18.2 The Management of Risk Flashcards
1
Q
How does risk relate to finance
A
- A key area in finance
o As key principle is that risk requires return - We always refer to wealth maximisation as the objective
o Focusing on return
o Or utility maximisation - But if risk is not managed properly the objective of wealth maximisation may not be achieved
- Wealth is determined by future cashflows
2
Q
How does risk relate to uncertainty
A
- Things that are uncertain you cannot draw a probability
- Risk is where we have data to draw a probability and can give values for and can model
3
Q
How do companies manage risk
A
- All companies are exposed to different degrees of risk
- If a company tried to remove all risk the cashflow levels it obtained would likely be low which is not ideal.
o Risk-Return relationship - A degree of risk is therefore inevitable.
- It is down to company management to decide upon those risks it wishes to avoid and those to take on
4
Q
Should risk be eliminated? Why so?
A
- Do not want to eliminate risk
- It is about control exposure to certain types of risk beyond that which might have serious consequences
- Companies are naturally risky
o Risk return relationship (again)
o So do want some risk - Have to do a cost benefit of each type and if the cost of mitigation is worthwhile when considering the volatility of returns
- Will do a ‘What if’ analysis. i.e. what if interest rate went up by 1, 2, 3% etc
- Having determined the sensitivity decisions can be made regarding the best course of action to reduce exposure to that particular risk
5
Q
How does a company’s effort to reduce risk impact profits
A
- The cost to reduce risk will reduce the company profits
- Objective is always to maximise shareholder wealth
- It’s a balance – we should not remove all risk
6
Q
What are the main ways a company can manage risk
A
- Accept (as part of business)
- Mitigate (try to reduce)
- Transfer (to a third party via insurance)
- Avoid (not take on)
7
Q
What are the costs of reducing risk
A
- Payments of insurance premiums
- Transaction costs in the derivative market
- Given the existence of such costs it is important that management undertake a cost benefit analysis to ensure that the benefits obtained from reducing risk are worthwhile
8
Q
Why might companies want to reduce risk
A
There are two main reasons why companies would want to give up potential cashflows in exchange from the reduction of the impact of adverse events
* It helps financial planning
* Reduces the fear of financial distress
9
Q
How can risk management help financial planning
A
- Future cashflows are uncertain, and if companies are able to reduce this uncertainty, within certain boundaries, this is beneficial to companies thereby allowing them to plan and invest with confidence.
- If a company’s future cashflows vary widely depending on, currency exchange rates, interest rates, price of raw material
o Then planning would be extremely difficult
10
Q
How can risk management reduce the fear of financial distress
A
- Risk of going into administration
- Some events can disrupt and damage a business to the point of threatening its existence.
- The consequence of such an event can be passed on to insurance companies
- The potential damage inflicted on companies can be controlled/limited, thus management and shareholders benefit.
- This can bring additional benefits given that providers of finance such as banks will have greater confidence.
- Thus cost of capital of the company will be reduced and the benefits this brings
11
Q
What are the main types of risk
A
- Business risk
- Insurable risk
- Currency risk
- Interest rate risk
12
Q
What is business risk
A
- There are various risks where companies have little control over and have to be accepted to a degree:
o i.e recession, union power, government imposed tariffs etc. - Other areas management can take action to reduce risk
13
Q
What are some examples of business risk
A
- How dependent on certain a material is a company ?
- Clearly if that material goes up in price it may make operations unprofitable.
- Also consider the supplier of the material may be concerned that its price may fall. Both would benefit from certainty
- Best way to achieve this certainty would be enter into some form of agreement:
- The company agrees to take delivery of the material at a later date at a price agreed today.
- Both parties know exactly how much material will be sold and at what price and so can plan ahead.
- There exists specific contacts that cover such agreements
- Can be helped out with a forward contract
14
Q
How can a forward contract reduce business risk
A
- Imagine you are responsible for purchasing potatoes to make crisps for your firm, a snack food producer.
- In the free market for potatoes the price rises or falls depending on the balance between buyers and sellers. The movements can be dramatic.
- Obviously you would like to purchase potatoes at a price as low as possible, while the potatoes producer would like to sell them at a high a price as possible.
- However, both parties have a similar interest in reducing the uncertainty of price. This would assist both to plan production and budget effectively.
- One way in which this could be done is to reach an agreement with the producer to purchase a quantity of potatoes at a price agreed to day to be delivered at a specific time in the future
15
Q
What is a forward contract
A
- A forward contract is an agreement between two parties to undertake an exchange at an agreed future date at a price agreed now.
- The party buying the future is said to be taking a long position. The counterparty which will deliver at the future date is said to be taking a short position.
- Forward contracts are tailor made to meet the requirements of the parties. This gives flexibility on the amounts and delivery dates.
- A forward agreement exposes the counterparties to the risk of default – the failure by the other party to deliver on the agreement. The risk grows in proportion to the extent to which the spot price diverges from the forward price
