CHP 39 Flashcards
- Categories of risk
Financial
Non-financial
- Categories of risk explanation
A clear understanding of the business and the organizational structure is very important when assessing the significance of each risk and how the outcome of that risk translates into financial impact on the balance sheet (capital position) and cashflow (liquidity) requirements.
Financial risks
Market
Credit
Business
Liquidity
Non Financial risks
Operational
External
Market risks
- Assets
- Liabilities
- Asset/Liability matching
Credit risks
- Asset default
- Counterparty risk
- Debtors
Business risks
- Underwriting
- Insurance
- Financing
- Exposure
Operational risks
- Business continuity
* Third party admin
Credit risk – the risk of failure of third party to repay debts.
Examples are:
- Corporate defaulting on bond. Also used to explain the risk of any credit event e.g. get down graded.
- Counterparty risk
- General debtors
2.2. Principles of good lending – the “canons of lending”
Character and ability
Is the borrower known, competent and trustworthy?
Do key personnel have the required depth and spread of skills and experience?
2.2. Principles of good lending – the “canons of lending”
Purpose
What use will the money be put?
Is the borrower in a sector where there are concerns, or where the total exposure is already sufficient?
Will the lending be subject to country, currency, environmental, resource, technological or other inherent risks? Ethical and moral grounds?
Are there controls to ensure the funds are correctly applied?
2.2. Principles of good lending – the “canons of lending”
Amount
Is the amount reasonable given the stated purpose? How much is the company contributing?
2.2. Principles of good lending – the “canons of lending”
Repayment
How certain is the source of repayment? What margins of safety has been built in?
2.2. Principles of good lending – the “canons of lending”
The decision process – risk vs reward
Some losses are inevitable no matter how well-regulated the lending process is – this must be recognized and built into the pricing models. Due diligence will reduce default.
2.4. Credit rating
Given by a rating agency and indicates the likelihood of default. A company may take action to improve credit rating and this will affect the market for that company’s and other companies’ shares.
The decision as to what security is taken is dependent on:
• The nature of the transaction underlying the borrowing
• The covenant of the borrower
• Market circumstances and the comparative negotiating strength of lender and borrower
• What security is available
It must be within the ability of the lender to realize the security if necessary in a cost-effective manner.
3.1. Market liquidity risk
Liquidity risk is where the market does not have capacity to handle the volume of an asset to be bought or sold at the time the deal is required without a potential adverse impact on the price. In general, the larger the market, the more liquid. This is because more participants trade at any time.
Marketability is
Marketability is how easy an asset can be converted into cash – nothing to do with the price.
Liquidity is
Liquidity is a measure of how long it will take an asset to become cash.
3.2. Individual or company liquidity risk
The risk that a company or individual (although solvent) does not have enough financial resources to meet its obligations as they fall due, or can secure resources only at excessive cost.
- Market risk defn
Risks relating to changes in investment market values or other features correlated with investment markets, such as interest and inflation rates.
Market Risks can be divided into:
- Consequences of changes on asset values – this is the most obvious implication
- Consequence of investment market value changes on liabilities
- Consequences of a provider not matching asset and liability cashflows
Asset value changes can result from:
- Changes in market values of equities and property. These risks can be systemic if they occur across all markets under consideration. It can be diversified in broad markets by holding a range of assets and asset classes.
- Changes in interest and inflation rates. These primarily affect the price of fixed interest and index-linked securities. There is usually a smaller effect on equities and property.
4.2. Liability value changes
These may occur because promises to stakeholders, policyholders or scheme members are directly related to investment market values or interest rates.
Alternatively, a change in interest or inflation rate may affect the level of provisions a provider needs to establish for future liabilities.
4.3. Asset / liability matching
Fundamental principle of investment: assets should be selected to match liabilities in nature, term and currency.
In practice a perfect hedge may not be possible because:
• There may not be a wide enough range of assets available, particularly at long durations.
• Liabilities may include options and hence have uncertain cashflows after option date
• Liabilities include discretionary benefits
• The cost of maintaining a fully- matched portfolio is likely to be prohibitive.
Thus, even well matched portfolios are likely to retain some element of risk.
Free assets give freedom to intentionally take an unmatched position in hope of achieving additional return. The capital will be used to cover the cost of the risk taken.
- Business risk
These are specific to the business undertaken. Business risk is different from operational risk in the sense that operational risk is non-financial events that have financial consequences.
Examples of business risk to financial product providers are:
- Inadequate underwriting standards, and thus taking on risk at a too low price – underwriting risk.
- An insurer suffering from more than expected claims – insurance risk.
- Provider of finance investing in a project that fails – financing risk.
- Reinsurer having greater exposure to a particular risk event than expected – exposure risk.
Integrated risk covers
Between insurers and reinsurers usually
Used to smooth results, avoid excess cover, lock into attractive terms
Securitisation
Transfer of insurance risk into the banking sector and capital markets
Insurance risk is uncorrelated with market risk so attractive to investors
