Risk and Risk Management

Chapter 9: Risk and Risk Management 1 t By the end of this chapter you will be able to: Determine factors affecting business risk (CS) Explain the nature of risk management (SP) Describe types of financial risks Describe the concept of insurance (CS) Describe the role and responsibilities of risk management personnel (SP) Chapter 9 Risk and Risk Management

2 Chapter 9: Risk and Risk Management 9.1 Nature of Business Risk Risk The possibility of the actual outcome varying from the expected outcome Natural risk The risk of loss associated with natural disasters Human risk The risk of loss associated with human vulnerabilities Economic risk The risk of loss caused by economic issues Speculative risk Risk that can result in either a loss or a gain Pure risk Risk that can only result in a loss 9.2 Credit Risk and Risk Management Debtor An entity that owes money to another party Creditor An entity that has lent money to another party Credit Risk The risk that a debtor is unable or unwilling to pay back its loans

Chapter 9: Risk and Risk Management 3 Creditworthiness The extent to which a debtor is likely to fulfill its debt obligations Delinquent When a debtor is late in paying off its debt Defaulted When a debtor does not pay off its debt Credit rating agency A company that assesses the creditworthiness of a customer

4 Chapter 9: Risk and Risk Management Worked Example: Credit Reports and Credit History Date: July 16 th, 2016 Equifax Credit Report for Jane Vernon Fields FICO score: 720 Current Outstanding Balances JP Morgan Chase Sapphire Credit Card ( 7652) $1,500 Bank of America Mortgage ( 2134) $150,400 Best Buy Credit Card (..3445) $4,200 Other Notes Ms. Vernon Fields has never declared bankruptcy. She has neither defaulted nor been delinquent. Figure 8.2.1

Chapter 9: Risk and Risk Management 5 Your Time to Shine Date: July 20 th, 2016 Transunion Credit Report for Albert Sanchez FICO score: 600 Current Outstanding Balances American Express Platinum Credit Card ( 8419) $2,000 Citigroup Mortgage ( 0609) $300,400 Lexus Automobiles Car Loan (..3425) $40,200 Other Notes Mr. Sanchez declared bankruptcy in 2010, resulting in the write off of several debts. As of 2016 she has not defaulted or been delinquent on a loan. Figure 8.2.2 Credit risk metrics Mathematical tools used to assess the extent and likelihood of loss associated with credit risk Altman Z-score A formula used to determine how likely it is that a company will go bankrupt

6 Chapter 9: Risk and Risk Management Exposure At Default (EAD) The original value of the loan that the creditor made Loss Given Default (LGD) The percentage of the EAD that the creditor will lose should the debtor default $10 $50 = 80% 1 Probability of default The probability that a debtor will not pay back its loans Expected loss The expected loss to the creditor arising from credit risk Expected Loss = PD LGD EAD Worked Example: Credit Risk Metrics Your Time to Shine CreditRisk+ A credit risk model developed by

Chapter 9: Risk and Risk Management 7 Poisson Distribution A statistical distribution that the CreditRisk+ model is based on Factoring The sale of a company s receivables to another company known as a factor 9.3 Market Risk and Risk Management Market risk The possibility of loss associated with adverse movements in the financial markets Standard deviation Measures the spread of data around the mean

8 Chapter 9: Risk and Risk Management σ σ, Value-at-Risk (VAR) A market risk metric that shows the expected amount of loss given a hypothetical worst-case scenario Lognormal distribution A set of data that, when a logarithmic transformation is applied, becomes approximately normally distributed Hedging Investing in a security that has an inverse correlation with the main portfolio in order to offset against possible losses Correlation coefficient A statistic that measures the extent to which two variables move in the same direction

Chapter 9: Risk and Risk Management 9 Worked Example Investment Choice Correlation Coefficient DEF -0.7 GHI 0.8 JKL 0.2 Table 8.3.1 Your Time to Shine Investment Choice Correlation Coefficient Beta 0.3 Delta 0.4 Gamma -0.6 Table 8.3.2

10 Chapter 9: Risk and Risk Management 9.4 Interest Rate Risk and Introduction to Swaps Interest rate risk The possibility of loss associated with changes in interest rates Benchmark rate An interest rate on which other interest rates are based London Interbank Offered Rate (LIBOR) The rate at which banks are willing to lend to each other

Chapter 9: Risk and Risk Management 11 Worked Example Your Time to Shine

12 Chapter 9: Risk and Risk Management 9.5 Operation Risk, Disaster Recovery Planning and Business Continuity Planning (DRP/BCP) Operational risk Risk of loss that is associated with weaknesses or failures in operations, systems, processes, and/or procedures Disaster recovery planning A business develops plans to deal with various worst-case scenarios Business continuity planning A process designed to increase the likelihood that a business can continue running its operations smoothly, even in the face of an operational challenge, such as the retirement of the CFO 9.6 General Risk Management Strategies Risk avoidance When a business decides to avoid taking on a potential risk Risk retention When a business decides to take on a particular risk Risk reduction When a business decides to take on a particular risk but tries to reduce the risk

Chapter 9: Risk and Risk Management 13 Risk transference When a business tries to transfer the risk to another entity Key person Person in a business senior leadership that is integral to the company s success (e.g. CEO) Term life insurance A life insurance policy that provides a payout to the beneficiary should the insured person die within the time period that the policy is valid for Whole life A life insurance that provides a payout to the beneficiary upon death of the insured person, regardless of when death occurs Universal life insurance A type of life insurance policy that combines insurance features with investment features Group insurance An insurance policy is offered to all members of a particular group

14 Chapter 9: Risk and Risk Management Independent events Two events are said to be independent if the outcome of one does not affect the outcome of the other μ B μ A σ A σ B μ c μ A μ B σ C σ C 2 = σ A 2 + σ B 2 σ c = σ A + σ B Adverse selection A phenomenon that causes a higher proportion of high-risk individuals in the pool of insurance policyholders

9.7 The Three Lines of Defense Model Chapter 9: Risk and Risk Management 15 1 st line of defence The employees working in the individual business lines Business line A particular business segment 2 nd line of defense The employees working in risk management 3 rd line of defense The employees working in internal audit Worked Example

16 Chapter 9: Risk and Risk Management Your Time to Shine

9.8 Questions for Comprehension Chapter 9: Risk and Risk Management 17

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20 Chapter 9: Risk and Risk Management 9.9 Sample Solutions Your Time to Shine Page 5: Page 6: = 20% 80% $50,000 = $8,000 Page 9: Page 11: 4.25% + 1.75% = 6.00%

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Chapter 9: Risk and Risk Management 23 Risk What the Company Does Well in Managing the Risk Risk Management Deficiencies Actions (Changes) to be Taken Credit Risk Not enough information. Most of the loans are unsecured. Could result in higher chance that debtors default on their loans. Start offering secured loans while reducing the amount of unsecured loans. Market Risk Company invests in a broad range of North American equities, which can help reduce non-systematic risk. The company s investments lack international exposure. Investing in international equities may help to further diversify the portfolio and reduce nonsystematic risk. Invest in international equities. Interest Rate Risk Not enough information. Not enough information. Company needs to ensure that it is offering the right mix of floating versus fixed rate loans. Operational Risk CEO has many years of experience. Company may be overly dependent on the CEO. Create a succession plan; purchase key person life insurance. Table 8.9.1