Chapter 26 - Risk identification and classification

Question 1

Outline 5 methods of identifying the risks associated with a project

Answer 1

D HERB

• DESKTOP analysis e.g. research similar projects
• HIGH-LEVEL preliminary analysis to confirm that the project does not have such a high-risk profile that it is not worth analysing further
• get EXPERTS opinions and out line plans for financing it
• RISK register / matrix with cross-reference to risks where there is interdependency
• BRAINSTORMING session with project experts and senior internal and external people with the aim to:
  - identify project risks, upsides and downsides
  - discuss these risks and interdependency
  - place a broad initial valuation on each risk
  - generate mitigating options
  - discuss these options briefly

Question 2

Suggest 7 categories of risks that could be used in a risk matrix for a typical project

Answer 2

PNEFCPB

1. Political - opposition to project, war, terrorism, etc
2. Natural - earthquakes, hurricanes
3. Economic - interest rate or exchange rate movements
4. Financial - sponsor default, incorrect cashflow estimates
5. Crime - fraud, theft
6. Project - time delays, budget overruns, bad design
7. Business - competition/lack of demand, operational problems

Question 3

What are the main risk categories

Answer 3

MOLE BC

• MARKET
• OPERATIONAL
• LIQUIDITY
• EXTERNAL
• BUSINESS
• CREDIT

Question 4

Market risk

Answer 4

The risk related to changes in investment market values or other features correlated with investment markets such as interest rates/inflation

Question 5

What is the effect of an increase in short term interest on fixed-interest bonds?

Answer 5

an increase in i will cause the price of short-term bonds to fall.

the values of long term bonds may go up or down depending on investors views on future levels of inflation and monetary policy

Question 6

What is the effect of an increase in short term interest on index-linked bonds

Answer 6

if higher short-term interest rates are interpreted as a sign of lower expected future inflation, then the demand for index-linked bonds, and so their values, might fall

Question 7

What is the effect of an increase in short term interest on equities

Answer 7

higher i might depress economic growth and so equity values might fall

Question 8

What is the effect of an increase in short term interest on property

Answer 8

higher i should lead to lower valuation of rents and therefore lower capital values of property

Question 9

Market risk could be removed through holding an asset portfolio that perfectly matches the liability portfolio.

Give reasons why a perfect match of assets and liabilities may not be possible in practice.

Answer 9

OUD WC

Liabilities may include OPTION and hence have uncertain cashflows after the option date.

Liabilities may be UNCERTAIN in amount and timing

Liabilities may include DISCRECINARY benefits

There may not be a WIDE enough range of assets available; in particular it may not be possible to find assets in sufficiently long duration.

The COST of maintaining a full-matched portfolio is likely to be prohibitive

Question 10

Outline 3 subdivisions of market risk

Answer 10

1. The consequences of changes in asset values (due to changes in the market value of assets or changes in interest and inflation rates)
2. The consequences of a change in investment market values on liability values, where liabilities are directly related to investment market values, interest rates or inflation rates.
3. The consequences of not matching assets and liability cashflows

Question 11

Credit risk

Answer 11

The risk of failure of third parties to meet their obligations

Question 12

Outline 5 factors that an investor should consider when assessing the security of a debt and the borrower

Answer 12

CT MAN

• COVENANT of the borrower
• nature of TRANSACTION underlying the borrowing
• MARKET circumstances
• AVAILABLE securities
• comparative NEGOTIATING strength of lender + borrower

Question 13

Liquidity risk

Answer 13

The risk that an insurer, although solvent, does not have sufficient capital available to enable it to meet its obligations as they fall due. The risk for an insurer is usually low since investments usually include a large proportion of cash, bonds and stock market assets

Question 14

Business risk

Answer 14

Risk specific to the business undertaken

Question 15

Categories of business risk

Answer 15

IF EU

• INSURANCE risk; uncertainties arising from claim rates and claim amounts
• FINANCING risk; arising in relation to the financing of projects or other activities
• EXPOSURE risk; arising in relation to the amount of business sold or retained, or to its concentration or lack of diversification
• UNDERWRITING risk; arising in relation to the underwriting approach taken

Question 16

Operational risk

Answer 16

The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. (non-financial risk that has a financial consequence)

Question 17

Give 5 examples where operational risk can arise from.

Answer 17

FIT DC

The FAILURE of recovery plans following an external event

INADEQUATE or failed internal processes, people or systems.

Reliance on THIRD parties to carry out various functions for which the organization is responsible, e.g. outsourcing

The DOMINANCE of a single individual over the running of a business (dominance risk)

CONDUCT risk, e.g mis-selling, interest rate manipulation and money laundering

Question 18

External risk

Answer 18

Arises from external events. e.g storm, fire, terrorist attacks

is a form of non-financial risk but is separate from operational risk

failure to arrange mitigation against such risks is an operational risk