Ch 26: Risk identification and classification Flashcards
Outline 5 methods of identifying the risks associated with a project
- High level preliminary analysis to confirm that there are no big risks that mean it is not worth continuing.
- Brainstorming with project experts and senior internal / external people to:
- 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 - Desktop analysis to supplement brainstorming, which involves looking at similar projects undertaken by the sponsor and others.
- Consult with experts who are familiar with the details of the project and the plans for financing it.
- 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
Wider risk identification techniques
- Risk classification
- Risk checklists
- Utilizing the experience of staff
Market risk
The risk related to changes in investment market values or other features correlated with investment markets such as interest rates/inflation
Credit risk
The risk of failure of third parties to meet their obligations
Liquidity risk
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
Business risk
Risk specific to the business undertaken
Operational risk
The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
External risk
Arises from external events
Outline 3 subdivisions of market risk
- The consequences of changes in asset values (due to changes in the market value of assets or changes in interest and inflation rates)
- The consequences of a change in investment market values on liability values, where liabilities are directly related to investment market values, interest rates or inflation rates.
- The consequences of not matching assets and liability cashflows
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.
- 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.
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
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.
