Risk Factor

From Open Risk Manual

Definition

Risk Factor (also Risk Driver) is a general term denoting an attribute, characteristic, variable or other concrete determinant that influences the risk profile of a system, entity, financial asset etc. Risk factors may be causes of risk or merely correlated with risk. Their identification is an essential aspect of formal Risk Management

Usage

Risk factors play an essential role during Risk Analysis, the identification phase of any risk management activity. While this activity is typically internal to an organization / firm, risk factors may have to be disclosed in the context of commercial operations of regulated entities

Role in Risk Quantification

In the context of quantitative Risk Measurement, risk factors are associated with (represented) determinant variables. Some indicative examples:


Risk Factor Disclosure

In the context of regulated financial services and in particular the offering of financial products there are concrete requirements around the formulation and communication of risk factors associated with such products[1]

Risk Factor Classification

There is an enormous variety of possible risk factors depending on context (the Risk Type) being considered.

Conceptual Classification

The following list offers an overall (generic) classification scheme of Risk Factors:

  • Quantitative versus Qualitative Risk Factors, indicating the degree to which factors can be associated with concrete data
  • Static versus dynamic factors, that is factors that change in time (with different possible timescales)
  • Idiosyncratic (specific) versus common (systemic) factors, that is factors that apply across multiple systems
  • Fundamental (lower level) factors versus composite (higher level factors)

Risk Factors of Issuers / Guarantors

Risk factors which are specific and material to the issuers/guarantors could, for example, be divided into the following categories:

  • Risks related to the issuer's financial situation;
  • Risks related to the issuer's business activities and industry;
  • Legal and regulatory risk;
  • Internal control risk; and
  • Environmental, social and governance risks.

Risk Factors in Securities

  • Risks related to the nature of the securities;
  • Risks related to the underlying;
  • Risks related to the guarantor and the guarantee; and
  • Risks related to the offer to the public and/or admission of the securities to trading on a regulated market.

Issues and Challenges

  • The conflation between risk factors and the Risk itself
  • The conflation between correlation and causation
  • The ability of the totality of identified risk factors to explain the risk being considered (Unexplained Variance))
  • The influence of different risk factors on outcomes may be overlapping and difficult to disentangle (correlation / dependency between factors)
  • The impact of a risk factor on the risk profile may not be monotonic
  • Certain risk factors may be very difficult to quantify / model. Qualitative factors are in general those that are difficult to quantify due to the complexity, emerging risk nature

References

  1. ESMA Guidelines on risk factors under the Prospectus Regulation, March 2019

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