Furthermore interest rate risk may also arise from

Info icon This preview shows pages 6–8. Sign up to view the full content.

View Full Document Right Arrow Icon
Furthermore, interest rate risk may also arise from having completely unhedged positions or having only partially hedged positions due to underlying transactions that did not fully offset (even though they were meant to offset). In the latter case, the loss could be attributed to basis risk , which means that the presumed correlation between the price of a bond and the price of the hedging vehicle used to hedge that bond has changed unfavorably. Equity price risk refers to the volatility of stock prices. It can be broken up into two parts: (1) general market risk , which is the sensitivity of the price of a stock to changes in broad market indices, and (2) specific risk , which is the sensitivity of the price of a stock due to unique factors of the entity (e.g., line of business, strategic weaknesses). For the investor, general market risk cannot be diversified away while specific risk can be diversified away.
Image of page 6

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
©2015 Kaplan, Inc. Page 7 Topic 1 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 1 Foreign exchange risk refers to monetary losses that arise because of unhedged or not fully hedged foreign currency positions. Foreign exchange risk results from imperfect correlations in currency price movements as well as changes in international interest rates. Potential large losses could reduce the extent of an entity’s foreign investment and also put it at a competitive disadvantage compared to its foreign competitors. Commodity price risk refers to the price volatility of commodities (e.g., precious metals, base metals, agricultural products, energy) due to the concentration of specific commodities in the hands of relatively few market participants. The resulting lack of trading liquidity tends to increase the amount of price volatility compared to financial securities. In addition, commodities may face significant price discontinuities (i.e., prices suddenly jump from one level to another). Credit Risk Credit risk refers to a loss suffered by a party whereby the counterparty fails to meet its financial obligations to the party under the contract. Credit risk may also arise if there is an increasing risk of default by the counterparty throughout the duration of the contract. There are four subtypes of credit risk: (1) default risk, (2) bankruptcy risk, (3) downgrade risk, and (4) settlement risk. Default risk refers to the non-payment of interest and/or principal on a loan by the borrower to the lender. The period of default past the due date could be at least 30 or 60 days. Bankruptcy risk involves taking possession of any collateral provided by the defaulting counterparty. The risk is that the liquidation value of the collateral is insufficient to recover the full loss on default. Downgrade risk considers the decreased creditworthiness (based on recent financial performance) of a counterparty to a transaction. A creditor may subsequently charge the downgraded entity a higher lending rate to compensate for the increased risk. For a creditor, downgrade risk may eventually lead to default risk.
Image of page 7
Image of page 8
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern