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Finance > Mod 13: Risk and Return > Flashcards

Mod 13: Risk and Return Flashcards

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1
Q

Business risk definition

A

The volatility of earnings arising from a change in a business’ operations or environment

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2
Q

Types of risk

A
  1. Business risk
  2. Non- business risk
    - Event risk
    - Financial risk
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3
Q

Examples of business risk include:

A
  1. Operational failings
  2. Gov’t actions (political risk)
  3. Failure in strategy
  4. Technological change
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4
Q

Business risk: operational failings

A

Failings due to HUMAN ERROR, breakdowns in internal procedures or systems failures/
= damage to an organisation’s reputation

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5
Q

Business risk: Gov’t actions (political risk)

A

Foreign investments = vulnerable to this. Possibility of restrictions on the right to repatriate funds, change tax levels or changes in the legal framework for doing business in a country

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6
Q

Business risk: failure in strategy

A

Insufficient understanding of the business environment e.g. different working practices and cultural norms which have a profound effect on the viability of an international investment proposition

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7
Q

Business risk: Technological change

A

may lead to product obsolescence

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8
Q

Non-business risk

A

Includes financial and event risk

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9
Q

Non business risk: Event risk

A

arises due to an ADVERSE EVENT e.g. an accident or natural disaster, or the loss of a key member of mgmt team

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10
Q

Non-business risk: Financial risk

A

Volatility of earnings due to the financial policies of a business

  • can arise form LT or ST factors
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11
Q

Non-business risk: LT Financial risk

A
  1. risk arising from company’s financial structure. If financial gearing is high => SH returns subject to higher degree of variability
  2. Risk of not being able to access funding
  3. Whether organisation has insufficient LT capital base for the amount of trading it is doing (overtrading)
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12
Q

Non-business risk: ST financial risk

A
  1. Credit risk
    - possibility of payment default by the customer (MOD 3)
  2. Liquidity risk
    - risk company cannot access the cash it needs in a cost efficient manner (MOD 2)
  3. currency and interest rate risk
    - risk arising from unpredictable CFs due to interest rate or exchange rate movements
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13
Q

Relationship between business and financial risk

A

High business risk => restricted in amount of financial risk business can sustain

If fin risk is also high - may push total risk above the level that is acceptable to SHs => to minimise risk, minimise debt finance and hedge greater proportion of its currency and interest rate exposure

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14
Q

Risk Management

A

Process of assessing risk and ADOPTING POLICIES to MANAGE this risk to an ACCEPTABLE LEVEL

Need to be SEEN to manage risk

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15
Q

Risk map/risk mapping

A
  • used to consider which risks are the most significant
  • assessed by considering the PROBABILITY of the risk occurring and its POTENTIAL IMPACT (severity)
  • important for accountants to realise that financial risk management is one part of an overall risk management framework - accountant must be able to manage wider issues of risk
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16
Q

Risk map: Quadrant 1 (High severity, low probability)

A

TRANSFER: insure risk or implement contingency plans

  • action should be taken to reduce the severity of the impact. Reduction of severity of risk will minimise insurance premiums
  • may involve hedging
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17
Q

Risk map: Quadrant 2 (Low severity, low probability)

A

ACCEPT: risks are n/s

  • risks should be kept under review, but costs of dealing with risks > benefit
18
Q

Risk map: Quadrant 3 (Low severity, high probability)

A

REDUCE/CONTROL: improve controls to reduce probability of occurrence

  • develop robust financial systems and internal controls
  • development of concise, meaningful reporting and forecasting tools
19
Q

Risk map: Quadrant 4 (High severity, high probability)

A

ABONDON/AVOID: take action to reduce impact and frequency

  • major overhaul of procedures
  • abandoning activities
20
Q

Risk mapping mnemonic

A 
TARA
Transfer (1)
Accept (2)
Reduce/control (3)
Avoid/abandon (4)
21
Q

Risk Register

A

Lists and prioritises the main risks an organisation faces

  • used as a basis for decisions on how to deal with risks
  • monetary values should be allocated if possible
  • interdependencies with other risks noted
  • details who is responsible for dealing with the risks and the actions taken
22
Q

Standard deviation

A

risk of an individual share measured by standard deviation

= measure of the variability of returns around the average

23
Q

Diversification

A

reduces the risk of variability of returns by investing in a number of securities.

  • Standard deviation of returns from our portfolio decreases rapidly at first as we increase the number of securities
  • marginal benefits of further diversification dwindles once we have around 20 securities in our portfolio
  • can virtually eliminate all unique risk to that industry/type of business
24
Q

Unique/specific risk

A

Component of risk associated with investing in that particular company

  • company specific risk is spread over the whole investment portfolio (and may create benefits to other parts of the portfolio)
25
Q

Market risk/ systematic risk

A

The portion of risk that remains even if a diversified portfolio has been created

26
Q

Business risk and diversification

A

Business risk is a mixture of UNIQUE and MARKET risk.

A diversified SH will only be concerned with market risk

27
Q

Beta factor

A

A measure of the sensitivity of a share to movements in the overall market. A beta factor measures market risk.

Beta of company reflects both business risk (risk of bus operations) and financial risk (risk of using debt finance in capital structure)

A security’s beta may bear very little relationship to its overall volatility

28
Q

Beta and undiversified portfolio

A

IMPORTANT! B measures the risk associated with a particular security in the context of a DIVERSIFIED portfolio

undiversified SH should measure risk in terms of that company’s standard deviation

29
Q

Normal range of beta values

A

Beta <1 => below average risk. Moves in SAME DIRECTION as market, but by NOT AS MUCH

Beta = 1 => average risk. moves in line with the market

Beat > 1 => Above average risk. Moves in SAME DIRECTION but by MORE than market

30
Q

Negative beta

A
  • unusual
  • security price moves in the OPPOSITE direction to the market
  • rare in practice
  • normally arises with commodities such as gold whose price tends to rise in a recession
31
Q

Portfolio risk

A
  • possible to measure portfolio risk in terms of the average Beta of the securities held
  • possible if a very large number of securities were chosen at random
  • if portfolio is smaller (15-20) - need to be careful to pick securities that give enough coverage of all main industrial and geographic sectors
32
Q

CAPM: Rf return

A

estimated using the rates offered by gov’t bonds as a benchmark

  • if held to maturity then they offer a risk-free return
33
Q

CAPM: risk premium

A

The risk premium on a particular security = beta x average risk premium (rm -rf)

34
Q

CAPM: required rate of return

A

r = rf + B(rm - rf)

OR

r= rf + B(risk prem)

35
Q

Equity (geared) beta: the detail

A

Beta of quoted company = equity beta
- most comps have some level of debt finance => equity beta can be assumed to be a ‘geared’ beta
= beta of a company that employs some debt finance => whose SHs face a level of financial risk

36
Q

Asset (ungeared) beta: the detail

A
  • Ungeared beta measures business risk only (not financial risk)
  • equity beta is adjusted to show its value if the company was ungeared => measuring business risk only
37
Q

Equity beta vs asset beta

A

Equity beta > asset beta because asset beta only measures business risk

Equity beta measures business risk and financial risk

Average ungeared beta = 0.8
Average geared beta = 1

38
Q

Equity beta definition

A

Measure of market risk of a security, including its business and financial risk

39
Q

Asset beta definition

A

Ungeared beta measuring only business risk

40
Q

Application to investment appraisal: Steps to evaluating

A

Company moving into a new business area can use Beta of a company in that sector (CQC) as a measure of business risk

Step 1: Ungear the equity beta relating to CQC

Step 2: Re-gear the asset beta with the capital structure to be used in the new investment

Step 3: Use the adjusted equity beta to calculate cost of equity to use in the appraisal of the project

41
Q

Application of CAPM to share valuation: the three steps

A

Ungearing an equity beta and re-gearing asset beta used to adjust CQC beta => reflecting approp financial risk when performing DCF valuation of unlisted comp or division

Step 1: Ungear the equity B relating to CQC

Step 2: Regear asset beta with capital structure of the unlisted company/division that is being valued

Step 3: use the adjusted equity beta to calculate the cost of equity to use in the valuation

Finance (13 decks)

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