There are four major types of risk
- Credit Risk – Credit risk arises from defaults, when the counter party to an agreement (individual, company or government) fails to honor a promise to make a payment. Ex – You lend money to someone and there is a probability that you may not get your money back.
- Market Risk – Market risk arises from the possibility of losses resulting from unfavorable market movements (Interest rates, equities etc.). It is the risk of losing money because of the potential loss in the value of an investment. Ex – You bought a 1 year Government bond, there is a risk that if market interest rates rise, value of your bonds will go down.
- Liquidity Risk – Liquidity risk is the possibility of sustaining significant losses due to inability to offload (sell, liquidate) the investment at a fair price. Ex – You are holding the bonds of a company and there is news of huge losses, in such a scenario there will be no buyers to such bonds at that point of time and offloading such a position will result in a significant loss.
- Operational Risk – Risk of direct or indirect losses resulting from inadequate or failed internal processes, people and systems or from external processes. Operating risk includes fraud and the possibility of a mistake being made. Ex – You give loan on property and in one case you make a mistake in verifying the documents of the property. Now borrower doesn’t pays his dues on time and when you try to recover the amount by selling the property, you realize that you can’t sell the property as papers are not in order.