RISK MANAGEMENT

A Subject Requirement
in
Risk Management
 I. General Categories of Risks

According to Investopedia “Risk is defined in financial terms as the chance that an outcome or

investment's actual gains which will differ from an expected outcome or return, it includes the

possibility of losing some or all of an original investment. Hence, Risk Management plays an

important role because it has an objective to identify potential threats that may occur during the

investment process and doing anything possible to mitigate or eliminate those dangers but in

order to apply the concept of management, it is important to identify the different categories of

risks. The following terms are referring to the general categories of risks:

 Preventable Risks:

Preventable Risks are internal risks arising within the organization that are controllable

and should be eliminated or avoided. These risks present only negative impacts. These

are risks that an organization is focused on eliminating, avoiding, mitigating, or

transferring in a cost-effective manner, as they offer no strategic benefits.

Examples:

 Business Misconduct,

 Regulatory Noncompliance,

 Fraud,

 Inaccurate financial statements or

 Errors or defects resulting from breakdowns in operational

process.
  Strategic Risks:

Strategic risks are risks that offer benefits, risks significant to the organization’s ability to

execute its business strategy and achieve its objectives. It is often focus on the risk opportunity,

“there is no return without risk”. Strategic risks are quite different from preventable risks

because it is not inherently undesirable.

A strategy with high expected returns generally requires the organization to take on significant

risks, and effective management of those risks is critical in order to capture potential gains.

Examples:

 Execution of acquisitions and divestitures,

 New projects development

 and Execution or expansion into emerging markets

 External Risks

External risks are those that arise from events outside of the organization’s control. These risks

can offer negative/or positive benefits. Organization cannot influence the likelihood of these risk

events but can reduce impact. External risks are those risks beyond the organization’s control:

these risks can be unpredictable, as they originate outside of the organization and typically have

a low rate of occurrence. External risks can offer negative or positive benefit.

Examples

 Natural disasters,

 Political changes,

 Macroeconomic changes including interest rates and exchange rates.

II. RISK FACTORS IN BUSINESS

1. Longevity Risk
According to Investopedia, Longevity risk

refers to the chance that life expectancies and

actual survival rates exceed expectations or

pricing assumptions, resulting in greater-than-

anticipated cash flow needs on the part of

insurance companies or pension funds. The risk exists due to the increasing

life expectancy trends among policyholders and pensioners and the growing

numbers of people reaching retirement age.

By understanding the longevity risk the average life expectancy figures are on

the rise , and even in minimal change in life expectancies can create severe

solvency issues for pension plans and insurance companies. Precise

measurements of longevity risk are still unattainable because the limitations of

medicines and its impact on life expectancies has not been quantified. In

addition, the number of people reaching retirement age – 65 or older is

growing as well , with the total projected to reach 95 million by 2060, up

from roughly 55 million in 2020.

Knowing Longevity Risks :

 Longevity risk is the risk that pension funds or insurance companies

face when assumptions about life expectancies and mortality rates are

inaccurate.

 The impact of medicine on life expectancies is difficult to measure, but

even minimal changes can increase longevity risk.

 An aging population and greater numbers of people reaching

retirement age add to longevity risk

 Pension funds and other defined- benefit programs that promise

lifetime retirement benefit programs that promise lifetime retirement

benefits have the highest risk.

 Current mortality rates and longevity trend risk are the two factors

considered when attempting to transfer longevity risk.

Longevity Risk Special Considerations

 Organizations can transfer longevity risk in several ways. The simplest

way is through a single premium immediate annuity (SPIA), whereby

a risk holder pays a premium to an insurer and passes both asset and

liability risk. This strategy would involve a large transfer of assets to a

third party, with the possibility of material credit risk exposure.

 Alternatively, it is possible to eliminate only longevity risk while

retaining the underlying assets via reinsurance of the liability. In this

model, instead of paying a single premium, the premium is spread over

the likely duration of 50 or 60 years (expected term of liability),

aligning premiums and claims and moving uncertain cash flows to

certain ones.

 When transferring longevity risk for a given pension plan or insurer,

there are two primary factors to consider. The first is the current levels

of mortality, which are observable but vary substantially across

socioeconomic and health categories. The second is longevity trend

risk, which is the trajectory of the risk and is systematic as it applies to

an aging population.

 The most direct offset available to the systematic mortality trend risk

is through holding exposure to increasing mortality—for example,

certain books of life insurance policies. For a pension plan or an

insurance company, one reason to cede risk is uncertainty around the

exposure to longevity trend risk, particularly due to the systematic

nature.
 https://www.investopedia.com/terms/l/longevityrisk.asp

2. Inflation Risk

Inflation affects all aspects of the

economy, from consumer

spending, business investment and

employment rates to government

programs, tax policies, and interest

rates. Understanding inflation is

crucial to investing because

inflation can reduce the value of

investment returns. It is a sustained rise in overall price levels. Moderate

inflation is associated with economic growth, while high inflation can signal

an overheated economy.

As an economy grows, businesses and consumers spend more money on goods and services. In

the growth stage of an economic cycle, demand typically outstrips the supply of goods, and

producers can raise their prices. As a result, the rate of inflation increases. If economic growth

accelerates very rapidly, demand grows even faster and producers raise prices continually. An

upward price spiral, sometimes called “runaway inflation” or “hyperinflation,” can result. In the

U.S., the inflation syndrome is often describe as “ too many dollars chasing too few goods;” in

other words, as spending outpaces the production of goods and services, the supply of dollars in

an economy exceeds the amount needed for financial transactions. The result is that the
purchasing power of a dollar declines. In general, when economic growth begins to slow,

demand eases and the supply of goods increases relative to demand. At this point, the rate of

inflation usually drops. Such a period of falling inflation is known as disinflation.

What causes inflation?

Economists do not always agree on what spurs inflation at any given time, but in general they

bucket the factors into two different types: cost-push inflation and demand-pull inflation.

Rising commodity prices are an example of cost-push inflation. They are perhaps the most

visible inflationary force because when commodities rise in price, the costs of basic goods and

services generally increase. Higher oil prices, in particular, can have the most pervasive impact

on an economy. First, gasoline, or petrol, prices will rise. This, in turn, means that the prices of

all goods and services that are transported to their markets by truck, rail or ship will also rise. At

the same time, jet fuel prices go up, raising the prices of airline tickets and air transport; heating

oil prices also rise, hurting both consumers and businesses.

By causing price increases throughout an economy, rising oil prices take money out of the

pockets of consumers and businesses. Economists therefore view oil price hikes as a “tax,” in

effect, that can depress an already weak economy. Surges in oil prices were followed by

recessions or stagflation – a period of inflation combined with low growth and high

unemployment – in the 1970s. In addition to oil, rising wages can also cause cost-push inflation,

as can depreciation in a country’s currency. As the currency depreciates, it becomes more

expensive to purchase imported goods - so costs rise - which puts upward pressure on prices

overall. Over the long term, currencies of countries with higher inflation rates tend to depreciate
relative to those with lower rates. Because inflation erodes the value of investment returns over

time, investors may shift their money to markets with lower inflation rates.

Unlike cost-push inflation, demand-pull inflation occurs when aggregate demand in an economy

rises too quickly. This can occur if a central bank rapidly increases the money supply without a

corresponding increase in the production of goods and service. Demand outstrips supply, leading

to an increase in prices.

How can inflation be controlled?

Central banks, such as the U.S. Federal Reserve, European Central Bank (ECB), the Bank of

Japan (BoJ) or the Bank of England (BoE) attempt to control inflation by regulating the pace of

economic activity. They usually try to affect economic activity by raising and lowering short-

term interest rates.

Lowering short-term rates encourages banks to borrow from a central bank and from each other,

effectively increasing the money supply within the economy. Banks, in turn, make more loans to

businesses and consumers, which stimulates spending and overall economic activity. As

economic growth picks up, inflation generally increases. Raising short-term rates has the

opposite effect: it discourages borrowing, decreases the money supply, dampens economic

activity and subdues inflation.

Management of the money supply by central banks in their home regions is known as monetary

policy. Raising and lowering interest rates is the most common way of implementing monetary

policy. However, a central bank can also tighten or relax banks’ reserve requirements. Banks
must hold a percentage of their deposits with the central bank or as cash on hand. Raising the

reserve requirements restricts banks’ lending capacity, thus slowing economic activity, while

easing reserve requirements generally stimulates economic activity.

A government at times will attempt to fight inflation through fiscal policy. Although not all

economists agree on the efficacy of fiscal policy, the government can attempt to fight inflation

by raising taxes or reducing spending, thereby putting a damper on economic activity;

conversely, it can combat deflation with tax cuts and increased spending designed to stimulate

economic activity.

How can we help protect my fixed income portfolio from

inflation?
To combat the negative impact of inflation, returns on some types of fixed income securities are

linked to changes in inflation:

Inflation-linked bonds issued by many governments are explicitly tied to changes in inflation. In

the 1980s, the U.K. was the first developed country to introduce “linkers” to the market. Several

other countries followed, including Australia, Canada, Mexico and Sweden. In 1997, the U.S.

introduced Treasury Inflation-Protected Securities (TIPS), now the largest component of the

global ILB market.

Floating-rate notes offer coupons that rise and fall with key interest rates. The interest rate on a

floating-rate security is reset periodically to reflect changes in a base interest rate index, such as

the London Interbank Offered Rate (LIBOR). Floating-rate notes have therefore been positively,
though imperfectly, correlated with inflation. However, some commodity-based investments are

influenced by factors other than commodity prices. Oil stocks, for example, can fluctuate based

on company-specific issues and therefore oil stock prices and oil prices are not always aligned.

https://global.pimco.com/en-gbl/resources/education/understanding-inflation

3. Sequence of Return Risk

The risk of receiving lower or negative returns early in a period when

withdrawals are made from an investment portfolio is known as sequence of

return risk. If you are taking withdrawals from your portfolio, the order or the

sequence of investment returns can significantly impact your portfolios overall

value. Sequence risk, or sequence of returns risk, analyzes the order in which

your investment returns occur. It affects you when you are periodically adding

or withdrawing money from your investments. In retirement, it can mean that

you earn a much lower internal rate of return than what you expected. The best

way to understand sequence risk is with an example.

Accumulation: No Additions, No Sequence of Returns Risk

Suppose you invested $100,000 in 1996 in the S&P 500 Index. These are the

index returns:

1996: 23.10%

1997: 33.40%

1998: 28.60%

1999: 21.0%
 2000: -9.10%

2001: -11.90%

2002: -22.10%

2003: 28.70%

2004: 10.90%

2005: 4.90%

Your $100,000 grew to $238,673. Not bad. Your $100,000 earned just over a

9% annualized rate of return.

If Returns Occur in the Opposite Order

Now if those returns played out in the opposite order, you still would have

ended up with the same amount of money: $238,673.

1996: 4.90%

1997: 10.90%

1998: 28.70%

1999: -22.1%

2000: -11.90%

2001: -9.10%

2002: 21.0%

2003: 28.60%

2004: 33.4%

2005: 23.10%
The order in which the returns occur has no effect on your outcome if you

aren't either investing regularly (buying investments) or withdrawing regularly

(selling investments).

Once you start withdrawing income, you're affected by the change in the

sequence in which the returns occurred. Now at the end of the 10 years, you

have received $60,000 of income and have $125,691 left. Add the two

together and you get $185,691. This equates to about a 7.80% rate of return.

Not bad, but not as good as the $222,548 you would have received if the

returns had happened the other way around.

During your retirement years, if a high proportion of negative returns occur in

the beginning years of your retirement, it will have a lasting negative effect

and reduce the amount of income you can withdraw over your lifetime. This is

called the sequence of returns risk.

When you're retired, you need to sell investments periodically to support your

cash flow needs. If the negative returns occur first, you end up selling some

holdings, and so you reduce the shares you own that are available to

participate in the later-occurring positive returns.

Withdrawing Income and Getting the Same Returns

Now suppose instead of the above scenario, you retired in 1996. You invested

$100,000 in the S&P 500 Index, and you withdrew $6,000 at the end of each

year. Over the ten years, you received $60,000 of income and you would have

$162,548 of the principal left. Add those two up and you get $222,548. Again,

you earned over a 9% rate of return.

Protecting Yourself from Sequence Risk

Because of sequence risk, it's not an effective way to plan for retirement by

plugging a simple rate of return into an online retirement planning tool, which

assumes you earn that same return each year. A portfolio doesn't work that

way. You can invest the exact same way, and during one 20-year period, you

might earn 10% plus returns, and in a different 20-year time period, you'd earn

4% returns. Average returns don't work either. Half the time, returns will be

below average. Do you want a retirement plan that only works half the time?

A better option than using averages is to use a lower return in your planning;

something that reflects some of the worst decades in the past. This way, if you

get a bad sequence (a bad economy), you've already planned for it.

You could also create a laddered bond portfolio, so that each year a bond

matures to meet your cash flow needs, you would cover the first five-to-10

years’ worth of cash flow needed. In this way, the rest of your portfolio can be

in equities. Since this equity portion is in essence still in the accumulation

 phase, you can choose to harvest gains from it to buy more bonds in years

during or after strong stock market returns.

The best thing you can do is understand that all choices involve a trade-off

between risk and return. Develop a retirement income plan, follow a time-

tested disciplined approach, and plan on some flexibility.

https://www.thebalance.com/how-sequence-risk-affects-your-retirement-money-2388672

4. Interest Rate Risk

Understanding Interest-Rate Risk

Interest-rate risk is the risk, taken by bond investors, that interest rates will rise

after they buy. Stated another way, it is the risk that a bond's yield will rise (as its

price falls) after it has been purchased.

All bonds involve interest-rate risk, but some involve more than others. The more

interest-rate risk a bond involves, the more its price will fall as its yield rises.

Duration quantifies the amount of interest-rate risk a bond involves.

Generally speaking, long-term bonds involve more interest-rate risk than short-

term ones do. And generally speaking, bonds with small coupons -- that is, bond

that don't involve much credit risk -- involve more interest rate risk than bonds of

the same maturity with large coupons. A rise in interest rates hurts more if you're

earning only 5% a year in coupon income than if you're earning 10% a year.

Like all bonds, corporates tend to rise in value when interest rates fall, and they

fall in value when interest rates rise. Usually, the longer the maturity, the greater

the degree of price volatility. If you hold a bond until maturity, you may be less

concerned about these price fluctuations (which are known as interest-rate risk, or

market risk), because you will receive the par, or face, value of your bond at

maturity.

Some investors are confused by the inverse relationship between bonds and

interest rates—that is, the fact that bonds are worth less when interest rates rise.

But the explanation is essentially straightforward:

When interest rates rise, new issues come to market with higher yields than older

securities, making those older ones worth less. Hence, their prices go down.

When interest rates decline, new bond issues come to market with lower yields

than older securities, making those older, higher-yielding ones worth more.

Hence, their prices go up. As a result, if you have to sell your bond before

maturity, it may be worth more or less than you paid for it. Various economic

forces affect the level and direction of interest rates in the economy. Interest rates
typically climb when the economy is growing, and fall during economic

downturns. Similarly, rising

inflation leads to rising

interest rates (although at

some point, higher rates

themselves become

contributors to higher inflation), and moderating inflation leads to lower interest

rates. Inflation is one of the most influential forces on interest rates.

http://investinginbonds.com/learnmore.asp?catid=5&subcatid=18&id=178

https://www.thestreet.com/topic/46581/interest-rate-risk.html

5. Liquidity Risk

Liquidity risk is the risk that a company or bank may be unable to meet short

term financial demands. This usually occurs due to the inability to convert a

security or hard asset to cash without a loss of capital and/or income in the

process.

How Does Liquidity Risk Work?

Liquidity risk generally arises when a business or individual with immediate

cash needs, holds a valuable asset that it can not trade or sell at market value

due to a lack of buyers, or due to an inefficient market where it is difficult to

bring buyers and sellers together.

For example, consider a $1,000,000 home with no buyers. The home

obviously has value, but due to market conditions at the time, there may be no

interested buyers. In better economic times when market conditions improve

 and demand increases, the house may sell for well above that price. However,

due to the home owner’s need of cash to meet near term financial demands,

the owner may be unable to wait and have no other choice but to sell the house

in an illiquid market at a significant loss. Hence, the liquidity risk of holding

this asset.

Why Does Liquidity Risk Matter?

Purchasers and owners of long-term assets must take into account the

salability of assets when considering their own short-term cash needs. Assets

that are difficult to sell in an illiquid market carry a liquidity risk since they

cannot be easily converted to cash at a time of need. Liquidity risk may lower

the value of certain assets or businesses due to the increased potential of

capital loss.

What you need to know about liquidity risk?

All businesses seek access to capital to not only accomplish long-term strategic

investments, but also to meet their short-term financial obligations. In turn, failure

to acquire sufficient funding within a realistic timespan could expose a company

to liquidity risk, resulting in negative consequences.

In regard to securities, liquidity risk occurs when the bid-ask spreads are widening

out to levels where investors need to spend large amounts of money to deal with

them.

There are two main types of liquidity risk: market and funding.

Market liquidity risk. It is the possibility that when you need to trade, the market

liquidity is poor, making it difficult to buy or sell assets. For example, assume you

own an expensive car. You need to sell it quickly. However, due to bad market

conditions, it can only be sold at a low, discounted price. In this case, the asset

does have a value, but owing to the temporary lack of buyers, this value cannot be

realized.

Funding liquidity risk. It is the possibility that when a company needs to pay off

its bills, it may fail to do so on time due to a lack of funding. For example, during
the period of slowdown, the business may be exposed to funding liquidity risk if its

obligations due at that time are greater than the operating cash flows generated.

Market liquidity risk can be measured by bid-ask spread, market depth,

immediacy and resilience. Fund liquidity risk can be measured by the current

ratio, which divides current assets by current liabilities, or by the quick ratio,

which divides the total cash and equivalents plus marketable securities and

accounts receivable by the total current liabilities.

__________________________________________________________________

https://capital.com/liquidity-risk-definition

https://investinganswers.com/dictionary/l/liquidity-risk

6. Market Risk

Market risk is the risk that the value of an investment will decrease due to

changes in market factors. These factors will have an impact on the overall

performance on the financial markets and can only be reduced by

diversification into assets that are not correlated with the market – such as
certain alternative asset classes. Market risk is sometimes called “systematic

risk” because it relates to factors, such as a recession, that impact the entire

market.

Market risk is the risk of losses on financial investments caused by adverse

price movements.

Examples of market risk are: changes in equity prices or commodity prices,

interest rate moves or foreign exchange fluctuations.

Market risk is one of the three core risks all banks are required to report and

hold capital against, alongside credit risk and operational risk. The standard

method for evaluating market risk is value-at-risk.

There are several different risk factors that make up market risk.

 Currency risk: The risk that exchange rates will go up or possibly

down

 Equity risk: The risk that share prices will go up or down

 Inflation risk: the potential for inflation to increase the price of all

goods and services such that it undermines the value of money

 Commodity risk: the possibility of commodity prices such as metals

change value dramatically

 Interest rate risk: the risk that comes from an increase or decrease in

interest rates
 https://www.risk.net/definition/market-risk

https://www.syndicateroom.com/learn/glossary/market-risk

7. Opportunity Risk

An opportunity-risk is defined as an uncertainty that if it occurs would

have a positive effect on achievement of project objectives. The exploit

response seeks to eliminate the uncertainty by making the opportunity

definitely happen.

Whereas the threat-risk equivalent strategy of avoid aims to reduce

probability of occurrence to zero, the goal of the exploit strategy for

opportunities is to raise the probability to 100%—in both cases the

uncertainty is removed.

This is the most aggressive of the response strategies, and should usually

be reserved for those “golden opportunities” with high probability and

potentially high positive impact, which the project or organization cannot

afford to miss.

In the same way that risk avoidance for threats can be achieved either

directly or indirectly (see Hillson 1999a, 1999b), there are also direct and

indirect approaches for exploiting opportunities.

Direct responses include making positive decisions to include an

opportunity in the project scope or baseline, removing the uncertainty over

whether or not it might be achieved by ensuring that the potential

opportunity is definitely locked into the project, rather than leaving it to

chance.

Indirect exploitation responses involve doing the project in a different way

in order to allow the opportunity to be achieved while still meeting the

project objectives, for example by changing the selected methodology or

technology. Where avoidance goes round a threat so that it cannot affect

the project, exploitation stands in the way of the opportunity to make sure

that it is not missed, in effect making it unavoidable.

https://www.pmi.org/learning/library/effective-strategies-exploiting-opportunities-7947
8.)

Tax risk is the risk that companies may be paying or accounting for an incorrect amount
of tax (including both income and indirect taxes), or that the tax positions a company adopts are

out of step with the tax risk appetite that the directors have authorized or believe is prudent.

We have embraced the increasingly global view that tax risk management should be a part of

good corporate governance. The presence and testing of a tax internal control framework are an

integral part of the risk-assessment protocols used by tax authorities.

This guide sets out principles for board-level and managerial-level responsibilities, with

examples of evidence that entities can provide to demonstrate the design and operational

effectiveness of their control framework for tax risk.

It was developed primarily for large and complex corporations, tax consolidated groups and

foreign multinational corporations conducting business in Australia. The principles outlined can

be applied to a corporation of any size if tailored appropriately. When appropriate we assess the

tax governance processes of large business entities that we have under review.

However, the aim of this guide is to help you understand what we believe better tax corporate

governance practices look like, so you can:

 Develop or improve your own tax governance and internal control framework

 Test the robustness of the design of your framework against our best practice benchmarks

 Understand how to demonstrate the operational effectiveness of your key internal

controls to your stakeholders

The Basics of Risk

Everyone is exposed to some type of risk every day – whether it’s from driving, walking

down the street, investing, capital planning, or something else. An investor’s personality,

lifestyle, and age are some of the top factors to consider for individual investment

management and risk purposes. Each investor has a unique risk profile that determines

their willingness and ability to withstand risk. In general, as investment risks rise,

investors expect higher returns to compensate for taking those risks.

A fundamental idea in finance is the relationship between risk and return. The greater the

amount of risk an investor is willing to take, the greater the potential return. Risks can

come in various ways and investors need to be compensated for taking on additional risk.

For example, a U.S. Treasury bond is considered one of the safest investments and when

compared to a corporate bond, provides a lower rate of return. A corporation is much

more likely to go bankrupt than the U.S. government. Because the default risk of

investing in a corporate bond is higher, investors are offered a higher rate of return.

Quantifiably, risk is usually assessed by considering historical behaviors and outcomes.

In finance, standard deviation is a common metric associated with risk. Standard

deviation provides a measure of the volatility of a value in comparison to its historical

average. A high standard deviation indicates a lot of value volatility and therefore a high

degree of risk.

Individuals, financial advisors, and companies can all develop risk management strategies

to help manage risks associated with their investments and business activities.

Academically, there are several theories, metrics, and strategies that have been identified

to measure, analyze, and manage risks. Some of these include: standard deviation, beta,

Value at Risk (VaR), and the Capital Asset Pricing Model (CAPM). Measuring and
 quantifying risk often allows investors, traders, and business managers to hedge some

risks away by using various strategies including diversification and derivative positions.

https://www.investopedia.com/terms/r/risk.asp

https://www.ato.gov.au/Business/Large-business/In-detail/Key-products-and-resources/Tax-risk-management-

and-governance-review-guide/