BUSI2050 Risk Decision Revision notes
Questions 1 & 2:
• 40 marks each
• Relevant to the lectures (7 topics)
• Requires essay answer
• Qualitative questions but you may be asked to provide graphical illustrations, numerical
examples and/or real-life case studies.
Question 3:
• 10 marks
• Relevant to Seminar A
• One short case study (Topic 3: Heuristics)
• Multiple Choice Question (MCQ)
• Choose the right answer and briefly explain your answer.
Question 4:
• 10 marks
• Relevant to Seminar B
• One short case study (Topic 5: Managerial Compensation)
• May require calculations (Not MCQ)
• Provide the right answer and briefly explain your answer.
TOPIC 1 : Introduction to risk and corporate finance
Risk concerns with the inability to foresee or control the future. Risk is used to describe the
possibility of an adverse outcome.
Why is risk a problem to firms?
Firms neither risk averse or risk loving
Agency costs arise from an ex-post information asymmetry between borrowers and lenders
and raise the cost of external financing. Costs of screening and monitoring, information
collecting and auditing.
Fluctuations in income & expenses, assets & liabilities, share prices (direct impact firm value) – internal
impacts
The impact of market and operational risk can affect the firm by producing fluctuations in
income and expenditure accounting items (including operating profits), in balance sheet
assets and liabilities, and in a quoted firm’s share price (and hence its market value). These
fluctuations are all ‘internal’ to the firm in the sense that they may have a direct impact on the
firm value via the operation of the various markets in which the firm contracts with its
stakeholders (product, labour, capital etc).
,While individuals have risk preferences (and obviously act at times in a risk averse or loss
averse way), it is difficult to see how firms could have risk preferences in the same way that
individuals do. The firm itself is merely a legal entity and Articles of Association cannot have
risk preferences! We cannot model the firm as if it were an individual unless it is a one
person business. In practice, corporate decisions are made by groups of people who may have
little of their personal wealth at risk.
The best way to think about this is to investigate the impact of risk on the value of the firm -
this is the maximum amount of money that the firm could be sold for. This value should be
equivalent to the present value of the firm’s future expected or average cash flows discounted
at an appropriate discount rate:
Firm Value = Σ t=0 E[cash flowt ] / (1 + r)
It follows therefore that risk will be a problem if it reduces firm value, and that this can happen
in three broad ways:
If risk increases the discount rate r. This has a direct impact on shareholders who cannot remove
this risk by diversifying there share portfolio (the so-called systematic risk).
2. If risk reduces profit, then stakeholders of the business may demand risk premium to
compensate for the risk taking.
3. Risk may reduce profits because information is asymmetric (leading to so-called agency
cost)
, Short-termism: concentration on short term projects or objectives for immediate profits at
the expense of long-term interest such as long-term value creation.
Risk management: Risk management is the process which organizations use to mitigate the
impact of preventable and external risk. This involves determining risk appetite in line with
corporate objectives, risk identification, risk assessment, or control to comply with risk
appetite, and risk reporting for stakeholders. To also generate improvement in welfare for for
individuals and shareholders. And to meet regulator requirements.
Types of risk management:
• Physical loss controls: Costly measure to reduce probability of bad outcome and its
consequences.
• Financial risk management takes a variety of forms including hedging (via futures
or options) which is a linear hedging strategy. We also have insurance (which is a
special form of hedging) a non-linear hedging strategy. Both these strategy therefore
reduces the risk of an adverse event and we get compensated when we lose however
the difference is that non-linear hedging strategy we keep our profits when we win.
• Diversification: Diversification occurs when the firm partitions the random variable X
into a number of (partially) independent sub-parts. The net result is to reduce the
variability of the total X so long as the sub-parts are not perfectly positively
correlated. For example, buying stocks in two separate industry that are not perfectly
correlated.
• Hedging : A hedge is a strategy that seeks to limit risk exposures in financial assets.
Risk management is the process which organisation use to mitigate the impact of internal
and external risk.
Questions 1 & 2:
• 40 marks each
• Relevant to the lectures (7 topics)
• Requires essay answer
• Qualitative questions but you may be asked to provide graphical illustrations, numerical
examples and/or real-life case studies.
Question 3:
• 10 marks
• Relevant to Seminar A
• One short case study (Topic 3: Heuristics)
• Multiple Choice Question (MCQ)
• Choose the right answer and briefly explain your answer.
Question 4:
• 10 marks
• Relevant to Seminar B
• One short case study (Topic 5: Managerial Compensation)
• May require calculations (Not MCQ)
• Provide the right answer and briefly explain your answer.
TOPIC 1 : Introduction to risk and corporate finance
Risk concerns with the inability to foresee or control the future. Risk is used to describe the
possibility of an adverse outcome.
Why is risk a problem to firms?
Firms neither risk averse or risk loving
Agency costs arise from an ex-post information asymmetry between borrowers and lenders
and raise the cost of external financing. Costs of screening and monitoring, information
collecting and auditing.
Fluctuations in income & expenses, assets & liabilities, share prices (direct impact firm value) – internal
impacts
The impact of market and operational risk can affect the firm by producing fluctuations in
income and expenditure accounting items (including operating profits), in balance sheet
assets and liabilities, and in a quoted firm’s share price (and hence its market value). These
fluctuations are all ‘internal’ to the firm in the sense that they may have a direct impact on the
firm value via the operation of the various markets in which the firm contracts with its
stakeholders (product, labour, capital etc).
,While individuals have risk preferences (and obviously act at times in a risk averse or loss
averse way), it is difficult to see how firms could have risk preferences in the same way that
individuals do. The firm itself is merely a legal entity and Articles of Association cannot have
risk preferences! We cannot model the firm as if it were an individual unless it is a one
person business. In practice, corporate decisions are made by groups of people who may have
little of their personal wealth at risk.
The best way to think about this is to investigate the impact of risk on the value of the firm -
this is the maximum amount of money that the firm could be sold for. This value should be
equivalent to the present value of the firm’s future expected or average cash flows discounted
at an appropriate discount rate:
Firm Value = Σ t=0 E[cash flowt ] / (1 + r)
It follows therefore that risk will be a problem if it reduces firm value, and that this can happen
in three broad ways:
If risk increases the discount rate r. This has a direct impact on shareholders who cannot remove
this risk by diversifying there share portfolio (the so-called systematic risk).
2. If risk reduces profit, then stakeholders of the business may demand risk premium to
compensate for the risk taking.
3. Risk may reduce profits because information is asymmetric (leading to so-called agency
cost)
, Short-termism: concentration on short term projects or objectives for immediate profits at
the expense of long-term interest such as long-term value creation.
Risk management: Risk management is the process which organizations use to mitigate the
impact of preventable and external risk. This involves determining risk appetite in line with
corporate objectives, risk identification, risk assessment, or control to comply with risk
appetite, and risk reporting for stakeholders. To also generate improvement in welfare for for
individuals and shareholders. And to meet regulator requirements.
Types of risk management:
• Physical loss controls: Costly measure to reduce probability of bad outcome and its
consequences.
• Financial risk management takes a variety of forms including hedging (via futures
or options) which is a linear hedging strategy. We also have insurance (which is a
special form of hedging) a non-linear hedging strategy. Both these strategy therefore
reduces the risk of an adverse event and we get compensated when we lose however
the difference is that non-linear hedging strategy we keep our profits when we win.
• Diversification: Diversification occurs when the firm partitions the random variable X
into a number of (partially) independent sub-parts. The net result is to reduce the
variability of the total X so long as the sub-parts are not perfectly positively
correlated. For example, buying stocks in two separate industry that are not perfectly
correlated.
• Hedging : A hedge is a strategy that seeks to limit risk exposures in financial assets.
Risk management is the process which organisation use to mitigate the impact of internal
and external risk.
