Mod 13: Risk and Return Flashcards
Business risk definition
The volatility of earnings arising from a change in a business’ operations or environment
Types of risk
- Business risk
- Non- business risk
- Event risk
- Financial risk
Examples of business risk include:
- Operational failings
- Gov’t actions (political risk)
- Failure in strategy
- Technological change
Business risk: operational failings
Failings due to HUMAN ERROR, breakdowns in internal procedures or systems failures/
= damage to an organisation’s reputation
Business risk: Gov’t actions (political risk)
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
Business risk: failure in strategy
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
Business risk: Technological change
may lead to product obsolescence
Non-business risk
Includes financial and event risk
Non business risk: Event risk
arises due to an ADVERSE EVENT e.g. an accident or natural disaster, or the loss of a key member of mgmt team
Non-business risk: Financial risk
Volatility of earnings due to the financial policies of a business
- can arise form LT or ST factors
Non-business risk: LT Financial risk
- risk arising from company’s financial structure. If financial gearing is high => SH returns subject to higher degree of variability
- Risk of not being able to access funding
- Whether organisation has insufficient LT capital base for the amount of trading it is doing (overtrading)
Non-business risk: ST financial risk
- Credit risk
- possibility of payment default by the customer (MOD 3) - Liquidity risk
- risk company cannot access the cash it needs in a cost efficient manner (MOD 2) - currency and interest rate risk
- risk arising from unpredictable CFs due to interest rate or exchange rate movements
Relationship between business and financial risk
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
Risk Management
Process of assessing risk and ADOPTING POLICIES to MANAGE this risk to an ACCEPTABLE LEVEL
Need to be SEEN to manage risk
Risk map/risk mapping
- 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
Risk map: Quadrant 1 (High severity, low probability)
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
Risk map: Quadrant 2 (Low severity, low probability)
ACCEPT: risks are n/s
- risks should be kept under review, but costs of dealing with risks > benefit
Risk map: Quadrant 3 (Low severity, high probability)
REDUCE/CONTROL: improve controls to reduce probability of occurrence
- develop robust financial systems and internal controls
- development of concise, meaningful reporting and forecasting tools
Risk map: Quadrant 4 (High severity, high probability)
ABONDON/AVOID: take action to reduce impact and frequency
- major overhaul of procedures
- abandoning activities
Risk mapping mnemonic
TARA Transfer (1) Accept (2) Reduce/control (3) Avoid/abandon (4)
Risk Register
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
Standard deviation
risk of an individual share measured by standard deviation
= measure of the variability of returns around the average
Diversification
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
Unique/specific risk
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)
