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Financial Terms related to Risk

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RISK
Affiliate risk

• If the parent company of a one-bank holding company (OBHC) or one of the


affiliate banks of multi-bank holding company (MBHC) fail, there is a risk that
Federal Reserve or other private claim holders will sue the non-failing bank to
recover their losses. Hence, failure of an affiliate presents contingent off-balance
sheet risk.

Bankruptcy risk

• The risk that a firm will be unable to meet its debt obligations. Also referred to as
default or insolvency risk.

Basis risk

• Is the risk in the basis time series. This can be influenced by many variables
although the total impact is less than the exposure for a naked position. When a
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hedge is placed, price risk is transformed into basis risk. Basis risk is substantially
less than price or inventory risk in terms of dollars.

• The uncertainty about the basis at the time a hedge may be lifted. Hedging
substitutes basis risk for price risk.

Business and industry risk

• Uncertainty of an investment's return due to a fall-off in business that is firm-related


or industry-wide.

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Business risk

• The risk to the firm of being unable to cover operating costs.

• The risk that the cash flow of an issuer will be impaired because of adverse
economic conditions, making it difficult for the issuer to meet its operating expenses.

Call risk

• The combination of cash flow uncertainty and reinvestment risk introduced by a call
provision.

Commercial risk

• The risk that a foreign debtor will be unable to pay its debts because of business
events, such as bankruptcy.

Company specific risk

• Related: Unsystematic risk

Completion risk

• The risk that a project will not be brought into operation successfully.

Counterparty risk

• The risk that the other party to an agreement will default. In an options contract, the
risk to the option buyer that the option writer will not buy or sell the underlying as
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agreed.

Country economic risk

• Developments in a national economy that can affect the outcome of an


international financial transaction.

Country financial risk

• The ability of the national economy to generate enough foreign exchange to meet
payments of interest and principal on its foreign debt.

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Country risk

• General level of political and economic uncertainty in a country affecting the value
of loans or investments in that country.

• See sovereign risk.

Country risk analysis models

• Country Risk Analysis Models incorporate variables such as Debt Service ratio,
Import Ratio, Variance of Export Revenue. Domestic Money Supply Growth Rate
and others to predict the probability of debt rescheduling problems.

Credit risk

• The risk that an issuer of debt securities or a borrower may default on his
obligations or that the payment may not be made on a negotiable instrument.
Related: Default risk

• Is the risk related to counterparty failure. It is a key concern for Over-the-Counter


transactions. This compares to listed trades passing through a clearinghouse.

• Credit risk refers to the possibility that borrowers sometimes default on their
promises.
The risk that an issuer of debt securities or a borrower may default on his
obligations, or that payment may not be made on sale of a negotiable instrument.
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(See overnight delivery risk.)

Cross border risk

• Refers to the volatility of returns on international investments caused by events


associated with a particular country as opposed to events associated solely with a
particular economic or financial agent.

Currency risk

• Related: Exchange rate risk

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Currency risk sharing

• An agreement by the parties to a transaction to share the currency risk associated


with the transaction. The arrangement involves a customized hedge contract
embedded in the underlying transaction.

Default risk

• The risk that a company will be unable to pay the contractual interest or Principal
on its debt obligations.

• Also referred to as credit risk (as gauged by commercial rating companies), the risk
that an issuer of a bond may be unable to make timely principal and interest
payments.

• see Credit Risk

Diversifiable risk

• Related: unsystematic risk.

• The portion of an asset's risk that is attributable to firm-specific, random causes;


can be eliminated through diversification.

Economic risk

• In project financing, the risk that the project's output will not be salable at a price
that will cover the project's operating and maintenance costs and its debt service
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requirements.

Equilibrium market price of risk

• The slope of the capital market line (CML). Since the CML represents the return
offered to compensate for a perceived level of risk, each point on the line is a
balanced market condition, or equilibrium. The slope of the line determines the
additional return needed to compensate for a unit change in risk.

Event risk

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• The risk that the ability of an issuer to make interest and principal payments will
change because of rare, discontinuous, and very large, unanticipated changes in the
market environment such as (1) a natural or industrial accident or some regulatory
change or (2) a takeover or corporate restructuring.

• The risk that a corporate bond will be downgraded, perhaps severely, due to some
unpredictable outside event, principally a leveraged buy-out.

Exchange rate risk

• Also called currency risk, the risk of an investment's value changing because of
currency exchange rates.

• a) The danger that an unexpected change in the exchange rate between the dollar
and the currency in which a project's cash flows are denominated can reduce the
market value of that project's cash flow; b) The risk caused by varying exchange
rates between two currencies.

Exchange rate risk capital budgeting

• Danger that an unexpected change in the exchange rate between the dollar and
the currency in which the project's cash flows are denominated can reduce the
market value of that project's cash flow.

Exchange risk
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• The variability of a firm's value that results from unexpected exchange rate
changes or the extent to which the present value of a firm is expected to change as
a result of a given currency's appreciation or depreciation.

Fallout risk

• A type of mortgage pipeline risk that is generally created when the terms of the
loan to be originated are set at the same time as the sale terms are set. The risk is
that either of the two parties, borrower or investor, fails to close and the loan falls out
of the pipeline.

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Financial risk

• The risk that the cash flow of an issuer will not be adequate to meet its financial
obligations. Also referred to as the additional risk that a firm's stockholder bears
when the firm utilizes debt and equity.

• The risk to the firm of being unable to cover required financial obligations (interest,
lease payments, preferred share dividends).

Firm specific risk

• See: diversifiable risk or unsystematic risk.

Flat price risk

• Taking a position either long or short that does not involve spreading.

Force majeure risk

• The risk that there will be an interruption of operations for a prolonged period after
a project finance project has been completed due to fire, flood, storm, or some other
factor beyond the control of the project's sponsors.

Forecasting risk

• The possibility that the estimated cash flows are wrong (either too high or too low)
and, as a result, a wrong decision made.
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Foreign exchange fx risk

• The risk that a long or short position in a foreign currency might, due to an adverse
movement in the relevant exchange rate, have to be closed out at a loss. The long
or short position may arise out of a financial or commercial transaction.

Foreign exchange risk

• This refers to the possibility of losing money due to changes in exchange rates. Net
Foreign Exchange Exposure will create a FX risk even if the bank is perfectly
hedged with respect to duration, credit risk, etc.

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• The risk that a long or short position in a foreign currency might have to be closed
out at a loss due to an adverse movement in the currency rates.

Funding risk

• Related: interest rate risk

Geographic risk

• Risk that arises when an issuer has policies concentrated within certain geographic
areas, such as the risk of damage from a hurricane or an earthquake.

Herstatt risk

• The risk of loss in foreign exchange trading that one party will deliver foreign
exchange but the counterparty financial institution will fail to deliver its end of the
contract. It is also referred to as settlement risk.

Idiosyncratic risk

• Unsystematic risk or risk that is uncorrelated to the overall market risk. In other
words, the risk that is firm specific and can be diversified through holding a portfolio
of stocks.

Inflation risk

• Uncertainty about the future real (after-inflation) value of your investment.


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• Also called purchasing-power risk, the risk that changes in the real return the
investor will realize after adjusting for inflation will be negative.

Insolvency risk

• The risk that a firm will be unable to satisfy its debts. Also known as bankruptcy
risk.

Interest rate risk

• The chance that interest rates will change and thereby change the required return

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and bond value. Rising rates, which result in decreasing bond values, are of greatest
concern.

• The risk that a security's value changes due to a change in interest rates. For
example, a bond's price drops as interest rates rise. For a depository institution, also
called funding risk, the risk that spread income will suffer because of a change in
interest rates.

• The risk of changes in value due to changes in interest rate is called interest rate
risk. Long lived assets lose more of their value when interest rates rise than short
lived assets. If a bank has more long-lived assets than liabilities, then the bank
worries about interest rate increases.

• Is the risk associated with changes in general interest rate levels or yield curves.
This compares to Prepayment Risk.

Interest rate risk management

• If a bank expects a rise in interest rates, it increases the maturity of its liabilities
and decreases the maturity of its assets. If a bank expects the interest rates to
remain the same or decline, it holds more long term assets than liabilities.

Liquidity risk

• In banking, risk that monies needed to fund assets may not be available in
sufficient quantities at some future date. Implies an imbalance in committed
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maturities of assets and liabilities.

• The risk that arises from the difficulty of selling an asset. It can be thought of as the
difference between the true value of the asset and the likely price, less commissions.

Macro political risk

• The subjection of all foreign firms to political risk (takeover) by a host country
because of political change, revolution, or the adoption of new policies.

Market price of risk

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• A measure of the extra return, or risk premium, that investors demand to bear risk.
The reward-to-risk ratio of the market portfolio.

Market risk

• Market risk is the risk that investments will change in value based on changes in
general market prices.

• Risk that cannot be diversified away. Related: systematic risk

• The potential for an investor to experience losses owing to day-to-day fluctuations


in the prices at which securities can be bought or sold. The Market Risk expresses
the volatility of a stock price relative to the overall market as indicated by beta.

Market risk return function

• A graph of the discount rates associated with each level of project risk.

Micro political risk

• The subjection of an individual firm, a specific industry, or companies from a


particular foreign country to political risk (takeover) by the host country.

Mortality risk

• The probability that the bond will default.

Mortgage pipeline risk


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• The risk associated with taking applications from prospective mortgage borrowers
who may opt to decline to accept a quoted mortgage rate within a certain grace
period.

Nondiversifiable risk

• Risk that cannot be eliminated by diversification.

• The relevant portion of an asset's risk attributable to market factors that affect all
firms and cannot be eliminated through diversification.

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Nonsystematic risk

• Non market or firm-specific risk factors that can be eliminated by diversification.


Also called unique risk or diversifiable risk. Systematic risk refers to risk factors
common to the entire economy.

Operating risk

• The inherent or fundamental risk of a firm, without regard to financial risk. The risk
that is created by operating leverage. Also called business risk.

Operational risk

• A technology-operational risk occurs when investments in new technology do not


produce the estimated cost savings.

Overnight delivery risk

• A risk brought about because differences in time zones between settlement centers
require that payment or delivery on one side of a transaction be made without
knowing until the next day whether the funds have been received in an account on
the other side. Particularly apparent where delivery takes place in Europe for
payment in dollars in New York.

• A risk brought about because differences in time zones between settlement centers
require that payment or delivery on one side of a transaction be made without
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knowing until the next day whether funds have been received in account on the
other side. Particularly apparent where delivery takes place in Europe for payment in
dollars in New York.

Pin risk

• Is the uncertainty that an option position may be exercised into the underlying
instrument. It is risky because it often refers to markets flirting with the prevailing at-
the-money level. At such times, the gamma on a position is very erratic and difficult
to hedge. Also, there are doubts about the exercise or assignment process. A trader

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can experience significant changes in net positions due to option exercises.

Political risk

• Possibility of the expropriation of assets, changes in tax policy, restrictions on the


exchange of foreign currency, or other changes in the business climate of a country.

• Risk that arises from the possibility that a host government might take actions that
are harmful to foreign investors or that political turmoil in a country might endanger
investments made in that country by foreign nationals. The potential discontinuity or
seizure of an MNC's operations in a host country due to the host's implementation of
specific rules and regulations (such as nationalization, expropriation, or
confiscation).

Prepayment risk

• The existence of prepayment options makes the cashflow of a pool of mortgages


uncertain. This uncertainty creates prepayment risk.

• Is the potential loss related to an early retirement of debt. The risk tends to be more
common in declining interest rate environments.

Price risk

• The risk that the value of a security (or a portfolio) will decline in the future. Or, a
type of mortgage-pipeline risk created in the production segment when loan terms
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are set for the borrower in advance of terms being set for secondary market sale. If
the general level of rates rises during the production cycle, the lender may have to
sell his originated loans at a discount.

• The risk that a debt security's price may change due to a rise or fall in the going
level of interest rates.

Product risk

• A type of mortgage-pipeline risk that occurs when a lender has an unusual loan in
production or inventory but does not have a sale commitment at a prearranged price.

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Purchasing power risk

• Related: inflation risk

Rate risk

• In banking, the risk that profits may decline or losses occur because a rise in
interest rates forces up the cost of funding fixed-rate loans or other fixed-rate assets.
See interest rate risk.

• In banking, the risk that profits may decline or losses occur because a rise in
interest rates forces up the cost of funding fixed-rate loans or other fixed-rate assets.

Regulatory pricing risk

• Risk that arises when regulators restrict the premium rates that insurance
companies can charge.

Reinvestment risk

• Is the situation whereby prepaid principal amounts will be reinvested in lower


yielding securities.

• The risk that proceeds received in the future will have to be reinvested at a lower
potential interest rate.

Residual risk
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• Related: unsystematic risk

Reverse price risk

• A type of mortgage-pipeline risk that occurs when a lender commits to sell loans to
an investor at rates prevailing at application but sets the note rates when the
borrowers close. The lender is thus exposed to the risk of falling rates.

Risk

• The chance of financial loss, or more formally, the variability of returns associated

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with a given asset. The chance that actual outcomes may differ from those
expected.

• The possibility that an investment will lose or not gain value; also refers to a peril
covered by an insurance contract.

• Degree of uncertainty of return on an asset.

• Possibility that an investment's actual return will be different than expected;


includes the possibility of losing some or all of the original investment. Measured by
variability of historical returns, or dispersion of historical returns around their average
return.

• Is the variability inherent in investment, speculative or trading activities. The greater


the variability, the higher the risk. Risk can be attributed to many factors. As such,
the specification of a risk can described with the use of an associated qualifying
term. These terms include but are not limited to credit, counterparty, liquidity,
market, fraud, currency, roll, agency, coupon, event, corporate and country.

• Typically defined as the standard deviation of the return on total investment.


Degree of uncertainty of return on an asset.

Risk adjusted discount rate

• Abbreviated RADR. The rate of return that must be earned on a given project to
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compensate for the risk of the project.

Risk adjusted profitability

• A probability used to determine a sure expected value (sometimes called a


certainty equivalent) that would be equivalent to the actual risky expected value.

Risk adjusted return

• Return earned on an asset normalized for the amount of risk associated with that
asset.

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Risk arbitrage

• Is a form of trading whereby the risk arbitrageur attempts to profit from issues
involved in merger/acquisitions. The underlying rationale is that the current price
after the announcement is still below the bid price. Also, the company may find itself
subject to other bids for its stock in excess of the initial announced bid. These price
differentials are the arbitrage part. The risk is that other bids do not materialize or the
initial announcement fails due to other considerations.

• Speculation on perceived mispriced securities, usually in connection with merger


and acquisition deals. Mike Donatelli, John Demasi, Frank Cohane, and Scott Lewis
are all hardcore arbs. They had a huge BT/MCI position in the summer of 1997, and
came out smelling like roses.

Risk arrays

• Refer to how a specific derivative instrument will change in value, from the present
to a specific point in time for a given set of market conditions. For SPAN® purposes,
this time period is typically one day. Here, risk array values are calculated basis a
single long position. Note that SPAN® views LONG as the purchase of a call or a
put and not as market direction strategy. This contrasts to LONG usually referring to
the side of the market and not the ownership of an instrument.

Risk averse
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• The attitude toward risk in which a higher return would be required by the investor
for an investment that offers greater risk.

• A risk-averse investor is one who, when faced with two investments with the same
expected return but two different risks, prefers the one with the lower risk.

Risk capital budgeting

• The chance that the inputs into the analysis of an investment project will prove to
be wrong.

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Risk classes

• Groups of projects that have approximately the same amount of risk.

Risk controlled arbitrage

• A self-funding, self-hedged series of transactions that generally utilize mortgage


securities as the primary assets.

Risk free asset

• An asset whose future return is known today with certainty.

Risk free rate

• The rate of return that one would earn on a virtually riskless investment such as a
Government of Canada Treasury Bill.

• The rate of return that one would earn on a virtually riskless investment such as a
three-month Government of Canada Treasury bill. Such an investment offers little or
no risk of default and very low interest rate (price) risk because of its short term to
maturity.

• The rate earned on a riskless asset.

Risk indexes

• Categories of risk used to calculate fundamental beta, including (1) market


variability, (2) earnings variability, (3) low valuation, (4) immaturity and smallness, (5)
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growth orientation, and (6) financial risk.

Risk indifferent

• The attitude toward risk in which no change in return would be required for an
increase in risk.

Risk lover

• A person willing to accept lower expected returns on prospects with higher


amounts of risk.

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Risk management

• Is the practice of adjusting exposures for the firm's positions or portfolios. It tries to
stabilize variability of returns while trimming large -dominant -net exposures as well.
It can also be used to secure more favorable financing for inventories or pricing of
securities or commodities. See the following features for more information:
Illustrative RAMS® Graphics and Tables. How Far with VAR (Value at Risk). More
about Risk Management. Risk Management and Analysis Software. RAMS®
Executive Summary. Risk Management Tutor 101.

• The process of identifying and evaluating risks and selecting and managing
techniques to adapt to risk exposures.

Risk management document

• Is a formal listing of trading and hedging processes, procedures and other activities
related to position taking. See Powers and Authorities for a illustrative example of
the scope of this important document.

Risk neutral

• Insensitive to risk.

Risk of technical insolvency

• The probability that a firm will be unable to pay its bills as they come due.
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Risk premium

• The amount by which the required discount rate for a project exceeds the risk-free
rate; or, the additional coupon interest investors will demand based on the risk of the
issuer and of the debt issue itself.

• Risk Premium is the explicit amount added to the base rate to cover default and
other risks. Hence, a loan might be quoted as 6-month LIBOR plus 150 basis points,
which means that the interest due will start out at the current LIBOR plus 150bp.
Each basis point is one-one hundredth of a percent. After 6 months, the interest rate

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will be revised to the LIBOR in effect at that time plus 150bp.

• The reward for holding the risky market portfolio rather than the risk-free asset. The
spread between Treasury and non-Treasury bonds of comparable maturity.

Risk premium approach

• The most common approach for tactical asset allocation to determine the relative
valuation of asset classes based on expected returns.

Risk prone

• Willing to pay money to transfer risk from others.

Risk return tradeoff

• The expectation that for accepting greater risk, investors must be compensated
with greater returns.

Risk reversal

• In option trading, buy a put and sell a call.

Risk seeking

• The attitude toward risk in which a decreased return would be accepted for an
increase in risk.

Risk transformation
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• Is the result of an effective hedge. Here, price, interest, or currency level risk is
transformed into the more manageable and less volatile, basis risk. This volatility is
measured in terms of comparative dollar value swings.

Risk types

• Include the following:

 agency

 bankruptcy

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 basis

 capital restrictions

 commodity

 compliance

 concentration

 conversion

 convexity

 corporate

 counterparty

 country

 coupon

 credit

 credit rating

 currency

 default

 dilution
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 disaster

 duration

 environmental

 event

 exercise

 force majeure

 funding

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 hazards

 legal

 liquidity

 market

 nonsystematic • obsolescence • operational • option

 pin

 political

 prepayment

 price level

 reinvestment

 residual

 roll

 rule change

 software, modelling, and financial assumptions


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 spread

 systematic

 technological

 time value decay -theta

 timing

 volatility

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 weather

 yield curve: shape, shift, tilt and twist.

The above risk terms relate to the capital and commodity markets. Other
risk terms relate to the insurance industry.

Risk/return trade off

• The balance an investor must decide on between the desire for low
risk and high returns; low levels of uncertainty (low risk) are associated
with low potential returns, and high levels of uncertainty (high risk) are
associated with high potential returns.

Riskless arbitrage

• The simultaneous purchase and sale of the same asset to yield a


profit.

Riskless or risk free asset

• An asset whose future return is known today with certainty. The risk
free asset is commonly defined as short-term obligations of the U.S.
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government.

Riskless rate

• The rate earned on a riskless asset.

• The rate earned on a riskless investment, typically the rate earned on


the 90-day U.S. Treasury Bill.

Risky asset

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• An asset whose future return is uncertain.

Settlement risk

• Banks and other financial intermediaries send most of their wholesale


payments either through Fedwire or Clearing House InterBank Payment
System (CHIPS). All claims sent on CHIPS clear at the end of the day. If
a bank were to fail during the day, or send funds it does not yet have,
this can create a chain of settlement problems for other banks who rely
on these incoming funds.

Shortfall risk

• The risk of falling short of any investment target.

Sovereign risk

• The special risks, if any, that attach to a security (or deposit or loan)
because the borrower's country of residence differs from that of the
investor's. Also referred to as country risk.

• Sovereign Risk refers to the fact that a foreign government can default
on its promises. Moreover, a foreign government can prohibit or restrict
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all domestic corporations and agencies from re-paying their foreign


currency denominated interest and principle payment.

• The risk that a central bank will impose foreign exchange regulations
that will reduce or negate the value of FX contracts. Also refers to the
risk of government default on a loan made to it or guaranteed by it.

Specific risk

• See: unique risk.

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Systematic risk

• Also called undiversifiable risk or market risk, the minimum level of risk
that can be obtained for a portfolio by means of diversification across a
large number of randomly chosen assets. Related: unsystematic risk.

Systematic risk principle

• Only the systematic portion of risk matters in large, well-diversified


portfolios. The, expected returns must be related only to systematic
risks.

Theta risk

• Refers to the time value exposure for an option. Academic literature


tends to view it on an instantaneous basis whereas practioners tend to
view it on a daily basis. For the later it can calculate the time value
difference between 6.7.00 and 6.8.00 all other things being held
constant. Then the amounts would be expressed in dollars or other
designated currency.
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Total risk

• The combination of a security's nondiversifiable and diversifiable risk.

Undiversifiable risk

• Related: Systematic risk

Unique risk

• Also called unsystematic risk or idiosyncratic risk. Specific company

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risk that can be eliminated through diversification. See: diversifiable risk
and unsystematic risk.

Unsystematic risk

• Also called the diversifiable risk or residual risk. The risk that is unique
to a company such as a strike, the outcome of unfavorable litigation, or a
natural catastrophe that can be eliminated through diversification.
Related: Systematic risk

Value at risk

• Is the methodology which measures the sensitivity of a portfolio or


firm's position with parametric statistical techniques. It uses historical
information to estimate the impact of various standard deviation events
upon the value of the holdings and the associated impact on earnings.

Value at risk model

• Abbreviated VAR. Procedure for estimating the probability of portfolio


losses exceeding some specified proportion based on a statistical
analysis of historical market price trends, correlations, and volatilities.
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Vega risk

• Refers to the monetary exposure for a change in volatility for an option.


It might refer to a change from 6 to 7 or 6 to 5 percent depending on
whether a party is short or long the option. Some participants breakdown
the vega risks into finer gradients or decimals.

Volatility risk

• The risk in the value of options portfolios due to the unpredictable

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changes in the volatility of the underlying asset.