Chapter 10: Risk Management Flashcards
What is the difference between risk and uncertainty?
Risk can be defined as “the possible variation in outcome from what is expected to happen”.
Uncertainty is “the inability to predict the outcome from an activity due to a lack of information”.
What are the two main types of risk?
Downside risk (pure risk) is the possibility that the outcome will be worse than expected – i.e. the worst case scenario.
Upside risk (opportunity risk) is the possibility that something could got better than expected – i.e. the best case scenario.
How do you measure risk?
The degree of risk that an organisation faces can be measured by considering two main issues.
Risk = Likelihood × Impact
What is the risk management process?
Risk management is the process of identifying and assessing (analysing and evaluating) risks and the development, implementation and monitoring of a strategy to respond to those risks.
What is risk appetite?
Risk appetite is the extent to which a company is prepared to take on risks in order to achieve its objectives.
What influences risk appetite?
- Expectations of shareholders
- National culture
- Regulatory framework
- Nature of ownerships
- Personal views of managers
What do Miles and Snow suggest the four main types of management attitudes are? (Reactors)
Reactors, Defenders, Analysers, Prospectors
Reactors:
Typical Characteristics
Inconsistent
Fail to link technology, structure and process to strategies
Approach to risk:
Risk averse
Only change if forced to do so
Strategies often out of date in changing markets
What do Miles and Snow suggest the four main types of management attitudes are? (Defenders)
Reactors, Defenders, Analysers, Prospectors
Defenders
Typical Characteristics:
Specialist provider of a specific product
Narrow area of operations
Management expertise
Stable, efficient
Approach to risk:
Low risk tolerance
Maintain share of chosen market
Ignore developments outside expertise
Grow incrementally
What do Miles and Snow suggest the four main types of management attitudes are? (Analysers)
Reactors, Defenders, Analysers, Prospectors
Analysers
Typical Characteristics:
Two business areas –
one stable (c.f. defenders) and one innovative (c.f. prospectors)
Approach to risk:
Balanced attitude to risk/return
Wait and see market reaction to new developments before committing
Then establish formal structures to ensure efficiency
What do Miles and Snow suggest the four main types of management attitudes are? (Prospectors)
Reactors, Defenders, Analysers, Prospectors
Prospectors
Typical Characteristics:
Continually changing structure/technology
Broad approach to planning
Results orientated
Wide portfolio
Risk seeking:
Entrepreneurial
Responsive to new trends
Seek new markets/products
What is risk identification? What can help you in the exam?
Risk identification sets out to identify an organisation’s exposure to risk.
Risks are fundamentally similar to threats.
You can use PESTEL analysis and Porter’s Five Forces model to help you to identify risks in the exam.
What is a risk assessment?
Risk assessment establishes the financial consequences of each risk (severity) and its likelihood of occurrence.
What are the potential difficulties of a risk assessment?
Measuring impact – the non-financial impact of potential outcomes could be difficult to quantify (e.g. loss of life).
Measuring likelihood – whilst insurance companies may be able to apply statistical models, measuring the likelihood of risks occurring for most businesses is likely to be subjective
What is risk evaluation? What should you consider?
Risk evaluation is the process by which a business determines the significance of any risk and whether those risks need to be addressed.
What is the likely cost?
What are the likely benefits?
Legal or regulatory requirements
Stakeholders views
Socioeconomic and environmental factors
What model should you use to assess risk response?
TARA
Transfer:
Transfer risk to a third party
e.g. insurance, hedging
Avoidance:
Avoid downside by not undertaking/terminating risky activities
Usually lose upside potential as well
Reduction:
Retain the activity but take action to limit risk to acceptable levels
Mitigating controls:
Preventative
Corrective
Directive
Detective
Acceptance/Retention:
Tolerating losses when they arise
For small risks could be cheaper than insurance (‘self insurance’)
Why do you need systems to monitor risk?
To monitor the effectiveness of the current risk management process.
To monitor whether the risk profile is changing.
How do you report on risk management?
Minimum board disclosure:
Existence of a process for managing risks.
How the board has reviewed the effectiveness of the process.
Process accords with Turnbull guidance.
Additional board disclosure:
That they are responsible for the company’s systems of internal control.
That systems have been designed to manage, not eliminate, risk.
How the board have dealt with the internal control aspects of significant problems highlighted in the accounts.
Any weaknesses in internal control that have resulted in material losses.
What is a risk register?
Risk registers can be used to document and monitor the risks that have been
identified and the risk mitigation strategies.
What methods of quantitative analysis can be used to analyse risks?
Break-even analysis
Sensitivity analysis
Expected values
Decision trees
Statistical analysis.
What is break-even analysis and how do you calculate it?
The break-even point is the level of production required for the business to make neither a profit nor a loss.
The exam often contains calculations which are based on the break-even concept.
Total profit = Total contribution – Total fixed costs
Total contribution = Units sold × Contribution per unit
Break-even point:
Total contribution = Total fixed costs
Break-even units = Total fixed costs /
Contribution on per unit
How do you perform a sensitivity analysis?
Sensitivity = Estimated profit / Total value of the cash flow affected
E.g.
Revenue 2,000 units × £30 per unit £60,000
Variable costs 2,000 units × £20 per unit (£40,000)
–––––––
Total contribution 2,000 units × £10 per unit £20,000
Fixed costs (£5,000)
–––––––
Profit £15,000
–––––––
Sensitivity analysis
Sensitivity of the selling price = £15,000/£60,000 = 25%
Sensitivity of the sales volume = £15,000/£20,000 = 75%
What is an expected value and why is it helpful?
An expected value is a weighted average value, based on probabilities.
These can offer a helpful guide for management decisions.
A project with a positive expected value should be accepted
A project with a negative expected value should be rejected
Expected value = sum of (outcome × probability)
E.g.:
A project with a 40% change of a £1,000 profit and a 60% chance of a £100 loss
would have the following expected value:
£1,000 × 40% = £400
(£100) × 60% = (£60)
–––––
Expected value £340
–––––
As the expected value is positive the project should be accepted.
What are the limitations of expected values?
- The probabilities are themselves estimates and may be inaccurate.
- Expected values are long-term averages and therefore less useful for one-off decisions.
- Expected values do not consider the attitudes to risk of the decision makers.
- No consideration of the time value of money.
What is a decision tree?
- A decision tree is a pictorial method of showing a sequence of
interrelated decisions and their expected outcomes. - Decision trees can incorporate both the probabilities of, and values of,
expected outcomes. - Commonly management will use decision trees to structure the choices
and outcomes of a decision.
How do you produce a decision tree?
Choices will be mapped as squares
Outcomes of those choices will be marked as circles
What is statistical analysis?
Statistical analysis is the collection and interpretation of data in order to
uncover patterns and trends, to help with decision making and analyse
risks.
What are the three statistical techniques we need to be aware of?
Mean – this is the average value of a data set. For example, if you measure the height of ten different people at random, what is the average height per person?
Standard deviation – in order to measure the risk associated with a particular project, it is helpful to find out how wide-ranging the possible outcomes are.
The conventional measure for this is the standard deviation. A low standard deviation means low variability and therefore lower risk; a high standard deviation (in relative terms) shows high variability and so higher relative risk.
Understanding standard deviation can help identify the relative risks of different projects.
Co-efficient of variation – this is the ratio of the standard deviation to the mean. It is useful when comparing the degree of variation from one data series to another, even if the means are quite different from each other.
In a financial setting, the coefficient of variation allows you to determine how much risk you are assuming in comparison to the amount of return you can expect from an investment. The lower the ratio of standard deviation to mean return, the better the risk-return trade-off will be.
