Ch 26: Risk identification and classification Flashcards
Risk Identification
3
- Recognition of risks that can threathen business plan
- Each risk needs to have a control process to reduce likelihood and impact
- Identify opportunities to exploit risk and gain advantages
Outline 5 methods of identifying Risk
5
- High level preliminary analysis to confirm that there are no big risks that mean it is not worth continuing.
- Brainstorming with project experts:
- identify likely/unlikely, upside/downside risks
- discuss these risks and their interdependency
- broadly evaluate the frequency and severity of each risk
- generate and discuss initial mitigation options
3.Research similar projects to supplement analysis
4.Consult with experts who are familiar with the details of the project and the plans for financing it.
5.Risk register or risk matrix setting out risks and ther interdependencies
Suggest 7 categories of risks that could be used in a risk matrix for a typical project
PNEFCPB
- Political - opposition to project, war, terrorism, etc
- Natural - earthquakes, hurricanes
- Economic - interest rate or exchange rate movements
- Financial - sponsor default, incorrect cashflow estimates
- Crime - fraud, theft
- Project - time delays, budget overruns, bad design
- Business - competition/lack of demand, operational problems
Risk Classification and Risk Categories
2
- Grouping of risks into homogeneous groups to allow data to be used in modelling,marketing,sales
- Main impact will come from key risks, need to understand business structure
Market risk
1,3
- The risk related to changes in investment market values or other features correlated with investment markets such as interest rates/inflation
Consequences:
* Change in asset values (Systematic/specific)
* Change market values of liabilities
* Mismatch between CF’s
Market risk could be removed through holding an asset portfolio that perfectly matches the liability portfolio.
Give reasons why a perfect match may not be possible in practice.
5
- There may not be a wide enough range of assets available; in particular it may may not be possible to find assets in sufficiently long duration.
- Liabilities may be uncertain in amount and timing
- Liabilities may include options and hence have uncertain cashflows after the option date.
- Liabilities may include discretionary benefits
- The cost of maintaining a full-matched portfolio is likely to be prohibitive.
Credit risk
1,5
- The risk of failure of third parties to meet their obligations
Used to cover:
* Default risk
* Change in credit rating (downgrade gov)
* Credit concentration risk (heavily invested in one sector)
* Credit spread risk: changes over time
* Counterparty risk (reinsurers)
What is a credit rating?
A credit rating is a rating given to a company’s debt by a credit-rating agency as an indication of the likelihood of default.
Outline 4 factors that an investor should consider when assessing the security of a debt and the borrower
- The nature of the debt
- The covenant of the borrower (e.g. credit rating, income and asset cover, level of gearing, prior ranking debt)
- Market circumstances and the relative negotiating strength of borrower and lender.
- What security is available and whether it can be realized if necessary
Liquidity risk
2
- The risk that an insurer, although solvent, does not have sufficient capital available to enable it to meet its obligations as they fall due.
- The risk for an insurer is usually low since investments usually include a large proportion of cash, bonds and stock market assets which can be converted to cash quickly
Define the term liquid asset.
What makes a market liquid?
A liquid asset is one that either:
- is close to cash in nature, or
- can be converted to cash quickly and the amount of cash it would become is almost certain
A liquid market is likely to be a large market with lots of ready marticipants.
(A marketable asset is one that can be converted to cash quickly, but the amount of cash received is uncertain)
Why are banks exposed to significant liquidity risk?
Banks lend depositors’ funds and funds raised from the money markets to other organizations for potentially long periods. Customers may want instant access to their deposits, creating a need for liquidity. There is a risk that more customers than expected demand cash.
Business risk
5
- Risk specific to the business undertaken
- Underwriting risk: Accept risk at inadequate price
- Insurance risk: Claim freq and severity is higher than expected
- Financing risk: Failure of a provider of finance
- Exposure risk: to certain events eg concentration risk
UIFE
Operational risk
1,4
- The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
Sources:
* Inadequate internal processes
* Conduct risk: Actions result in losses
* Dominance risk: Business run by single indivdual
* 3rd party risk: Reliance on 3rd part to carry out function
External risk
3
- Risk of losses due to external events
- Type of operational risk
- eg Regulatory, tax changes
