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Chapter Eleven

Risk Management (Home Study)

1 Introduction

1.1 The examining team has stated that this is a key topic within the
syllabus. His article, that has been reproduced at the end of the
chapter is an important read,

1.2 Risk Management is a substantial part of ACCA P1. A lot of that

knowledge will be required here but with some emphasis on
particular areas.

2 Summary of P1

2.1 Sources and impacts of common business risks

! market
! credit
! liquidity
! technological
! legal
! health and safety
! reputation
! business probity
! derivatives

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2.2 Approach to risk management

! Identify
! Assess
! Measure
! Avoid
! Accept
! Hedge/Reduce Effect

3 ACCA P4-Main Risk Categories

3.1 At this level there are four major areas of risk:-

! Business Risk
! Financial Risk
! Foreign Currency Risk
! Interest Rate Risk

4 Business Risk

4.1 Defined as being the cause of variations in:

" Company profits

" Returns to a shareholder

It is related to:

i. Nature of business activity

ii. Level of operational gearing –amount of fixed costs that make
up the operational cost base.

4.2 Total business risk is measured using the standard deviation Si. Hand
in hand goes expected return Ri.

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4.3 Business risk can be managed or reduced initially using

“Portfolio Theory”.

5 Portfolio Theory(PT)

5.1 PT can be used by

! Directors-combine business activities logically

! Shareholders- create a logical share portfolio

5.2 PT relies upon the basic concept that if shares or business

activities that are combined are LESS THAN PERFECTLY
CORRELATED, risk can be reduced

5.3 The correlation coefficient is a key value and its range is:

-1 0 +1

Perfect No Correlation Perfect

Negative Positive

Correlation Correlation

6 Extend PT-more investments

6.1 The above only assumes that two investments are combined.
Naturally the more the investments are added the lower Sp should
go.

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6.2 Sp does not reach nil

Market Portfolio

Sp

Unsystematic

Risk

Systematic Risk

20

No of investments

6.3 PT removes one part of Sp –unsystematic risk. This is the specific risk
caused by factors relating to the company or industry.

6.4 The risk remaining is systematic risk-that caused by general

economic and political factors. This can be measured via Beta factor.

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7 CAPM

7.1 Once the “market portfolio” fully diversified position has been
reached ,the company and shareholders should use CAPM.

Risk =βe

Return= RF + (Rm-RF)βe

OR

RF + (ERP)βe

7.2 Remember from the earlier chapter on Cost Of Capital how a βe

can be analysed.

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8 WHY DO DIRECTORS LIKE TO HAVE A DIVERSIFIED BUSINESS?

Several Reasons:

! Stabilise profits
! Lead to move predictable cash flows
! “Larger” or safer business
! Conglomerate theory-some directors feel they can run any
type of business (Virgin, Tata)
! Foreign acquisitions will reduce economic risk.
! Risk of the investment failing a more of a problem for the
shareholder than the director
! May be the only expansion option.

RELEVANT ACCA ARTICLE

“Risk Management”

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