or business model shifts (e.g., disruptive technology). Hard to quantify, easier to ruin a firm.

Manage with: governance, communication, strategic flexibility.

---

Quick comparison table

Risk Type	Measurable?	Hedgable?	Typical Tools
Market risk	High (VaR, beta)	Yes (derivatives)	Futures, options, duration
Credit risk	Medium (PD, LGD)	Partly (CDS)	Credit analysis, CDS, covenants
Liquidity risk	Low–Medium	Hard	Liquidity buffers, contingent funding
Operational risk	Low	No (prevent only)	Controls, insurance
Model risk	Low	No	Validation, backtesting

---

Two tiny formulas (for the lovers of math)

Portfolio variance (simplified for two assets):

Var_p = w1^2 * Var1 + w2^2 * Var2 + 2*w1*w2*Cov(1,2)

VaR (conceptual pseudocode):

Sort historical P&L outcomes; VaR at 95% = loss at 5th percentile

These show: correlations matter (diversification helps but isn’t magic), and VaR is a history-based snapshot — not a prophecy.

---

Questions to keep you sharp

• Is the loss you're worried about a market-wide shock or a single-issuer problem?
• Can you measure it reliably, or is it mostly judgment and scenario analysis?
• If policy changes, which risk buckets flip from manageable to dangerous? (Hint: sovereign and regulatory risks.)

---

Closing: Key takeaways and next moves

• Name the risk: labeling lets you pick the right toolkit. Systematic = hedges and macro strategies. Idiosyncratic = diversification and credit due diligence.
• Measure but stress-test: metrics (VaR, PD, duration) are necessary but not sufficient; stress tests and scenario analysis catch the weird stuff.
• Liquidity and funding are existential: an asset can be solvent but illiquid — and that’s a problem.
• Operational, model, reputational risks are silent killers: they don’t show up in neat spreadsheets until they explode.

Next steps: Revisit Financial Crisis Analysis to see these risks interacting in the wild, and re-read Impact of Economic Policy on Markets to link policy moves to changes in market, credit, and sovereign risks.

Final mic drop: risk isn’t a single beast — it’s an ecosystem. Learn the taxonomy, keep your tools sharp, and always assume something unexpected is planning a surprise party.

---