Chapter 26 - Risk ID & Classification Flashcards
Why is it important to identify risks?
o In order to determine and put in place any control processes that will either reduce the likelihood or impact of the risk event;
o In order to identify opportunities to exploit risks and gain a competitive advantage over competitors (coronavirus – are you able to increase production of face masks in time of panic?)
What knowledge is required to ID risks of business?
• Identifying risks in an organisation requires good knowledge of:
o The circumstances of the organisation
o The features of the business environment
o General business and regulatory environment
What are the different ways in which to ID risks?
o Business Analysis
o SWOT ANALYSIS – SW are internal, OT are external
o Risk checklist given by a regulator (RBC requirements)
o Mnemonic checklists like PESTEL
o Risk taxonomy
o Case studies – can be internal or external. What are risks that have arisen historically and how were they mitigated. Issue: they are cumbersome and out of date when publicly released
o Process analysis (PERT)
o Junior staff – speaking truth to power is difficult and middle management may hide shortcomings from the top. Juniors may not have those considerations
o Outsiders – pick up on obvious things i.e. a pilot who is an expert in dealing with risk looking at an insurance company may pick up obvious errors
o Experienced staff/consultants with broad experience in industry
Outline the 4 steps necessary to be taken to identify and analyse effectively the risks facing a project
4 Steps necessary to be taken to identify and analyse effectively the risks facing a project:
- Make a high-level preliminary analysis to confirm that the project does not have such a high-risk profile that it is not worth analysing further.
• For example, a clear risk is that finance for a project cannot be raised.
• It is important to determine where the finance is likely to come from and who is managing the process of raising it. - Brain storming sessions (mini risk management process) with experts and senior people who are used to think strategically about the long term. The aims of this are:
• Identify project risks, both upside and downside, likely and unlikely;
• to discuss these risks and their interdependency;
• and to attempt to place a broad initial evaluation on each risk, both for frequency of occurrence and probable consequences if it does occur.
• What are the show stopping risks – those that derail the project no matter how unlikely they are to occur?
• Discuss potential mitigation options for each risk - Perform desktop analysis to identify any further risks and mitigation options
Obtain expert opinion of people familiar with details of the project
Obtain agreement from the people involved as to what the believed risks are and define terms - Set out all the identified risks in a risk register/matrix, with cross references to other risks where there is interdependency and review it regularly
Differentiate between financial and non-financial risks
Financial risk:
Cause of risk related to a financial event and impact will be financial
Non-financial risk:
Cause of risk not related to a financial event but impact will be financial
Define market risk
• Risks related to changes in investment market values or other features correlated with investment markets, such as interest and inflation rates, shape of yield curve, downgrade of a country, market crash etc.
Market risk can be divided into the consequences of:
o Changes in asset values resulting in lower investment returns than expected – Systematic/specific risk, supply vs demand, changes in interest and inflation rates
o Investment market value changes on liabilities – e.g. change in interest rated might affect provisions needed to establish future liabilities
o Mismatching assets and liabilities
Perfect matching is unlikely. Why?
o There may not be a wide enough range of assets available…
o … in particular it is unusual to find assets of long enough duration
o Liabilities may be uncertain in amount and timing
o Liabilities may include options and hence have uncertain cashflows after option date
o Liabilities may include discretionary benefits
o Cost of maintaining fully-matched portfolio is likely to be prohibitive
• Can deliberately mismatch if have additional capital and additional return is high enough to justify the additional risk
Define credit risk and give examples
- Default risk on corporate bonds (changes in credit rating/credit spread)
- Counterparty risk (including settlement risk – party pays cash or delivers assets before other party performed their part of deal)
- General debtors (purchaser of goods/services fails to pay for them or not delivering those that have been paid for)
Security may be used as a way of reducing credit risk when lending money to a third party. What affects the decision in terms of the security taken?
o Nature of transaction underlying the borrowing
o Willingness and ability to pay the debt of the borrower (covenant)
o Negotiating power – think loan shark, maybe future finance dependent on paying back
o The security that is actually available
• The most common asset to take as security is property
• It must be within the ability of the lender to realise the security if necessary in a cost-effective manner
Distinguish between liquidity and marketability
- Marketability is the ability to trade an asset at a given price in given volumes. It essentially relates to the ease of trading. For example how long it takes to deal and at what cost
- Liquidity is a measure of how quickly assets can be converted into cash at a predictable price without being marketed. For example a seven-day fixed term deposit at a clearing bank might be completely un-marketable, because the deposit cannot be transferred or assigned. It is however extremely liquid
Distinguish between financial market and company/individual liquidity risk
• Risk that a market does not have the capacity to handle the volume of an asset to be bought/sold at the time when the deal is required, at least without potential adverse impact on the price.
(The larger the market, more marketable the 𝔸 will be ∵ more participants in market trading at any time. More likely that when member wishes to complete trade, market able to find counterparty to accept trade)
• Risk that the individual/company, although solvent, does not have available sufficient financial resources to enable it to meet its obligations as they fall due
Discuss the liquidity risks for different organisations
- Non-financial institutions: liquidity pressures most common reason why trading companies go into liquidation – if it has sufficient assets but they can’t be realised, company can’t satisfy creditors.
- Insurance companies, benefit schemes: little exposure since large proportion of assets are in cash deposits/bond and stock markets
- Banks – high liquidity risk since they take short term deposits and issue long term loans. Banks face liquidity risk if more customers than expected make withdrawals
- CIS: invest in real property so exposed to liquidity risk if clients request access to their funds. Such funds usually have the power to defer withdrawals for a few months
How can liquidity risk be managed?
- Maintain a degree of liquidity to deal with anticipated 𝕃
- Allowing a margin for 𝕃 being higher than expected and allowing for predictable seasonal variation
- In the event of 𝕃 being > than expected, convert less liquid 𝔸 to cash/try borrow additional fund
Define and list examples of business risk
Definition: risks specific to the business undertaken
Examples: IV BEER & FLOUR
