Chapter 26: Risk identification and classification Flashcards
Outline 5 methods of identifying the risks associated with a project
- Make a high-level preliminary analysis to confirm that there are no big risks that mean it is not worth continuing
- 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 - Desktop analysis to supplement brainstorming, which involves looking at similar projects undertaken by the sponsor and others.
- Consult with experts who are familiar with the details of the project and the plans for financing it.
- Risk register or risk matrix setting out risks and their interdependencies.
Suggest 7 categories of risks that could be used in a risk matrix for a typical project
PNEFCPB
- Political - opposition to project, war, terrorism, etc.
- Natural - earthquakes, hurricanes
- Economic - interest rate or exchange rate movements
- Financial - sponsor default, incorrect cashflow estimates
- Crime - fraud, theft
- Project - time delays, budget overruns, bad design
- Business - competition/lack of demand, operational problems.
Wider risk identification techniques
- Risk classification
- Risk checklist
- Utilizing the experience of staff
Market risk
Market risks are the risks related to changes in investment market values or other features correlated with investment markets, such as interest and inflation rates.
What are the 3 subdivisions of market risk
- The consequences of changes on asset values (due to changes in the market value of assets or changes in interest and inflation rates)
- The consequences of investment market value changes on liabilities, where liabilities are directly related to investment market values, interest rates or inflation rates.
- The consequences of a provider not matching asset and liability cashflows.
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
- There may not be a wide enough range of assets available; in particular it may not be possible to find assets in sufficiently long duration
- Liabilities may be uncertain in amount and timing
- Liabilities may include options and hence have uncertain cashflows after the option date
- Liabilities may include discretionary benefits
- The cost of maintaining a full-matched portfolio is likely to be prohibitive.
Credit risk
Credit risk is the risk of failure of third parties to meet their obligations
What is a credit rating?
A credit rating is given to a company’s debt by a credit-rating agency as an indication of creditworthiness, i.e. the likelihood of default / credit loss
Outline 4 factors that an investor should consider when assessing the security of a debt and the borrower
- The nature of the debt
- The covenant of the borrower
- Market circumstances and the comparative negotiating strength of the lender and borrower.
- What security is available and whether it can be realised if necessary.
Liquidity risk
Liquidity risk is the risk that the individual or company, although solvent, does not have available sufficient financial resources to enable it to meet its obligations as they fall due.
Define the term liquid asset.
What makes a market liquid?
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 participants
A marketable asset is one that can be converted to cash quickly, but the amount of cash received is uncertain.
Why are banks exposed to significant liquidity risk?
Banks lend depositors’ funds and funds raised from the money markets to other organisations 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.
Business risk
Business risks are risks that are specific to the business undertaken
Outline 4 examples of business risks to a financial provider
- Underwriting risk - arising in relation to the underwriting approach taken.
- Insurance risk - arising from the uncertainties relating to claim rates and amounts
- Financing risk - arising in relation to the financing of projects or other activities
- Exposure risk - arising in relation to the amount of business sold or retained, or to its concentration or lack of diversification.
Operational risk
Operational risk refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
Outline 5 examples of operational risk
- Inadequate or failed internal processes, people or systems
- Conduct risk, interest rate manipulation and money laudering
- The dominance of a single individual over the running of a business, sometimes called dominance risk
- Reliance on third parties to carry out various functions for which the organisation is responsible
- The failure of plans to recover from an external event.
How are operational risks likely to be identified and analysed?
While it is possible to develop computer models to analyse and price operational risk, such models are only as good as the parameters input. Whether or not a model is used, identification of operational risks requires considerable input from owners, senior management and other individuals who have a detailed working knowledge of the operations of the business.
External risk
External risk arises from external events, such as storm, fire, flood etc.
External risk is a form of non-financial risk but is separate to operational risk. However, the failure to arrange mitigation against such risks is an operational risk
