Principal Terms Flashcards
What is the overall risk portfolio of a company?
It is the collective build-up of individual business decisions and risks, which results in a unique risk profile.
Lam - ERM Textbook - pg. 4
What does a company’s risk profile determine?
It determines the company’s earnings and earnings volatility.
Lam - ERM Textbook - pg. 4
What are the key components of risk management?
1) Using a portfolio approach
2) Establishing control systems
3) Having the right people and risk culture
4) Reducing downside potential
5) Increasing upside opportunity
Lam - ERM Textbook - pg. 4
How is the relationship between risk and return often misunderstood?
Many believe no risk = no return and high risk = high return, viewing it as linear, but it is better to view it as a parabolic relationship focusing on risk-adjusted return.
Lam - ERM Textbook - pg. 4
What does NPV stand for?
Net Present Value.
Lam - ERM Textbook - pg. 5
What does EVA mean?
Economic Value Added. Calculated as earnings - opportunity cost * capital allocated.
Lam - ERM Textbook - pg. 5
Why should a company develop an integrated approach to measuring and managing risk?
To optimize its risk/return profile.
Lam - ERM Textbook - pg. 6
What are the four main reasons that risk management should be important to the management of a firm?
Managing risk …
1) is management’s job
2) can reduce earnings volatility
3) can maximize shareholder value
4) promotes job and financial security
Lam - ERM Textbook - pg. 6
What knowledge is required for effective risk management? Who is responsible for risk management?
1) Knowledge of historical data (risk/return results, volatility, correlations)
2) Current risk exposures
3) Future business plans
The average investor does not have the knowledge or expertise, so it is management’s responsibility to manage the firm’s risk.
Lam - ERM Textbook - pg. 7
How can improvements to shareholder value be achieved through risk management?
In short, it reduces the cost of capital and reduces the uncertainty of commercial activities.
1) Establish target returns
2) Allocate capital to attractive projects (based on risk-adjusted returns)
3) Align performance metrics with risk objectives
4) Give the company the skills to manage risks (like large financial losses or reputation damage)
5) Incorporate risk when making key decisions such as mergers and acquisitions
Lam - ERM Textbook - pg. 8
What types of risks are interdependent? Give an example.
Financial risk, business risk, and operational risk. Within financial risk, market, credit, and liquidity risks are also interdependent.
Ex: The quality of loan documentation is usually considered an operational risk. If the loan is performing, the documentation has no real economic impact. But if the loan is in default, the quality of the loan documentation can have a significant impact on loss severity, with respect to collateral and bankruptcy rights.
Lam - ERM Textbook - pg. 10
Why is a silo-based risk management strategy inferior?
1) It does not account for interdependencies between risks and may overlook the big picture.
2) It is difficult to aggregate risk exposure across an organization if business units use different methodologies and systems.
Lam - ERM Textbook - pg. 10
What is funding risk?
The risk that positions may be profitable in the long run, but bankrupt a company in the short run
Lam - ERM Textbook - pg. 16
