Chapter 5 - Key risk-management concepts Flashcards
What is a risk?
A risk is an uncertain, random event which may occur in the future – its likelihood can only be estimated
Frank Knight formalised a clear distinction between risk and uncertainty - what is this?
- Uncertainty is something that is unquantifiable due to the unpredictability of future event constraints.
- Risk is something that can be estimated with a certain degree of confidence using statistical methods.
Give examples of uncertainty
- The effects of negative news media coverage
- The effects of political or regulatory change
- The research and development of a new product
What is a risk event?
any outcome that arises from a single decision or an action that could result in more than one potential outcome. Every outcome in an organisation is technically a risk event.
What is the difference between a pure and speculative risk?
Pure risks are risks that only have neutral or negative outcomes, such as a fire, physical injury or illness
Speculative risks are risks that may have three outcomes: positive, neutral or negative. Gains are usually financial but they can also be non-financial human welfare or social gains, such as improved health, happiness or environmental benefits.
What is the difference between inherent, residual and target risks?
Inherent risk means the level of risk or exposure that is present in the absence of any controls or mitigating actions to manage the risk in question.
Residual risk describes the level of exposure that remains given the current effectiveness of the controls that are in place to manage the risk in question
Target risk – the desired level of risk exposure, usually the level required to keep within the risk appetite
What is the difference between principal and emerging risks?
**Principal risk **(significant or key risk) is a risk that is considered material and can affect the viability of the business. In finance, a principal risk is also defined as the risk of losing an entire investment.
Emerging risk (also known as disruptive risk) refers to the risk that does not yet affect an organisation but may develop to become a principal risk in the future e.g. changes in consumer tastes and preferences, use of AI, etc.
What is a risk profile?
Risk profile represents a combination of all principal and emerging risks that an organisation faces
What is a tail risk or black swan event?
Tail risk (‘black swan’ events) is the risk arising from a highly improbably and difficult-to-predict event or an event that has a very small probability of occurring but has widespread ramifications e.g. COVID-19 or 9/11 attacks
What is a cliff risk?
Cliff risk – risk arising from an event that is probable and has widespread ramifications (high impact) e.g. credit-rating downgrade, the UK leaving EU without a deal in place, etc.
What is a wrong-way risk?
Wrong-way risk – when the risk exposure to a counterparty is adversely correlated to the credit quality of that counterparty. This is mostly used in relation to poorly collateralised transactions. E.g. bank lending money against the company’s own equity shares as collateral, with the bank now exposed to the wrong-way risk.
What is a risk taxonomy?
Risk taxonomy is a set of all risk categories used within an organisation.
How would you categorise risk using CLOMBR?
- Credit risk – risk that borrower will suffer a real or perceived deterioration in its credit rating
- Liquidity risk – asset degree of illiquidity – the inability to easily sell this asset – Northern Rock
- Operational risk – risk of loss resulting from inadequate or failed internal processes, people and systems or from external events e.g. fraud by employees, human error, damage to physical assets, IT breakdown etc.
- Market risk – systematic risk – risk inherent to the entire market
a. Equity
b. Interest-rate
c. Foreign-exchange risk
d. Commodity price risk - Business risk – non-financial – specific actions of its competitors and changes in economic or political conditions – e.g. changes in minimum-wage, or competitor acquiring another business – Blockbuster – physical DVDs and reliance on late fees
- Reputation risk – example of strategic risk – risk of loss resulting from damages to the reputation of an organisation, the value of its brand and perceived goodwill – intangible – gives competitive advantage – Sports Direct
Using PES, what are the three risk categorisation’s set by Kaplan and Mikes?
- Preventable – internal risks faced by an organisation that are controllable e.g. employee risks. Best managed through active prevention: monitoring risky activities and guiding human behaviours within an organisation
- External – beyond an organisation’s influence or control e.g. major political changes, wars and natural disasters – can be managed through identification and mitigation, business continuity and disaster planning
- Strategy – assumed by organisations willingly in order to gain a competitive advantage
a. Credit
b. Research and development
c. Mergers
d. Major change project e.g. new IT system
What are cognitive biases and give four examples
Cognitive biases may affect the decision-making process, especially when it comes to estimating the impact from emerging risks
Influencing factor that causes someone’s judgement to deviate from a norm or from rationality
- Group-think bias happens when individual decision-makers strive for group consensus over alternative viewpoints
- Authority bias when senior member’s viewpoints overrules the viewpoints of other contributors
- Status quo bias favours preservation of the current state
- **Myopia bias **leads to an increased focus on smaller and less impactful risks at an expense of more strategic
