Credit risk

The possibility that a bond issuer will default, by failing to repay principal and interest in
a timely manner. Bonds issued by the federal government, for the most part, are immune
from default (if the government needs money It can just print more). Bonds issued by
corporations are more likely to be defaulted on, since companies often go bankrupt.
Municipalities occasionally default as well, although it is much less common also called
default risk.

SOURCES

Interest rate risk

Sovereign risk
Sovereign risk is the risk of a government becoming unwilling or unable to meet its loan
obligations, or reneging on loans it guarantees. The existence of sovereign risk means
that creditors should take a two-stage decision process when deciding to lend to a firm
based in a foreign country. Firstly one should consider the sovereign risk quality of the
country and then consider the firm's credit quality.
Counterparty risk
Counterparty risk, otherwise known as default risk, is the risk that an organization does
not pay out on a bond, credit derivative, credit insurance contract, or other trade or
transaction when it is supposed to. Even organizations who think that they have hedged
their bets by buying credit insurance of some sort still face the risk that the insurer will be
unable to pay, either due to temporary liquidity issues or longer term systemic issues.
MITIGATING CREDIT RISK
Enders mitigates credit risk using several methods:
1. Risk-based pricing: Lenders generally charge a higher interest rate to borrowers
who are more likely to default, a practice called risk-based pricing. A lender
considers factors relating to the loan such as loan purpose, credit rating, and loan-
to-value ratio and estimates the effect on yield (credit spread).
2. Covenants: Lenders may write stipulations on the borrower, called covenants,
into loan agreements:
• Periodically report its financial condition
• Refrain from paying dividends, repurchasing shares, borrowing further, or other
specific, voluntary actions that negatively affect the company's financial position
• Repay the loan in full, at the lender's request, in certain events such as changes in
the borrower's debt-to-equity ratio or interest coverage ratio
1. Credit insurance and credit derivatives: Lenders and bond holders
may hedge their credit risk by purchasing credit insurance or credit
derivatives. These contracts transfer the risk from the lender to the seller
(insurer) in exchange for payment. The most common credit derivative is
the credit default swap.
2. Tightening: Lenders can reduce credit risk by reducing the amount of
credit extended, either in total or to certain borrowers. For example,
a distributor selling its products to a troubled retailer may attempt to lessen
credit risk by reducing payment terms from net 30 to net 15.
3. Diversification: Lenders to a small number of borrowers (or kinds of
borrower) face a high degree of unsystematic credit risk, called
concentration risk. Lenders reduce this risk by diversifying the borrower
pool.
4. Deposit insurance: Many governments establish deposit insurance to
guarantee bank deposits of insolvent banks. Such protection discourages
consumers from withdrawing money when a bank is becoming insolvent,
to avoid a bank run, and encourages consumers to holding their savings in
the banking system instead of in cash.
COMMODITY RISK
Commodity risk refers to the uncertainties of future market values and of the size of the
future income, caused by the fluctuation in the prices of commodities.[These
commodities may be grains, metals, gas, electricity etc. A commodity enterprise needs to
deal with the following kinds of risks:

• Price risk (Risk arising out of adverse movements in the world prices, exchange
rates, basis between local and world prices). Commodity price risk occurs when
there is potential for changes in the price of a commodity that must be purchased
or sold. Commodity exposure can also arise from non-commodity business if
inputs or products and services have a commodity component. Commodity price
risk affects consumers and end-users such as manufacturers, governments,
processors, and wholesalers. If commodity prices rise, the cost of commodity
purchases increases, reducing profit from transactions.
• Quantity risk: Organizations have exposure to quantity risk through the demand
for commodity assets. Although quantity is closely tied to price, quantity risk
remains a risk with commodities since supply and demand are critical with
physical commodities. For example, if a farmer expects demand for product to be
high and plans the season accordingly, there is a risk that the quantity the market
demands will be less than has been produced. Demand may be less for a number
of reasons, all of which are out of the control of the farmer. If so, the farmer may
suffer a loss by being unable to sell the entire product, even if prices do not
change dramatically. This might be managed using a fixed price contract covering
a minimum quantity of commodity as a hedge.

SOURCES

1. Market risk This involves the risk in commodities that stems from fluctuations
in world commodity prices, exchange rates, and the basis between local and world
prices. This fluctuation stems from supply and demand of the commodities and
provides the relationship to the other risk elements below.
 2. Operational risk. Organizations face a range of operational risks that stem from
commodity risk management. Supply risk (also known as quantity risk) is an
operational commodity risk that centers on supply availability. It is the risk in an
organization’s ability to deliver goods/services to their customers based on the
organization’s ability to acquire the commodities they need, when they need it
and in the right quantity and quality.
3. Counterparty/credit risk. This element of commodity risk focuses on
maintaining viable business relationships and transactions. Counterparty risk (e.g.,
default risk) is the risk an organization faces when another party does not provide
payment on a credit derivative, credit default swap, credit insurance contract, or
other trade/transaction that it is obligated to pay on.
4. Regulatory risk. Organizations face a range of legal and compliance risks within
commodity risk management. Compliance oversight is required to manage
training, policy-making, and monitoring of commodity sales, marketing, and
business operation/transaction activities. This frequently requires understanding
and adherence to a complex array of international regulations governing
commodities which often focus on: monitoring and documenting trade flows,
order routing/execution, and trade reporting functions for compliance as well as
irregularities; maintaining the commodities compliance policies and procedures
and appropriate training; and documenting, categorizing, and tracking of error
trades and error trading policies.

Commodity Risk Management

Organizations looking to manage commodity risk start with defining their commodity
risk management as part of their enterprise risk management. Today, organizations
manage commodity risk in different systems that are not integrated. Under this scenario,
organizations will struggle to get a full picture of the risk it faces. An isolated view does
not allow an organization to look at the entire exposure in a consolidated manner.
Core to commodity risk management architecture is the ability to provide multi-
commodity risk management that allows an organization to manage across its commodity
risk areas. Organization benefits from a common platform for commodity risk
management as it provides the ability to monitor risk across commodities, provide
integration and visibility, and as a result produce greater transparency into intricate risk
relationships.
Elements of commodity risk management include:

• Counterparty risk management. The organization needs complete visibility to

manage and monitor counter party risk. This includes functionality that allows the
organization to manage business relationships through a complete understanding
of collateral and credit risks to that relationship.
• Operational risk management. Organizations require the ability to track
movement of commodities and to track transactions across supply chains. This
includes fully integrated views into supply chain tracking so the organization can
identify where inventory is and where it is moving.
• Price risk management. To facilitate compliance with trading and credit limits
the organization needs an integrated platform architecture which manages and
monitors price risk and ties it to key-performance and risk indicators.
• Compliance management. The architecture should allow the organization to
demonstrate and validate compliance to different standards, and other hedge
accounting and compliance regulations. The ability to validate compliance is
necessary because the organization may consider something as a hedge but it not
be valid to be accounted for as a hedge. Strong compliance management
capabilities should allow the organizations to control swings in P&L, which is
critical for public companies.
• Risk intelligence. Organizations require the ability to track internal as well as
external commodity risk data to monitor exposure, predict losses, and manage to
commodity risk metrics of key-performance and key-risk indicators.
• Process management. The architecture is to support business process
management through streamlining the management of the commodity risk
processes. This includes integrating alerting and workflow capabilities into the
architecture.