Ch 26: Risk identification and classification

Question 1

Outline 5 methods of identifying the risks associated with a project

Answer 1

1. High level preliminary analysis to confirm that there are no big risks that mean it is not worth continuing.
2. Brainstorming with project experts and senior internal / external people to:
   - identify likely/unlikely, upside/downside risks
   - discuss these risks and their interdependency
   - broadly evaluate the frequency and severity of each risk
   - generate and discuss initial mitigation options
3. Desktop analysis to supplement brainstorming, which involves looking at similar projects undertaken by the sponsor and others.
4. Consult with experts who are familiar with the details of the project and the plans for financing it.
5. Risk register or risk matrix setting out risks and ther interdependencies

Question 2

Suggest 7 categories of risks that could be used in a risk matrix for a typical project

Answer 2

PNEFCPB

1. Political - opposition to project, war, terrorism, etc
2. Natural - earthquakes, hurricanes
3. Economic - interest rate or exchange rate movements
4. Financial - sponsor default, incorrect cashflow estimates
5. Crime - fraud, theft
6. Project - time delays, budget overruns, bad design
7. Business - competition/lack of demand, operational problems

Question 3

Wider risk identification techniques

Answer 3

1. Risk classification
2. Risk checklists
3. Utilizing the experience of staff

Question 4

Market risk

Answer 4

The risk related to changes in investment market values or other features correlated with investment markets such as interest rates/inflation

Question 5

Credit risk

Answer 5

The risk of failure of third parties to meet their obligations

Question 6

Liquidity risk

Answer 6

The risk that an insurer, although solvent, does not have sufficient capital available to enable it to meet its obligations as they fall due. The risk for an insurer is usually low since investments usually include a large proportion of cash, bonds and stock market assets

Question 7

Business risk

Answer 7

Risk specific to the business undertaken

Question 8

Operational risk

Answer 8

The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

Question 9

External risk

Answer 9

Arises from external events

Question 10

Outline 3 subdivisions of market risk

Answer 10

1. The consequences of changes in asset values (due to changes in the market value of assets or changes in interest and inflation rates)
2. The consequences of a change in investment market values on liability values, where liabilities are directly related to investment market values, interest rates or inflation rates.
3. The consequences of not matching assets and liability cashflows

Question 11

Market risk could be removed through holding an asset portfolio that perfectly matches the liability portfolio.

Give reasons why a perfect match may not be possible in practice.

Answer 11

1. There may not be a wide enough range of assets available; in particular it may may not be possible to find assets in sufficiently long duration.
2. Liabilities may be uncertain in amount and timing
3. Liabilities may include options and hence have uncertain cashflows after the option date.
4. Liabilities may include discretionary benefits
5. The cost of maintaining a full-matched portfolio is likely to be prohibitive.

Question 12

What is a credit rating?

Answer 12

A credit rating is a rating given to a company’s debt by a credit-rating agency as an indication of the likelihood of default.

Question 13

Outline 4 factors that an investor should consider when assessing the security of a debt and the borrower

Answer 13

1. The nature of the debt
2. The covenant of the borrower (e.g. credit rating, income and asset cover, level of gearing, prior ranking debt)
3. Market circumstances and the relative negotiating strength of borrower and lender.
4. What security is available and whether it can be realized if necessary

Question 14

Define the term liquid asset.

What makes a market liquid?

Answer 14

A liquid asset is one that either:

• is close to cash in nature, or
• can be converted to cash quickly and the amount of cash it would become is almost certain

A liquid market is likely to be a large market with lots of ready marticipants.

(A marketable asset is one that can be converted to cash quickly, but the amount of cash received is uncertain)

Question 15

Why are banks exposed to significant liquidity risk?

Answer 15

Banks lend depositors’ funds and funds raised from the money markets to other organizations for potentially long periods. Customers may want instant access to their deposits, creating a need for liquidity. There is a risk that more customers than expected demand cash.

Question 16

Outline 4 examples of business risks to a financial provider

Answer 16

1. Inadequate underwriting standards leading to the mis-pricing of risks (underwriting risk)
2. More claims than anticipated (insurance risk)
3. Investment in a business or project that fails to be successful (financing risk)
4. Greater exposure than planned to a particular risk event. (expose risk)

Question 17

Outline 4 examples of operational risk

Answer 17

1. Inadequate or failed internal processes, people or systems.
2. The dominance of a single individual over the running of a business (dominance risk)
3. Reliance on third parties to carry out various functions for which the organization is responsible, e.g. outsourcing
4. The failure of recovery plans following an external event

Question 18

How are operational risks likely to be identified and analyzed?

Answer 18

A model could be used but such models are only as good as the parameters input.

Identification and analysis of operational risks typically requires considerable input from the owners of a business, senior management and other individuals with a good working knowledge of the business.

Question 19

Outline three examples of types of external risks

Answer 19

1. Natural disasters
2. Terrorist attacks
3. Regulatory, legislative and tax changes

The failure to arrange mitigation options for these risks is an operational risk and not an external risk

Question 20

Market risks

Answer 20

• Change in interest rates / inflation
• Market crashes
• Mismatch of assets and liabilities
• Currency risk

Question 21

Credit risks

Answer 21

• reinsurer, broker and asset default

Question 22

Liquidity risks

Answer 22

• insufficient cash resources to meet liabilities as they fall due

Question 23

Operational risks

Answer 23

• fraud
• mismanagement
• systems failure

Question 24

External risks

Answer 24

• natural disasters
• terrorist threats
• legislative and tax changes