CMA USA PART2 SECTION D
RISK MANAGEMENT STEPS
STEP 3 PRIORITIZATION:
[ risk ranking]
After the risk has been identified and assessed the company must
decide which risk rank as the highest priority and thus should be addressed first.
Four terms are used to express the measurement of potential loss
that could occur from a specific risk.
1. Expected loss
2.
Unexpected loss
3.
Maximus probable loss
4.
Maximum possible loss
Ø
EXPECTED LOSS:
It is an amount that management expects to lose to a given
risk per year on average over several years.
Example:
|
|
|
|
|
probability |
amount of
loss |
dollar |
|
10% |
100000 |
10000 |
|
20% |
120000 |
24000 |
|
30% |
160000 |
48000 |
|
35% |
180000 |
63000 |
|
5% |
500000 |
25000 |
|
|
expected
loss> |
170000 |
|
|
|
|
The expected loss is expected, it should be included budget.
2. unexpected loss:
It is an access amount of budget for the expected loss.
The business should reserve the unexpected loss amount as
capital.
3. maximum probable loss:
It is also known as probable maximum loss or[PML]
It is the largest loss that can occur under future
circumstances.
5. 4. Maximum possible loss:
It is also known as catastrophic.
It is the worst-case scenario.
The maximum possible loss for a building is total distractions
and the distraction of all its content.
It represents the greatest possible loss from a specific risk.
Note: the goal of risk management strategy maximize shareholders' wealth.
STEP-4 RESPONSE PLANNING:
Once the management of a company has identified accessed and ranked risks, management will need to determine the appropriate response to each risk.
A company can choose five different responses for each specific risk.
1. Avoiding or eliminating the risk:
It might be the best cause of action when the probability of loss and expected loss amount is high.
It is a response where the company stops doing an activity that causes a particular risk.
For example: avoiding or eliminating risk includes selling or disposing of a business unit or product line.
2. Reducing or mitigating risk:
It is a response where a company takes action to lower the risk related to an activity.
Example: expand an existing product line.
Split an IT into 2 geographically separate areas or diversification.
3. Transferring or sharing the risk:
Management moves the risk of loss either partially or wholly to another entity.
Example: purchasing of insurance, hedging with derivative.
4. Retained risk or retention risk:
It is a response where a company accepts the risk of an activity. It is also called self-insuring.
Self-insuring means not purchasing insurance at all and simply peering at any loss that occurs.
5. Accept or exploit a risk:
It is an action where a company initially takes on more risk as a way to earn high returns.
Ø STEPS IN RISK MANAGEMENT
STEP 5: RISK MONITORING :
After the risk management strategies have been implemented the company must continue to monitor the situation to ensure that each risk has been addressed as intended.
Risk appetite:
It is the broadly defined level of risk an organization is willing to accept in pursuit of value.
Risk tolerance:
It is more narrowly defined
It expresses the acceptable level of variation around objectives.
For example; the company does not accept the risks that literally result in a marketable investment loss of greater than 20% in a given year.
Managing operational risk:
Operational risks are connected to the day-to-day operations of a business.
1. Proper employee training
2. Continues receiving of business process
3. Proper internal control.
Ø Managing financial risk:
Maintain the amount of debt
Specific policies for short-term and long-term investment.
Diversify investment
Deriminating instrument
Such as forward future swaps and options.
Note: maximum probable loss to a commercial building is inversely related to the size of the building.
Ø Cost benefits analysis in risk management:
A company would probably decide not to buy an insurance policy with a premium of $2000 to cover an expected loss of $1200
Ø Risk measurement in the bank:
Banks are invested with the duty of protecting the money of depositors.
So they have risk.
In the us, bank deposits are insured by an agency of the federal government.
Because they are assuming much of the bank depositors' risk, the regulator requires banks to maintain adequate capital.
Ø Capital adequacy:
It is a measurement used by bank regulators to assess whether a bank has sufficient capital compared to its liability.
Ø Capital adequacy ratio:
It is an international standard that regulatory authorities use to monitor banks to protect bank depositors.
It measures the degree to which a bank can cover its obligation or liability.
CAR= tier1 capital + tier2 capital÷ risk-weighted asset [ RWA]
CAR increase = bank is well capitalized and healthy.
CAR decreases = danger
Ø Tier 1 capital:
It is the bank's core capital.
It includes a common stock account including retained earnings and preferred shares.
The regulator views tier 1 capital as the measurement of a bank's financial strength.
Ø Tier2 capital:
It is a secondary capital
It includes an undisclosed reserve.
Revaluation reserve and general provisions etc.
Risk-weighted asset:
It is an adjusted total asset figure based on the premise that assets have different risk profiles.
The risk weight used ranges from zero percent to 200%.