Chapter 10: Risk Management

Question 1

What is the difference between risk and uncertainty?

Answer 1

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”.

Question 2

What are the two main types of risk?

Answer 2

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.

Question 3

How do you measure risk?

Answer 3

The degree of risk that an organisation faces can be measured by considering two main issues.

Risk = Likelihood × Impact

Question 4

What is the risk management process?

Answer 4

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.

Question 5

What is risk appetite?

Answer 5

Risk appetite is the extent to which a company is prepared to take on risks in order to achieve its objectives.

Question 6

What influences risk appetite?

Answer 6

• Expectations of shareholders
• National culture
• Regulatory framework
• Nature of ownerships
• Personal views of managers

Question 7

What do Miles and Snow suggest the four main types of management attitudes are? (Reactors)

Answer 7

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 Strategies often out of date in changing markets

Question 8

What do Miles and Snow suggest the four main types of management attitudes are? (Defenders)

Answer 8

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

Question 9

What do Miles and Snow suggest the four main types of management attitudes are? (Analysers)

Answer 9

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

Question 10

What do Miles and Snow suggest the four main types of management attitudes are? (Prospectors)

Answer 10

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

Question 11

What is risk identification? What can help you in the exam?

Answer 11

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.

Question 12

What is a risk assessment?

Answer 12

Risk assessment establishes the financial consequences of each risk (severity) and its likelihood of occurrence.

Question 13

What are the potential difficulties of a risk assessment?

Answer 13

 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

Question 14

What is risk evaluation? What should you consider?

Answer 14

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

Question 15

What model should you use to assess risk response?

Answer 15

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’)

Question 16

Why do you need systems to monitor risk?

Answer 16

 To monitor the effectiveness of the current risk management process.
 To monitor whether the risk profile is changing.

Question 17

How do you report on risk management?

Answer 17

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.

Question 18

What is a risk register?

Answer 18

Risk registers can be used to document and monitor the risks that have been
identified and the risk mitigation strategies.

Question 19

What methods of quantitative analysis can be used to analyse risks?

Answer 19

 Break-even analysis
 Sensitivity analysis
 Expected values
 Decision trees
 Statistical analysis.

Question 20

What is break-even analysis and how do you calculate it?

Answer 20

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

Question 21

How do you perform a sensitivity analysis?

Answer 21

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%

Question 22

What is an expected value and why is it helpful?

Answer 22

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.

Question 23

What are the limitations of expected values?

Answer 23

• 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.

Question 24

What is a decision tree?

Answer 24

• 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.

Question 25

How do you produce a decision tree?

Answer 25

 Choices will be mapped as squares
 Outcomes of those choices will be marked as circles

Question 26

What is statistical analysis?

Answer 26

Statistical analysis is the collection and interpretation of data in order to
uncover patterns and trends, to help with decision making and analyse
risks.

Question 27

What are the three statistical techniques we need to be aware of?

Answer 27

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.