The purpose of measuring risk is to find out what would be the most likely maximum loss in the portfolio value or investment. However if losses have exceeded expectations then one cannot just say the risk measurement process is flawed each time this happens. There are cases when such occurrences might happen and they may not be due to flaws in the model but due to bad luck purely. Blaming the risk measurement model may not entirely be the right thing in this case.
A general classification has then been created for the risks that are being measured in the risk management process. Broadly there are three classifications of the different types of risk:
1. Known Knowns
These are risks that have been correctly identified and properly measured. It however does not mean that any losses other than this can occur due to flawed models or juts random nature (i.e. bad luck). The variation in losses other than the known losses however should not happen too frequently otherwise it would be indicative of something unusual.
2. Known Unknowns
These are risks that have not been accurately measured by a risk management system but are expected to be there. These arise due to expected imperfections in the risk measurement model like assumptions about distributions of rates not perfect or factors like leaving some parameters out of equations due to the complexity of the measurement process or human error while doing the measurement. These are normal risks associated with the measurement model.
One of the examples of this would be the assumption that the distribution the log of returns always follows a normal distribution, which is the basis of many risk management processes like PVAR. In practice distributions show a variation from this in that they have fat tails or kurtosis.
Liquidity risk forms another way of measuring known unknown’s. This is normally classified into accounting liquidity risk and market liquidity risk. Market liquidity risk is the risk that the price of an asset that may vary too much if an order has been placed to trade large quantities of the asset. This normally happens when the asset does not trade very frequently.
3. Unknown Unkonwns
These are risks that arise due to events or causes of losses than cannot be modeled or the existence of such factors cannot even be determined properly. These include political events affect normal operations that are not predicted, defaults on obligations by the opposite party involved in the transaction and also some types of liquidity risks that cannot be measured properly. There are many examples of such risks. For example in third world countries there is a lot of instability at a political level as governments and ministers rise and fall arbitrarily without any proper causes. India would be a good example of this and the assassination of former Prime Minister Rajiv Gandhi is just one of the examples of incidents that have caused turmoil in people’s lives. Some forms of liquidity risks which arise due to factors like forced sales etc also cause such issues.