Commodity Derivatives, 2nd Edition

CHAPTER 3Risk Management Principles

3.1 DEFINING RISK

The use of the phrase ‘risk management’ needs to be clarified. For our purposes, risk within a financial context can be broken down into five major subcategories:

• Market risk – the risk that something that is owned or owed will change in value as market prices change.
• Credit risk – the risk that monies owed will never be repaid.
• Business risk – the risk that an entity engages in a business, which they do not fully understand.
• Operational risk – the risk that an entity loses money because of an operational control weakness.
• Legal and documentary risk – the risk that a contract is deemed to be null and void (e.g. ultra vires), or that a loss is incurred because of a contractual commitment.

Although most institutions would be concerned about market and credit risk, in reality most catastrophic losses have probably been caused by a lack of understanding of the business in which the entity has been involved (business risk) or very poor internal controls (operational risk). In some ways there is an irony in that the risks that are most commonly at the root of most institutions' losses cannot be easily hedged. For example, poor internal control issues are usually a result of cultural issues and a lack of discipline. For market risks a host of products exist that allow an institution to protect themselves against an adverse move in prices. Next time there is an announcement of losses incurred by an institution that are initially ...