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P3 - Risk Management > Chapter 1 - Risk and Risk Exposure > Flashcards

Chapter 1 - Risk and Risk Exposure Flashcards

1
Q

What is risk?

A

Quantifiable possibility that actual results will turn out different than expected

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2
Q

What is uncertainty?

A

Inability to predict the outcome from an activity due to lack of info

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3
Q

What is downside risk?

A

Risk that something could go wrong + effect is damaging

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4
Q

What is upside risk?

A

Things work out better than expected

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5
Q

What is fundamental risk?

A

Risks that affect society & beyond control of any one individual
E.g. Risk of atmospheric pollution

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6
Q

What is particular risk?

A

Risks over which individual have some measure of control

E.g. Risk attached to smoking

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7
Q

What is speculative risk?

A

Risks from which either good/ harm may result

E.g. Business venture which may earn losses or profits

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8
Q

What is pure risk?

A

Risk whose only possible outcome is harmful

E.g. Loss of data on computer systems due to a fire

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9
Q

Describe the nature of risk:

A
  • Nature of risk means it cannot be eliminated altogether, but can be managed as much as possible.
  • Balancing act between upside- & downside risk = org may need to accept a degree of downside risk to pursue upside risk
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10
Q

What is the impact of risk factors?

A
  • Risk factors could impact successful implementation of strategy or achievement of objectives
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11
Q

Typical risk factors could include:

A
  • External events = economic changes, political developments + technological advances
  • Internal events = equipment failure, human error or difficulties with products
  • Leading event indicators = conditions that could give rise to event (overdue customer balances could lead to default)
  • Escalation triggers = events happening/ levels being reached that require immediate action (making changes after deadline has passed)
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12
Q

Institute of Risk Management (IRM) risk drivers:

A
  1. Financial Risks:
    * Externally driven = Interest rates, foreign exchange, credit
    * Internally driven = Liquidity + cash flow
  2. Strategic Risks:
    * Externally driven = Competition, customer changes, industry changes, customer demand
    * Internally driven = R + D, intellectual capital
  3. Operational Risks:
    * Externally driven = Regulations, culture, board compensation
    * Internally driven = Recruitment, supply chain, accounting controls, info systems
  4. Hazard Risks:
    * Externally driven = Contracts, natural events, suppliers, environment
    * Internally driven = Public access, employees, properties, products & services
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13
Q

Purposes of risk categorisation:

A
  1. Identifying risks that are interrelated
  2. Encouraging a systematic approach
  3. Making it easier to assign responsibility for managing risks + designing controls
  4. Assisting management review + reporting of risk
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14
Q

What is strategic risk?

A
  • Potential volatility of performance over the longer-term caused by org’s decisions and events
  • Key bearing on org’s situation in relation to its environment
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15
Q

What is operational risk?

A
  • Risk of loss from failure of internal business and control processes (process risk)
  • Risks that something could go wrong on day-to-day basis
  • Not relevant to org’s key strategic decisions
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16
Q

Main differences between strategic & operational risks:

A
  • Scope of impact
  • Source of risk
  • Duration of impact
  • Scale of financial + resource consequences
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17
Q

Factors influencing strategic risk:

A
  1. Types of industries/markets
  2. State of economy
  3. Actions of competitors and possibility of mergers + acquisitions
  4. Stage in product’s life cycle
  5. Dependence upon inputs with fluctuating prices
  6. Level of operational gearing
  7. Flexibility of production processes
  8. Org’s R&D capacity and ability to innovate
  9. Significance of new technology
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18
Q

What is market risk?

A
  • Risk of loss due to changes in value or availability of certain resources
  • Risk of small price movements that change value of holder’s position
  • Risk of losses relating to a change in maturity structure of an asset, passage of time or market volatility
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19
Q

Strategic risks include:

A
  1. Reputation and ethics
  2. Information risks
  3. Financial risks
  4. Interest rate risks
  5. Currency risk
  6. Market risk
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20
Q

Operational risks include:

A
  1. Losses from internal control system or audit inadequacies
  2. Non-compliance with regulations or internal procedures
  3. Information technology failures
  4. Human error
  5. Loss of key person risk
  6. Fraud
  7. Business interruptions
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21
Q

Types of risk faced by an international business:

A
  • Economic risk
  • Market risk
  • Translation risk
  • Transaction risk
  • Political risk
  • Product + cultural risk
  • Trading + credit risk
22
Q

What is economic risk?

A

Degree to which value of the firm’s future cash flows can be influenced in the medium to long term by foreign exchange movements

23
Q

Market risk in relation to international businesses

A
  • Includes borrowing costs in different country
  • Exchange rate changes
  • Commodity price changes
  • Changes in price of shares or financial instruments
24
Q

What is translation risk?

A
  • Risk of assets + liabilities changing in value due to exchange rate movements
  • Impact retained profits and overall valuation of company
25
Q

What is transaction risk?

A
  • Risk that transaction is recorded at one rate and settled at another
  • Risk due to timing between entering into the transaction and time actual cash flows materialise
26
Q

What is political risk?

A

Caused by government action which can render assets worthless or alter ability to expatriate cash

27
Q

What is product + cultural risks?

A

Risks relating to customs, tastes, laws and language

28
Q

Types of trading and credit risk?

A
  • Physical risk = goods lost or stolen in transit
  • Credit risk = payment default by customers
  • Liquidity risk = inability to finance an increased working capital
29
Q

Market risk – Short vs. long positions:

A
  1. Short position = investing in shares + other securities where you sell something first and then have to buy it subsequently to close out transaction (want to see price fall in order to make a profit)
  2. Long position = (buy low, sell high model) where you buy first before selling later (with expectation that rise in value will not happen immediately)
30
Q

Methods of quantifying risk exposures:

A
  1. Regression
  2. Simulation
  3. Scenario Planning
  4. Expected values
  5. Accounting ratios
31
Q

Regression:

A
  • Assess the volatility of future cash flows by attaching a value to the various risk factors and calculating their impact
  • Historic data is used so new risk factors might not be considered
32
Q

Regression formula:

A

X=a + B1i + B2f + B3m

X = Change in cash flows
A = underlying performance of business
B1, B2, B3 etc = sensitivity of cash flows to changes in risk factors
I = change in interest rates
F = change in foreign exchange rates
M = change in commodity prices
33
Q

Simulation:

A

Calculating a possible range of outcomes to calculate a mean and standard deviation of a range of expected profits, costs or cash flows

34
Q

Scenario Planning:

A
  • Identifying possible future situations + determining best ways to control or manage them
  • Contingency plans can then be established
35
Q

Expected values:

A
  • Expected value of loss = probability of loss x impact (size of potential loss)
  • Expected value = sum of expected values of losses
  • When faced with number of alternative decisions, highest EV is chosen
  • Obtains an idea of severity of consequences of risk materialising and how likely risk will materialise
36
Q

Sensitivity analysis:

A
  • Assesses sensitivity of a change in a key variable in relation to the NPV
  • Weakness = may be mistake to look at factors in isolation as variables may be interdependent
37
Q

Accounting ratios to quantify risk exposures:

A
  1. Debt ratio
  2. Gearing ratio
  3. Interest cover
  4. Cash flow ratio
  5. Current ratio
  6. Quick ratio
38
Q

Debt ratio:

A

Debt ratio= (Total debt)/(Total assets) × 100

  • If debt ratio appears heavy = finance providers will be unwilling to provide further funds + shareholders may be unhappy with excessive interest burdens threatening dividends & value of company
39
Q

Gearing ratio:

A

Gearing= (Interest bearing debt)/(Equity+interest bearing debt) × 100

  • Gearing emphasises the importance of shareholder reaction = shareholders might not want dividends threatened by interest payments but may also not be willing to see dividends fall as company builds up equity base
40
Q

Interest cover:

A
  • Interest cover= PBIT / Interest

* Interest cover of three times or less is generally considered as worryingly low

41
Q

Cash flow ratio:

A
  • Cash flow ratio= (Net cash flow)/(total debts)

* Low figure may not be a particular concern if majority of debt is due to be paid a long time ahead

42
Q

Current ratio:

A
  • Current ratio= (current assets)/(current liabilities)
  • Key indicator of liquidity
  • Ratio in excess of 1 expected
43
Q

Quick ratio:

A
  • Quick ratio= (Current assets-inventories)/(current liabilities)
  • Reflects the fact that some comp’s may not be able to convert inventory into cash quickly
  • Slow inventory turnover = ideally at least 1
  • Fast inventory turnover = comfortable less than 1
44
Q

Interpreting ratios for signs of danger:

A
  1. Changes in revenue
    * Business may not have infrastructure to cope with rapid increases in demand
  2. Changes in cost
    * Large increase = business may become unprofitable or not being controlled well
    * Fall in costs = better control or providing less value for customers
  3. Increases in receivables or inventories
    * Indicate poor control and risk of not realising assets
    * Decreased revenue and increased inventory together may be strong indicator of commercial problems
  4. Increase in short-term payables
    * Imply risky dependence on finance that has to be repaid soon
  5. Loan finance that has to be repaid in the next 12 – 24 months
    * Risk of whether business has the cash to make repayment without serious impact on operations
45
Q

What does risk mapping involve?

A
  • Typical risk map assesses the severity or impact of loss and the likelihood or frequency of loss
46
Q

What is objective risk perception?

A

Assumes both hazard and risk can be quantified or raked and

assessment can be made with high degree of certainty/ scientific accuracy

47
Q

When is subjective risk perception used?

A

Quantitative accuracy is not possible

48
Q

What should an org do where high levels of risk may not be avoidable:

A

Org’s trade off cost and benefit by implementing controls appropriate to the level of risk faced (ALARP – as low as reasonably practicable)

49
Q

What is correlated risks?

A
  • Two risks that vary together
  • Positive correlation = risks will increase/ decrease together
  • Negative correlation = one risk will increase as other decrease
50
Q

What is related risks?

A

Risks that are connected because they have the same causes

51
Q

Diversification of risks (portfolio approach):

A
  • Offsetting risks that are negatively correlated to balance their impact and likelihood regardless of the circumstances
  • Org may have to consider what the experiences of certain risks will have on other risks it faces

P3 - Risk Management (12 decks)

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