Topic 17 Understanding risk

Question 1

1. Explain the difference between pure risk and speculative risk.

Answer 1

Pure risk (or downside risk) is the risk of something going wrong. The two possible outcomes of pure risk are either that nothing will happen or that something bad will happen; there is no upside risk. 
Speculative (two way) risk arises when the actual outcome could be either better or worse than expected.

Question 2

2. What is the difference between the amount at risk and exposure to risk?

Answer 2

The amount at risk is not necessarily the same as the exposure. The exposure to risk is the maximum that can be lost but the amount at risk is usually less than this; it is the shortfall between the amount loaned and the total amount the bank is likely to receive.

Question 3

3. Identify four financial risks that a business could face.

Answer 3

Financial risks include:
	credit risk;
	foreign exchange risk;
	interest rate risk;
	market risk;
	liquidity risk;
	gearing risk;
	capital adequacy risk;
	commodity price risk.

Question 4

4. Explain the difference between systematic and non systematic risk.

Answer 4

Systematic risk is the risk that events within the financial system, the economy or markets in general will cause share values to fall across the markets.

Non systematic risk is more specifically related to investments and investors rather than businesses. It is the risk of a particular share or sector of a market failing to deliver expected returns, or collapsing due to factors more to do with the company than the markets or economy in general.

Question 5

5. What is ‘credit risk’?

Answer 5

Credit risk refers to the possibility that creditors of a business will fail to pay what they owe in full and on time, and includes the risk of a failure by the borrower to pay the principal sum and/or the interest payments.

Question 6

6. A company arranges a variable rate loan. To what specific risk is the companyexposed?

Answer 6

A company that has borrowed on a variable interest rate is exposed to interest rate risk, which in turn could have a negative effect on its value in the market.

Question 7

7. Explain the term ‘concentration risk’.

Answer 7

Concentration risk refers to the danger of failing to diversify investments – ‘putting all your eggs in one basket’. An investor with an undiversified investment portfolio runs the risk that they have placed too great a proportion of their funds in one company, one industry or one region, thus suffering heavy losses if the company fails or the industry or region goes into recession.

Question 8

8. What is ‘counterparty risk’?

Answer 8

Counterparty risk is the risk to one party that the other party to an agreement or a contract will fail to carry out their part of the agreement and default on payments agreed under a contract.

Question 9

9. Explain what is meant by the term ‘gearing’ and its implications for investors.

Answer 9

Gearing (or leverage) is an accounting ratio that measures the extent to which a company is funded by debt – the total debt expressed as a percentage of the capital employed in the business. The higher the gearing ratio, the higher the percentage of debt to equity and the more vulnerable the company or investment to the effects of a downturn.

Question 10

10. What are the two elements of ‘liquidity risk’?

Answer 10

The two elements of liquidity risk are:
 cash flow risk – the possibility of an unexpected shortage of cash, which could result in an inability to pay obligations when they fall due;
 the possibility that a transaction cannot be made at the current market prices because the size of the transaction is either too large or too small relative to the normal acceptable size of trading ‘lots’.