Ch 26: Risk Identification And Classifiaction Flashcards
Type of exam Questions
Identifying risk and apply their catergories
Risk Identification
Recognise risk that can threaten an organisation’s business plan
Two reasons we identify risk
- Risk Control: Find control process to reduce either likelihood of the risk event happening or impact of risk.
- Risk Exploitations: to gain competitive advantage over other provider. taking on risk can be a source of profit.
who is involved
Everyone.
The mangers are not able to redaily identify the risk on operations level.
The supervises and employees are more able to do so.
- Internal staff : all levels and new staff
- External experts: They can help with the more difficult to identify risk
- External stakeholders: customers can reports risks with using product or visiting the premises
What you need to identfiy risk
Have good knowledge of:
1. Circumstance of the organisation : e.g small , large, new, old
2. The features of the business enviroment in which it operates: e.g annuity, insurance,
3. the general business and regulatory environment:
Techniques used to identify risks:
- Risk classification (to ensure full coverage)
- Risk checklists e.g., as used for setting regulatory capital requirements like Solvency II will have lists of risks that are relevant to the business
- Experience of staff joining from similar organisations, consultants, experts
- Project management risk identification techniques
- high-level preliminary analysis: pick up on projects that have high risk profile and are not worth further ano
Project management risk identification techniques:
- High-level preliminary analysis
- Brainstorming of project experts and senior people
— Identify project risks and upsides and downsides
— Discuss risks and interdependency
— Broad initial evaluation on each risk
— Mitigation options - Desktop analysis
— Identify further risks and mitigation options - Risk register / risk matrix
— Stage of project and causes of risk
— Cross-references to other risks where there is interdependency
Risk classification
Allocating identified risks into higher level categories, in order to aid the other stages of the risk management control cycle
* Need to understand significance of each risk and financial impacts of outcome
* Some sources of risk will span several categories - climate change, pandemics
RISK CATEGORIES
- Market risk
- Credit risk
- Liquidity risk
- Business risk
- Operational risk
- External risk
COMBEL
Market risk
Risks related to changes in investment market
values or other features correlated with
investment markets, such as interest and inflation
rates
Sources of market risk
- Changes in asset values
- Investment market value changes on liabilities
- Liability amount (e.g unit-linked benefits) /
liability value (change in interest rate/ inflation) - Mismatching assets and liabilities
- Capital risk - risk that the amount of available
capital falls below the level required to support
other risks
Why a perfect match might be impossible:
- may not be wide enough range of assets
available - unusual to find assets of long
enough duration - Liabilities may be uncertain in amount and
timing - Liabilities may include options which have
uncertain CF’s after the option date - Liabilities might include discretionary benefits
- Cost of maintaining a fully-matched portfolio is
likely to be prohibitive
Describe the effect of an increase in short-term
interest rates on:
1. Fixed interest bonds
2. Index-linked bonds
3. Equities
4. Property
- Fixed interest bonds: will almost certainly cause
prices of short-term bonds to fall. Values of
long-term bonds could go up or down depending
on investor’s views of future inflation - Index-linked bonds: If interpreted as sign of
lower expected future inflation, demand for I-L
bonds & their values might fall - Equities: might depress economic growth & so
equity values might fall - Property: should lead to lower valuation of
future rents & therefore lower capital values of
property
Consequences of mismatching:
- Greater exposure to market risk - assets and
liabilities will not move in line with each other - Higher liquidity risk
- Reinvestment risk - risk of having to invest
asset proceeds on unknown future terms
Credit risk
Risk of failure of third parties to meet their
obligations
examples
- Borrowers defaulting on interest and capital
payments - Credit concentration risk - lending heavily
weighted towards individual borrowers,
industrial sectors / countries - Credit spread changes and credit-linked
events - Counterparties to a transaction failing to
meet their obligations - Settlement risk - pays cash / delivers asset
before counterparty completed part of deal - Debtors failing to pay for purchased goods /
services
Define credit spread in relation to a corporate bond:
Credit spread is the difference in yield between the
corporate bond and an otherwise equivalent
government bond. This can change due to perceived
changes in credit quality of the issuers
Security
- Security may be required from borrower as a way
of reducing credit risk when lending money - Credit ratings are an indication of creditworthiness,
i.e., the likelihood of default
Decision as to what security is taken is dependent on:
- Nature of the transaction underlying the borrowing
- Covenant of the borrower - overall creditworthiness
- Market circumstances and comparative negotiating
strength - What security is available
Liquidity risk
Risk that the individual / company,
although solvent, does not have
available sufficient financial resources
to enable it to meet its obligations as
they fall due
* Or can secure such resources only at
excessive cost
Managing liquidity risk:
- Maintain degree of liquidity
- Convert less liquid assets to cash /
borrow additional funds - Risk issues arise as a result of a
sudden surge in liability withdrawals
Liquidity risk for different organisations
- Non-financial institutions - if assets (stock and work in
progress) cannot be realised - Insurance companies and benefit schemes
- Little exposure - assets in cash deposits / bond and
stock market - Insurers - claim costs higher than expected
- Benefit schemes - bulk transfer out of schemes
- Banks
- Since they ‘borrow short & lend long”
- Significant risk - behavioural aspects
- Liquidity coverage ratio will require banks to hold
sufficient high quality liquid assets to withstand a
liquidity stress event specified by regulators - Collective investment schemes and insurance funds
- Invest in real property - possible to defer withdrawals
- Invest in illiquid assets - lock-in periods to mitigate risk
- More surrenders / more sell units than expected
Market liquidity risk
- Market does not have capacity to handle
that volume of transacted asset without
a potential adverse price impact - Liquidity - how quickly asset can be
converted into cash at a predictable
price - Marketability - how easy it is to trade an
asset
Example of an asset that is:
1. highly liquid but not marketable
2. marketable but not liquid
a.) highly liquid but not marketable
7-day fixed-term deposit at a bank is highly liquid - will
become cash within a week but such assets cannot be
traded - unmarketable
b.) marketable but not liquid
Long-term government bond - marketable because there
are many market participants willing to trade at any time
but not liquid since the market value is quite volatile
