10
Operational risk
When looking at risk in relation to any activities in the financial
markets it is usually broken down into three high-level definitions
covering market, credit and operational risk.
Market risk can be simply defined as the risk of financial loss due to
trading errors, liquidity issues, adverse market movements or breaches
of market rules and regulations.
Credit risk can be simply defined as the risk of financial loss due to
the failure of a counterparty. This loss can be failure to receive either
cash or assets, or both, and the cost of replacement.
Not surprisingly market and credit risk are high on the agenda of
regulators and risk managers.
Establishing the extent of the market risk associated with trading is
not simple, but it is possible to measure the exposure, given various
scenarios, and to allocate capital to cover the possible worst-case out-
come. Value at Risk (VaR), Monte Carlo Simulation, etc. are common
approaches.
Operational risk is defined by the Basel Committee on Banking
Supervision as being the risk of loss resulting from inadequate or
failed internal processes, people and systems or from external
events.
Given that derivatives have certain characteristics that not only
make them risk management tools but also generate certain types of
risk if they are not managed and settled properly, we need to look at
operational risk in some detail.
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