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Business > FIN 3305 Exam 1 > Flashcards

FIN 3305 Exam 1 Flashcards

1
Q

Definition of Risk

A

Uncertainty about economic loss

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2
Q

What are the consequences of risk?

A

Risk creates additional costs for businesses, government, and individuals
- Losses (when they occur)
- Higher borrowing costs
- Greater liquidity needs
- Opportunity costs

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3
Q

Cost of Risk

A

Cost to finance potential losses + cost of unreimbursed losses + outlays to reduce risk + opportunity cost of forgone activities

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4
Q

What are the 4 Categories of Risk?

A
  1. Pure vs. Speculative Risk
  2. Fundamental vs. Particular Risk
  3. Static vs. Dynamic Risk
  4. Subjective vs. Objective Risk
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5
Q

Pure Risk

A

2 Possible outcomes: loss or nothing
(ex. fire, theft, flood)

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6
Q

Speculative Risk

A

3 Possible Outcomes: Loss, nothing, or GAIN
(ex. investing, gambling, entrepreneurship)

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7
Q

Fundamental Risk

A

Impacts a large number of people or companies
(ex. Hurricanes, inflation, pandemics)

**Losses are correlated

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8
Q

Particular Risk

A

Impacts only one or a few people or companies
(ex. auto accidents, burglaries, lightning strikes)

**Losses are uncorrelated

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9
Q

What is one important thing to note about fundamental vs. particular risk? (category 2)

A

Unlike pure vs speculative, this is a continuum … some risks impact a medium number of people and could be categorized as either

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10
Q

Static Risk

A

Risk in an unchanging environment
(ex. lightning, windstorms, death)

**These risks look similar from each year to the next

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11
Q

Dynamic Risk

A

Risk created by changes in society
(cyber attacks, regulatory/tax compliance, oil prices)

**These risks look quite different each year

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12
Q

Subjective Risk

A

Risk based on the mental state of an individual; Stems from doubt or worry about outcomes; Psychological uncertainty (ex. fear of airplane travel)

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13
Q

Objective Risk

A

The probable variation of actual from expected experience; Precisely observable and thus measurable
(ex. outcome of a dice roll)

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14
Q

Property Risk

A
  • The risk that property may be damaged, destroyed, or stolen
  • Property includes real property (land, buildings, and the things attached to them) and personal property (items that can be moved, such as inventory and vehicles)
  • Property losses that happen to others can have domino effects - a fire at a supplier can cause interruptions and shortages for others in the supply chain.
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15
Q

Liability Risk

A
  • The risk of being held financially liable for “damages” to another party (ex. bodily injury, property damage, breach of contract, regulatory noncompliance)
  • Stems from judicial and regulatory systems
  • Damages include judgements, settlements, legal fees, and fines
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16
Q

Life, Health, and Loss of Income Risk

A
  • The risk that a person loses their ability to generate income
  • Can be caused by death, injury/illness, retirement, unemployment, etc.
  • In addition to loss of income, there may be: funeral costs, medical expenses, additional education/training/travel
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17
Q

Financial Risk

A

The risk created by fluctuations in financial markets and economies (ex. credit risk, commodity prices, foreign exchange rates, investment returns, interest rates)

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18
Q

Peril

A

A cause of a loss

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19
Q

Hazard

A

Conditions that increase the cause of loss

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20
Q

Loss

A

Injury or damage sustained by an insured

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21
Q

Identify the Peril, Hazard, and Loss in this scenario

“Rashid wrecked his car in the rain yesterday, resulting in a dented fender and crumpled hood”

A

Peril - wrecked his car
Hazard - in the rain
Loss - dented fender and crumpled hood

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22
Q

Moral Hazard

A
  • An intentional change in behaviors or attitudes caused by the presence of insurance
  • People act differently when they have insurance than when they don’t
  • Ex. Committing arson to collect insurance money on a building
  • Can be, but is not necessarily, immoral behavior … How likely are you to go to the doctor for a cold if you don’t have insurance?
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23
Q

Morale Hazard

A
  • Carelessness or indifference to loss, usually caused by the presence of insurance or other protection from loss
  • Ex. Forgetting to lock your front door, distracted driving, building in a flood zone
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24
Q

Moral Hazard vs. Morale Hazard

How does this relate to “Adverse Selection”?

A
  • Insurance traditionally distinguishes between these two, economics does not
  • Closely related to “adverse selection” - the tendency of a higher-than-average risk to seek insurance coverage at the rate for an average risk
  • Both are issues of asymmetric information - the insured knows more of their own behavior and motives than the insurer
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25
Q

Risk Management

A
  • The process used to systematically manage risk exposures
  • Traditionally referred to management of PURE RISKS only
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26
Q

Risk Manager

A

A person responsible for minimizing the adverse impact of losses on the achievement of a company’s goals

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27
Q

Enterprise Risk Management (ERM)
(also known as “integrated risk management”)

A
  • A modern and expanded risk management approach which targets all forms of risk
  • Management of BOTH pure and speculative risks
    *Also known as integrated risk management
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28
Q

Chief Risk Officer (CRO)

A

A risk manager responsible for coordinating and executing a company’s ERM strategy

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29
Q

Risk Management Process

A
  1. Identify risks
  2. Quantify risks (frequency and severity)
  3. Evaluate
  4. Model - risk map
  5. Manage
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30
Q

How is financial statement analysis important in the risk management process?

A
  • Review of a firm’s balance sheet and income statement
  • Helpful to identify risks associated with: asset values, market risks, and business interruption
  • Also useful to review strategic plans, budgets, forecasts, etc.
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31
Q

Loss Exposure Checklists
(way of identifying risk)

A
  • Lists of potential sources of loss
    • Audits
    • Customer complaints
    • Industry trends
    • Current Events
    • New or pending legislation or regulation
  • “Is this a potential source of loss to me or my firm?”
  • Focuses primarily on property and liability exposure
  • Some lists are designed for specific industries (ex. education)
  • Some lists focus on specific risk categories (ex. property)
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32
Q

Loss Exposure

A

A potential loss that may be associated with a specific type of risk

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33
Q

Analysis of Past Losses
(way of identifying risk)

A
  • Review loss history (lawsuits, regulatory fines, significant financial losses)
  • Conduct statistical analysis
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34
Q

Risk Management Information System (RMIS)

A
  • Software to track past losses and their characteristics
  • Increasingly sophisticated and user-friendly
  • Trend toward web-based access
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35
Q

Flowcharts
(way of identifying risk)

A
  • Graphical representation of a firm’s inputs, processes, and outputs
  • “What events could disrupt the even and uninterrupted flow of parts to the final assembly floor, on which the whole production process depends?”
  • Helpful to identify risks associated with: supply chains, interdependencies between two processes, Potential bottlenecks and domino effects
    *Pay special attention to new products, procedures, personnel
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36
Q

Contract Analysis
(way of identifying risk)

A
  • Review of the firm’s contracts with other parties
  • Helps to identify
    1. New risks from other parties
    2. Whether the firm is effectively transferring risk to
    other parties
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37
Q

Contractual Liability

A

Liability arising from contractual agreements, which state that some losses (if they occur) are to be borne by specific parties

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38
Q

On-site inspections
(way of identifying risk)

A
  • Physical inspection of property
  • May include interviews/discussions with on-site employees
  • Helps to identify both property and liability risk (and hazards)
  • Can be done by internal parties (risk manager) or external parties (consultant)
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39
Q

Risk Maps
(way of evaluating risk)

A
  • A matrix of all major risks the firm faces
  • Plots frequency against severity
  • May also denote risk type, risk management activities, etc.
  • Helps to prioritize risks and allocate risk management resources
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40
Q

Frequency
(way of evaluating risk)

A
  • The long-term probability of an event’s occurrence (aka chance/likelihood)
  • ranges from 0 (impossible) to 1 (certain)
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41
Q

Probability Distribution

A

Mutually exclusive and exhaustive list of possible events and their probabilities

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42
Q

Law of Large Numbers (LLN)

A
  • As the number of exposure units increases, the more likely that actual loss experience will equal probable loss experience
  • In other words … if you have more data, your predictions will be more accurate
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43
Q

How many exposure units are needed? (LLN formula)

A

S = number of standard deviations in the distribution
p = probability of loss
E = degree of accuracy required

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44
Q

Chance of Loss

A
  • The probability that a specific loss occurs in a particular period of time
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45
Q

Expected Loss

A

The average loss amount, adjusting for loss probability

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46
Q

Degree of Risk

A
  • The amount of objective risk present in a situation
  • The difference between actual losses and expected losses
  • Actual losses involve a range of outcomes
  • Captures variation around expected loss

(only meaningful for uncertain events … definite or impossible events do not involve risk)

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47
Q

Measuring Degree of Risk (calculation)

A
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48
Q

Risk Evaluation

A

Estimate frequency and severity of potential losses

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49
Q

Inherent Risk

A

Risk before any risk management implemented

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50
Q

Residual Risk

A

Risk remaining after risk management has been implemented

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51
Q

Common Measures of Risk

A

Frequency and Severity

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52
Q

Frequency

A

The number of losses during a specified period

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53
Q

Severity

A

The average magnitude of loss (usually $ value) per claim

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54
Q

Mean

A

Sum of measurements divided by number of measurements (average)

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55
Q

Median

A

The midpoint in a range of measurements

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56
Q

Mode

A

The value that occurs most often in a frequency distribution

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57
Q

Is severity a continuum?

A

Yes, severity is a continuum - assets may not be completely destroyed

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58
Q

Maximum Probable Loss

A

The likely amount of loss that might result

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59
Q

Maximum Possible Loss

A

The worst amount of loss that could result

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60
Q

Historical Method of Valuing Risk

A

Measuring actual gains or losses over a period of time

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61
Q

Probability

A

The long-term frequency of an event’s occurrence (aka likelihood); Ranges from 0 to 1

62
Q

Expected Value or Expected Loss

A

Uses weighted averages based on the probability of certain events; Some events are more likely than others

63
Q

Common Measures of Risk

A

Variance and Standard Deviation

64
Q

How are Variance and Standard Deviation related?

A

Square root of variance = standard deviation

65
Q

Coefficient of Variation

A
  • The standard deviation of a distribution divided by its mean
  • It compares risk (measured by the standard deviation) to the expected result (mean)
  • It is especially useful to indicate a relative value of risk when the means of the distributions are not equal
66
Q

The Normal Distribution

A
  • Aka the “bell curve”
  • ~68% of observations are within 1 standard deviation of the mean
  • ~95% of observations are within 2 standard deviations of the mean
  • ~99% of observations are within 3 standard deviations of the mean
67
Q

How is the normal distribution useful in risk management?

A
  • Useful in measurement of natural phenomena
  • Often used for systemic risks such as currency exchange risk, inflation, and interest rates
  • Can measure infinite outcomes (ex. different levels of $ losses per occurrence)
68
Q

The Binomial Distribution

A
  • Measures number of outcomes in a fixed number of trials
  • Probability of an event is p
  • Probability of an event NOT happening is q = p-1
  • There are n possible times the event could happen
  • The probability that the event happens r times
69
Q

Requirements for a Binomial Distribution

A
  1. Must have a fixed number of occurrences in view
  2. Outcomes measured must be binary
70
Q

The Poisson Distribution

A
  • Models the number of events occurring in a fixed interval of time or space
  • Event occurs with probability p
  • Mean loss frequency is m
  • The probability that the event happens r times
    (e is the constant 2.72)
71
Q

What is a requirement of the Poisson Distribution and how is it useful?

A
  • Outcomes measured must be binary
  • Useful in predicting the number of events over a specific time
  • Useful for measuring relatively rare and independent events
72
Q

Value at Risk (VAR)

A
  • The maximum amount exposed to loss with a specified degree of likelihood
  • Holistic measure that captures correlation between risks
73
Q

Risk-Adjusted Return on Capital (RAROC)

A

The capital required to keep the probability of bankruptcy below a specified level, given the risk posed by the organization’s activities

74
Q

Real Property
(Category of Loss Exposure)

A

Land and all structures permanently attached to land (buildings, fixtures, crops)

75
Q

Personal Property
(Category of Loss Exposure)

A

All other property (not permanently attached to real property); Vehicles, contents

76
Q

Liability
(Category of Loss Exposure)

A

Amount owed to reimburse another for injury caused by you or your personal property or occurring on your real property

77
Q

Direct Loss
(Types of Loss)

A

A loss that stems directly from an unbroken chain of events leading from a peril to a loss (ex. fire damage, theft, bodily injury)

78
Q

Indirect Loss
(Types of Loss)

A

A loss that occurs as the consequence of a direct loss (business interruption, renting alternative space, loss of income)

79
Q

Bodily Injury
(Types of Liability Damages)

A

Damages to a person’s body or mind (medical bills, loss of income, rehabilitation costs, pain and suffering, punitive damages)

80
Q

Property
(Types of Liability Damages)

A

Property damage to property of another; Includes indirect damages such as loss of use

81
Q

Legal Expenses
(Types of Liability Damages)

A

Legal expenses to defend; Most liability insurance includes coverage for defense costs

82
Q

Criminal Law

A
  • Wrongs against society (murder, robbery, rape, assault, etc)
  • Charges made by government body or agent
  • Punishable by fine and/or imprisonment
  • Limited risk management options, not insurable
83
Q

Civil Law

A
  • Wrongs against individuals or organizations (breach of contract, negligence, etc)
  • Lawsuit filed by injured party
  • Punishable by paying damages, fines, require change in action
  • Primary focus on liability risk management
84
Q

Can one action result in both criminal and civil charges?

A

Yes

85
Q

Torts

A
  • A legal injury or wrong to another that arises out of actions other than breach of contract
  • Civil action
  • Negligence is primary focus
  • Torts also include intentional torts, such as libel, slander, trespass, and assault
86
Q

Negligence

A
  • The failure to exercise the degree of care required by law
  • Injured party (plaintiff) must prove 4 elements
87
Q

What must the plaintiff prove in negligence cases?

A
  1. Legal duty owed (reasonable care)
  2. Breach of legal duty
  3. Damages (usually bodily injury or property damage)
  4. Proximate cause of loss
88
Q

Does negligent action have to be voluntary and intentional?

A

Negligent action must be voluntary, does not have to be intentional

89
Q

Vicarious Liability

A

Imputed acts may transfer liability to another (ex. employer may be held liable for employee’s negligence)

90
Q

Contributory Negligence
(Defenses to Negligence)

A

If plaintiff contributed to their own injury, they may not recover any damages (only in some states)

91
Q

Comparative Negligence
(Defenses to Negligence)

A

If plaintiff contributed to their own injury, damages are allocated based on percentage of fault

92
Q

Assumed Risk
(Defenses to Negligence)

A

Plaintiff assumed that there was risk of harm from:
1. Conduct of the defendant
2. Condition of the premises
3. The defendant’s product

93
Q

Guest-Host Statutes
(Defenses to Negligence)

A

State laws that lower the standard of care an automobile driver owes to their passengers

94
Q

Factors Leading to Higher Standards of Care

A
  • Expanding application of liability
  • Weakening of defenses against liability
  • Changing concepts of damage
  • Increased damage awards
95
Q

Res ipsa loquitur

A

“the thing speaks for itself”
Plaintiff may collect without proving negligence in some circumstances

96
Q

Joint and Several Liability

A
  • Expansion of imputed (vicarious) liability
  • If several different parties are negligent, larger parties may pay more than their share of damages
97
Q

Employer-Employee Liability

A

Employers owe the following duties to their employees:
* Provide a safe place to work
* Employ people reasonably competent to carry out tasks
* Warn of danger
* Furnish appropriate and safe tools
* Set up and enforce proper rules of conduct as they relate to safe working procedures

98
Q

What laws do employee injuries usually fall under?

A

Employe injuries usually fall under workers’ compensation liability laws, but there are some exceptions

99
Q

Property Owner-Tenant Liability

A
  • Owner or tenant of real property has a duty of care to those who enter
    - Highest degree of care for invitees (customers, guests)
    - Lower degree of care for licensees, who are on the
    premise with permission (police officers, firefighters,
    delivery drivers)
    - No degree of care owed to trespassers (but cannot
    deliberately injure)
  • Tenant usually takes on duty of care from landlord in the lease contract
100
Q

Attractive Nuisance Doctrine

A

A higher degree of care is owed to children when property contains items that may attract them (ex. swimming pool)

101
Q

Liability with the Consumption or Use of Products

A
  • Sellers (including manufacturers) have a duty to ensure their products are safe
  • Goods must be reasonably fit for their intended purpose
  • Breaching this duty may be grounds for negligence
  • Dangerously defective products may fall under “strict liability”, which has a lower burden of proof than negligence
102
Q

Liability with the Ownership and Operation of Automobiles

A
  • Operator of vehicle may be liable for bodily injury or property damage in an accident
  • Employers may be vicariously liable for negligent drivin by their employees in the course of their work
  • Owners are typically not held negligent if someone else drives their vehicle (primary exception: head of a household may be responsible for family members driving their vehicle, especially minor children)
103
Q

Professional Liability

A
  • Liability arising from errors of a professional in the performance of his/her duties
  • Medical malpractice is probably the most well-known
  • Also accountants, lawyers, insurance agents, architects, etc.
104
Q

Contractual Liability

A

Liability created or transferred by the terms of a contract

105
Q

Completed Operations of a Contractor

A

Liability arising from errors in construction or installation after the work has been completed

106
Q

Principal-Agent Liability

A

Principals (those directing work) may be legally liable for the actions of their agents (those conducting the work)

107
Q

Risk Avoidance
(Risk Mgt. Techniques - Non Insurance)

A
  • A conscious decision not to expose oneself or one’s firm to a particular risk of loss
  • Consequences: sometimes results in assuming more risk, inefficiencies, loss of opportunity
108
Q

Loss Control
(Risk Mgt. Techniques - Non Insurance)

A
  • Actions to reduce the frequency and/or severity of losses
  • Conscious decisions about how activities are conducted
109
Q

Loss Prevention

A

Actions to reduce the FREQUENCY of loss
(ex. security measures, training, and process)

110
Q

Loss Reduction

A

Actions to reduce the SEVERITY of loss
(sprinklers, crash barriers)
Separation - Dispersal of activities (includes diversification)
Duplication - Redundant systems

111
Q

When is loss control implemented?

A

Loss control can be implemented pre-loss, concurrent to loss, or post-loss

112
Q

Can some loss control activities lower both frequency and severity?

A

Yes, but usually one more than the other

113
Q

Benefits of Loss Control

A
  • Long-Term savings from fewer or smaller losses
  • Lower costs for other risk management investments (ex. lower insurance premiums)
  • Intangibles such as higher employee morale and positive public relations
114
Q

Costs of Loss Control

A
  • Dollar amounts invested to implement loss control, such as installation and maintenance
  • Some costs are not immediately obvious (ex. electricity bills)
  • Possible reduction in efficiency or productivity
115
Q

Risk Retention

A

Paying for losses with available funds

116
Q

Planned Retention

A

Conscious and deliberate assumption of risk

117
Q

Unplanned Retentions

A

Implicit assumption of risk, usually because the risk was not identified or was underestimated

118
Q

Funded Retention

A

A pre-loss arrangement to ensure that money is readily available to pay for losses that occur (high-severity losses)

119
Q

Unfunded Retention

A

Absorbing the expense of losses as they occur (low-severity losses)

120
Q

Credit
(Types of Funded Retention)

A

(ex. Bank loan)
* May be challenging for high-severity risks
* Important to arrange pre-loss

121
Q

Reserve Funds
(Types of Funded Retention)

A

(ex. savings)
* Good for smaller-severity losses
* Cash holdings are key

122
Q

Self-Insurance
(Types of Funded Retention)

A
  • A form of reserve funding using sophisticated modeling to predict needs
  • Need large group of exposure units (to take advantage of the law of large numbers)
123
Q

The Retention Decision

A
  1. Financial Resources
    (Does the firm have sufficient funds to pay for losses?)
  2. Ability to Predict Loss
    (Can loss frequency and severity be predicted)
  3. Administrative issues
    (Will the firm need to dedicate significant resources to investigating, managing, and paying for losses?)
124
Q

Risk Transfer

A

Shifting responsibility for payment of a loss to another party

125
Q

Methods of Risk Transfer

A
  1. Insurance - Special contracts involving pooling of risks
  2. Incorporation
  3. Contracts
  4. Capital Market Transactions
126
Q

Incorporation
(Methods of Risk Transfer)

A

Incorporation creates a “corporate veil” between the assets of the firm and the assets of its owners; Effectively transfer risk to creditors

127
Q

Contracts
(Methods of Risk Transfer)

A
  • Warranty - Manufacturer accepts risk of loss due to repair or replacement for a limited time
  • Guaranty - Person exposed to potential loss seeks a third party to pay for any loss
  • Allocation of liability for various events can be specifically described in a contract (usually occurs in an “indemnity” or “hold harmless” clause.
128
Q

Hold-Harmless Agreements

A

Provisions inserted into contracts that transfer responsibility for losses from one party to another

129
Q

Limited Form Hold-Harmless Agreements

A

Clarifies that all parties are responsible for liabilities arising from their own actions

130
Q

Intermediate form Hold-Harmless Agreements

A

One party agrees to pay for any losses that both parties are jointly responsible for

131
Q

Broad Form Hold-Harmless Agreements

A

One party agrees to pay for all losses, regardless of fault

132
Q

Typical Financial Risks

A

Price changes, interest rate changes, currency exchange rates, liquidity, credit risk, general market conditions

133
Q

What kind of risks are financial risks?

A

Financial risks are speculative risks (there is a possibility of gain or loss)

134
Q

3 Financial Risk Management Techniques

A

Diversification, Hedging, Securitization

135
Q

Describe Diversification

A
  • Strategy to reduce unsystematic risk - risk that is unique to a specific investment
  • Adding additional assets to portfolio from a different company/source reduces variance and standard deviation of expected results (i.e. reduces risk)
  • Tools include mutual funds, REITS, money market funds, reinsurance (for insurers)
136
Q

How are hedging and securitization usually done?

A

Generally done by using derivatives

137
Q

Derivatives

A

A financial security whose value is derived from another underlying asset

138
Q

Futures

A

A contract to buy or sell an asset for a specified price at a specified future time that is standardized and traded on an exchange

139
Q

Forwards

A

A contract to buy or sell an asset for a specified price at a specified future time that is specific to a customer and traded over the counter

140
Q

Spot Price

A

The current price for a particular asset on the public market

141
Q

Basis

A

The difference between spot price and the price of the asset in the futures or forward contract with the closest expiration date

142
Q

Options

A
  • A contract that gives the right to buy or sell an asset for a specified price at a specified future time
  • Differs from a forward/futures contract because of OPTION to buy or sell, not an obligation to buy or sell
143
Q

Call Option

A

The right to buy at a specific price

144
Q

Put Option

A

The right to sell at a specific price

145
Q

Strike Price

A

The price that triggers the right to buy or sell - aka exercise price

146
Q

Swaps

A

Agreement to exchange or transfer variable factors for a fixed contractual price
* Commodity prices
* Interest rates
* Exchange rates

147
Q

Securitization

A

Process by which illiquid assets are converted into tradable securities

148
Q

Asset-Backed Security (ABS)

A

Generic term for a tradable security backed by a pool of cash-producing assets

149
Q

Mortgage-Backed Security (MBS)

A

ABS backed by a pool of mortgages

150
Q

Collateralized Debt Obligation (CDO)

A

ABS backed by a pool of diversified assets

151
Q

Credit Default Swaps

A

Derivative providing the security investor a guaranty of income stream should the underlying asset in the derivate fail to provide the expected income stream

152
Q

Catastrophe (Cat) Bonds

A
  • Cat Bonds are a form of securitization
  • The risk of catastrophes are transferred from insurers to investors in capital markets
  • If insurers suffer large loss from defined catastrophic events, investors in Cat Bonds lose their money
  • The insurance risk of the insurance company is traded - by making it a commodity and taking it to the capital markets in addition to or instead of to the insurance/reinsurance market

Business (3 decks)

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