Daily, every entity—a firm or person—is exposed to risk. When quantified, the total amount of risk an entity is exposed to based on interactions with a particular party is known as aggregate risk.
Transactions always involve two or more parties. In most cases, one party is owed by another. The more obligations owed by one party to another, the higher the aggregate risk. In essence, it is advised that firms spread their risk across diverse parties.
Let’s break down aggregate risk
As a metric, firms (particularly financial institutions) monitor this to avoid cases like a majority of defaults coming from one party. That way, if 1 out of 5 people default they are better off than 1 of 1 person defaulting.
Once again, this is a measure of the risk you are exposed to from transacting with a party. Let’s take a look at an example.
Example of aggregate risk
As a supplier of drinks, you give your clients a credit period of two weeks. However, you have a great client who you have allowed to take on products for 6 weeks without paying.
At the end of the sixth week, you can place a hold on supplies for that particular client till they pay. The aggregate risk here is that the said client might not be able to meet up with payments hence your decision. In finance, this decision is known as a limit and it is used to manage aggregate risk.
Quick Fact: Aggregate risk is also known as counter-party risk.
Aggregate risk is a comprehensive view of an organization’s or individual’s risk profile and takes into account all possible risks that they face. These risks can include market risk, credit risk, operational risk, etc.
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