Chapter 1 - Risk and Risk Exposure Flashcards
What is risk?
Quantifiable possibility that actual results will turn out different than expected
What is uncertainty?
Inability to predict the outcome from an activity due to lack of info
What is downside risk?
Risk that something could go wrong + effect is damaging
What is upside risk?
Things work out better than expected
What is fundamental risk?
Risks that affect society & beyond control of any one individual
E.g. Risk of atmospheric pollution
What is particular risk?
Risks over which individual have some measure of control
E.g. Risk attached to smoking
What is speculative risk?
Risks from which either good/ harm may result
E.g. Business venture which may earn losses or profits
What is pure risk?
Risk whose only possible outcome is harmful
E.g. Loss of data on computer systems due to a fire
Describe the nature of risk:
- 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
What is the impact of risk factors?
- Risk factors could impact successful implementation of strategy or achievement of objectives
Typical risk factors could include:
- 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)
Institute of Risk Management (IRM) risk drivers:
- Financial Risks:
* Externally driven = Interest rates, foreign exchange, credit
* Internally driven = Liquidity + cash flow - Strategic Risks:
* Externally driven = Competition, customer changes, industry changes, customer demand
* Internally driven = R + D, intellectual capital - Operational Risks:
* Externally driven = Regulations, culture, board compensation
* Internally driven = Recruitment, supply chain, accounting controls, info systems - Hazard Risks:
* Externally driven = Contracts, natural events, suppliers, environment
* Internally driven = Public access, employees, properties, products & services
Purposes of risk categorisation:
- Identifying risks that are interrelated
- Encouraging a systematic approach
- Making it easier to assign responsibility for managing risks + designing controls
- Assisting management review + reporting of risk
What is strategic risk?
- 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
What is operational risk?
- 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
Main differences between strategic & operational risks:
- Scope of impact
- Source of risk
- Duration of impact
- Scale of financial + resource consequences
Factors influencing strategic risk:
- Types of industries/markets
- State of economy
- Actions of competitors and possibility of mergers + acquisitions
- Stage in product’s life cycle
- Dependence upon inputs with fluctuating prices
- Level of operational gearing
- Flexibility of production processes
- Org’s R&D capacity and ability to innovate
- Significance of new technology
What is market risk?
- 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
Strategic risks include:
- Reputation and ethics
- Information risks
- Financial risks
- Interest rate risks
- Currency risk
- Market risk
Operational risks include:
- Losses from internal control system or audit inadequacies
- Non-compliance with regulations or internal procedures
- Information technology failures
- Human error
- Loss of key person risk
- Fraud
- Business interruptions
Types of risk faced by an international business:
- Economic risk
- Market risk
- Translation risk
- Transaction risk
- Political risk
- Product + cultural risk
- Trading + credit risk
What is economic risk?
Degree to which value of the firm’s future cash flows can be influenced in the medium to long term by foreign exchange movements
Market risk in relation to international businesses
- Includes borrowing costs in different country
- Exchange rate changes
- Commodity price changes
- Changes in price of shares or financial instruments
What is translation risk?
- Risk of assets + liabilities changing in value due to exchange rate movements
- Impact retained profits and overall valuation of company
What is transaction risk?
- 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
What is political risk?
Caused by government action which can render assets worthless or alter ability to expatriate cash
What is product + cultural risks?
Risks relating to customs, tastes, laws and language
Types of trading and credit risk?
- Physical risk = goods lost or stolen in transit
- Credit risk = payment default by customers
- Liquidity risk = inability to finance an increased working capital
Market risk – Short vs. long positions:
- 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)
- Long position = (buy low, sell high model) where you buy first before selling later (with expectation that rise in value will not happen immediately)
Methods of quantifying risk exposures:
- Regression
- Simulation
- Scenario Planning
- Expected values
- Accounting ratios
Regression:
- 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
Regression formula:
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
Simulation:
Calculating a possible range of outcomes to calculate a mean and standard deviation of a range of expected profits, costs or cash flows
Scenario Planning:
- Identifying possible future situations + determining best ways to control or manage them
- Contingency plans can then be established
Expected values:
- 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
Sensitivity analysis:
- 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
Accounting ratios to quantify risk exposures:
- Debt ratio
- Gearing ratio
- Interest cover
- Cash flow ratio
- Current ratio
- Quick ratio
Debt ratio:
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
Gearing ratio:
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
Interest cover:
- Interest cover= PBIT / Interest
* Interest cover of three times or less is generally considered as worryingly low
Cash flow ratio:
- 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
Current ratio:
- Current ratio= (current assets)/(current liabilities)
- Key indicator of liquidity
- Ratio in excess of 1 expected
Quick ratio:
- 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
Interpreting ratios for signs of danger:
- Changes in revenue
* Business may not have infrastructure to cope with rapid increases in demand - 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 - 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 - Increase in short-term payables
* Imply risky dependence on finance that has to be repaid soon - 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
What does risk mapping involve?
- Typical risk map assesses the severity or impact of loss and the likelihood or frequency of loss
What is objective risk perception?
Assumes both hazard and risk can be quantified or raked and
assessment can be made with high degree of certainty/ scientific accuracy
When is subjective risk perception used?
Quantitative accuracy is not possible
What should an org do where high levels of risk may not be avoidable:
Org’s trade off cost and benefit by implementing controls appropriate to the level of risk faced (ALARP – as low as reasonably practicable)
What is correlated risks?
- Two risks that vary together
- Positive correlation = risks will increase/ decrease together
- Negative correlation = one risk will increase as other decrease
What is related risks?
Risks that are connected because they have the same causes
Diversification of risks (portfolio approach):
- 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
