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Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default.[1][2] Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.[3][4]

A science has evolved around managing market and financial risk under the general title of modern portfolio theory initiated by Dr. Harry Markowitz in 1952 with his article, "Portfolio Selection".[5] In modern portfolio theory, the variance (or standard deviation) of a portfolio is used as the definition of risk.

Financial risk, market

Non-financial risks summarize all other possible risks

DiversificationFinancial risk, market risk, and even inflation risk can at least partially be moderated by forms of diversification.

The returns from different assets are highly unlikely to be perfectly correlated and the correlation may sometimes be negative. For instance, an increase in the price of oil will often favour a company that produces it,[15] but negatively impact the business of a firm such an airline whose variable costs are heavily based upon fuel.[16] However, share prices are driven by many factors, such as the general health of the economy which will increase the correlation and reduce the benefit of diversification. If one constructs a portfolio by including a wide variety of equi

The returns from different assets are highly unlikely to be perfectly correlated and the correlation may sometimes be negative. For instance, an increase in the price of oil will often favour a company that produces it,[15] but negatively impact the business of a firm such an airline whose variable costs are heavily based upon fuel.[16] However, share prices are driven by many factors, such as the general health of the economy which will increase the correlation and reduce the benefit of diversification. If one constructs a portfolio by including a wide variety of equities, it will tend to exhibit the same risk and return characteristics as the market as a whole, which many investors see as an attractive prospect, so that index funds have been developed that invest in equities in proportion to the weighting they have in some well-known index such as the FTSE.

However, history shows that even over substantial periods of time there is a wide range of returns that an index fund may experience; so an index fund by itself is not "fully diversified". Greater diversification can be obtained by diversifying across asset classes; for instance a portfolio of many bonds and many equities can be constructed in order to further narrow the dispersion of possible portfolio outcomes.

A key issue in diversification is the correlation between assets, the benefits increasing with lower correlation. However this is not an observable quantity, since the future return on any asset can never be known with complete certainty. This was a serious issue in the late-2000s recession when assets that had previously had small or even negative correlations[citation needed] suddenly starting moving in the same direction causing severe financial stress to market participants who had believed that their diversification would protect them against any plausible market conditions, including funds that had been explicitly set up to avoid being affected in this way.[17]

Diversification has costs. Correlations must be identified and understood, and since they are not constant it may be necessary to rebalance the portfolio which incurs transaction costs due to buying and selling assets. There is also the risk that as an investor or fund manager diversifies, their ability to monitor and understand the assets may decline leading to the possibility of losses due to poor decisions or unforeseen correlations.

Hedging is a method for reducing risk where a combination of assets are selected to offset the movements of each other. For instance, when investing in a stock it is possible to buy an option to sell that stock at a defined price at some point in the future. The combined portfolio of stock and option is now much less likely to move below a given value. As in diversification there is a cost, this time in buying the option for which there is a premium. Derivatives are used extensively to mitigate many types of risk.[18]

According to the article from Investopedia, a hedge is an investment designed to reduce the risk of adverse price movements in an asset. Typically, a hedge consists of taking a counter-position in a related financial instrument, such as a futures contract.[19]

The Forward Contract The forward

According to the article from Investopedia, a hedge is an investment designed to reduce the risk of adverse price movements in an asset. Typically, a hedge consists of taking a counter-position in a related financial instrument, such as a futures contract.[19]

The Forward Contract The forward contract is a non-standard contract to buy or sell an underlying asset between two independent parties at an agreed price and date.

The Future Contract The futures contract is a standardized contract to buy or sell an underlying asset between two independent parties at an agreed price, quantity and date.

Option contract The Option contract is a contract gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price prior to or on a specified date, depending on the form of the option.

ACPM - Active credit portfolio management

EAD - Exposure at default

EL - Expected loss

LGD - Loss given default

PD - Probability of default

KMV - quantitative credit analysis solution developed by credit

EAD - Exposure at default

EL - Expected loss

LGD - Loss given default

PD - Probability of default

KMV - quantitative credit analysis solution developed by credit rating agency Moody's

VaR - Value at Risk, a common methodology for measuring risk due to market movements