Question

Competency Evaluate multiple risk types and their impact on different securities. Instructions You have just completed your third training for the new class of interns at your employer, Bank of Wealth Investment Brokers. You have now been asked to create a security risk FAQ (frequently asked questions) document. You will need to develop a security risk FAQ document that evaluates the various sources of investment risk and the methods to mitigate and avoid risk. An FAQ will provide brief and clear information on the required subjects. Typically, only questions and answer are in an FAQ document; however, since interns will be expected to know and understand the material thoroughly, your FAQs should be more detailed and offer supporting evidence, including a reference list. Write a total of 8 to 10 FAQs. The FAQ document should give the interns enough information to understand the various sources of investment risk, risk mitigation, and risk avoidance. Be sure to use audience-specific language and tone in the document. Remember, you are writing the FAQs for the interns, but the Portfolio Manager may read it. Be creative, and make your FAQs fun, yet still clearly organized.

Answer 1

FREQUENTLY ASKED QUESTIONS (FAQs)

1. What is Investment Risk?

Investment risk can be defined as the probability or likelihood of occurrence of losses relative to the expected return on any particular investment. In simply terms, it is a measure of the level of uncertainty of achieving the returns as per the expectations of the investor. It is the extent of unexpected results to be realized.
Risk is an important component in assessment of the prospects of an investment. Most investors while making an investment consider less risk as favorable. The lesser the investment risk, more lucrative is the investment. However, the thumb rule is the higher the risk, the better the return.

2. What is an Investment Platform?

An investment platform is an online service which provides access to funds from a wide range of Investment Managers, which means that you can pick various funds from various Investment Managers but you do not have to go to each one of them individually as they are bought by the Platform provider on your behalf. The various types of product on the Platform such as ISA, Pension, Investment Bonds, Investment Trusts, OEIC’s ETF’s etc.

3. What is Investment Risk Management? What is the purpose?

Investment risk management is the secret to safe, consistent profits in any market condition. The purpose of risk management is to ensure that your investment losses never exceed acceptable boundaries by following disciplined practices including position sizing, diversification, valuation, loss prevention, due diligence, and exit strategies. The reason risk management is essential - not optional - is because the amount you lose during the tough times determines how much you must make during the good times to meet your financial goals. You must preserve your capital during difficult periods so that your offensive investment strategy has a larger base of capital to grow from when profitable times return. For example, imagine a football team with such an effective defense (risk management strategy) that they never give up a first down to their opponent. This team will be very tough to beat because their offense doesn't have to score many points to win, and they will have most of the game to do it since the defense will spend so little time on the field.The same is true with investing. Financial risk management controls the investment game. It keeps the line of scrimmage near break even so the offense doesn't have to make up for losses when executing the next play. It preserves capital when the opponent is pounding away at you so that the next touchdown is new profit rather than recovered losses.

4. What are the various sources of Investment Risk?

Types of Investment risk are as follows:-

1. Market risk. The risk of investments declining in value because of economic developments or other events that affect the entire market. The main types of market risk are equity risk, interest rate risk and currency risk.

• Equity risk – It applies to an investment in shares. The market price of shares varies all the time depending on demand and supply. Equity risk is the risk of loss because of a drop in the market price of shares.
• Interest rate risk – It applies to debt investments such as bonds. It is the risk of losing money because of a change in the interest rate.
• Currency risk – It applies when you own foreign investments. It is the risk of losing money because of a movement in the exchange rate.

2. Inflation risk. The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time – the same amount of money will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or debt investments like bonds. Shares offer some protection against inflation because most companies can increase the prices they charge to their customers. Share prices should therefore rise in line with inflation. Real estate also offers some protection because landlords can increase rents over time.

3. Concentration risk. The risk of loss because your money is concentrated in 1 investment or type of investment. When you diversify your investments, you spread the risk over different types of investments, industries and geographic locations.

4. Credit risk. The risk that the government entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit risk applies to debt investments such as bonds. You can evaluate credit risk by looking at the credit rating of the bond. For example, long-term Canadian government bonds have a credit rating of AAA, which indicates the lowest possible credit risk.

5. Reinvestment risk. The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a bond paying 5%. Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular interest payments at 4%. Reinvestment risk will also apply if the bond matures and you have to reinvest the principal at less than 5%. Reinvestment risk will not apply if you intend to spend the regular interest payments or the principal at maturity.

6. Foreign investment risk. The risk of loss when investing in foreign countries. When you buy foreign investments, for example, the shares of companies in emerging markets, you face risks that do not exist in Canada, for example, the risk of nationalization.

7. Horizon risk. The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long term. If you must sell at a time when the markets are down, you may lose money.

8. Longevity risk. The risk of outliving your savings. This risk is particularly relevant for people who are retired, or are nearing retirement.

9. Liquidity risk. The risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price. In some cases, such as exempt market investments, it may not be possible to sell the investment at all.

5. What is an Investment Advice?

“Investment advice” is an advice relating to investing in, purchasing, selling or otherwise dealing in securities or investment products, and advice on investment portfolio containing securities or investment products, whether written, oral or through any other means of communication for the benefit of the client and shall include financial planning.

Provided that the investment advice given through newspaper, magazines, any electronic or broadcasting or telecommunications medium, which is widely available to the public shall not be considered as investment advice for the purpose of IA regulations. However, investment advisers who make public appearance or make recommendations or offer an opinion concerning securities or public offers through public media while making recommendations through public media.

6. What are the steps to evaluate a Risk?

For the risk evaluation, appropriate risk reduction methods cannot be developed until the possible hazards, or losses are thoroughly evaluated.

The steps included in risk evaluation are as follows:-

1. Identification:- Risk identification must include whether the risk is, first and foremost, preventable. These risks come from within — they can usually be managed on a rule-based level, such as employing operational procedures monitoring and employee and manager guidance and instruction. Strategy risks are those that are taken on voluntarily to achieve greater rewards. External risks originate outside and are not in the businesses’ control, such as natural disasters. External risks are not preventable or desirable. Cost, performances and schedules are some of the business variables that may be impacted by any category of risk. Considerations of risks included in the assessment should include those that may impact current and potential customers and those that impact resources necessary to accomplish internal practices successfully.

2. Impact Assessment:- Determine the probability and significance of certain "risky" events. Anticipated risks can be rated according to their degree of probability.

3. Develop Strategies:-Risk mitigation planning strategies and implementations should be developed for risks categorized as high or medium probability. Low risks may be tracked or monitored for impact but are less important in this step.

7. What are the methods of Risk Mitigation? Explain with examples.

(1) Accept the Risk - The risk is accepted because it has a low impact or low likelihood of occuring.

Examples of this mitigation strategy: Allowing company executives to travel by air or train. Using a script to upload data, because it is much faster than manual data entry, even though manual data entry might be safer. Going ahead with an event despite the risk of rain. Deciding to take part in a risky activity, which while well managed and supervised is still risky (e.g. motor racing). Effect on risk:

• Action on likelihood
• Action on impact
• Action on proximity

(2) Hedge the Risk - It is used to manage financial risk. The risk is offset or limited by taking an opposite position in two markets.

Example of Hedging a risk: A US company exporting to Europe takes out a Currency Forward Contract with a bank, this is an agreement to exchange an amount of dollars for Euros on a future date. It effectively allows the company to make a sale at the current exchange rate, so they don't lose out due to currency fluctuations. Effect on risk:

• Action on likelihood
• Action on impact
• Action on proximity

(3) Risk Buffer - The impact of a risk is reduced by the provision of buffer. The obvious example is a contingency budget set aside to cover risks, but buffer could also be additional resources, or time built into a project.

Example of using a Risk Buffer: A manufacturer keeps a buffer of raw materials inventory in case a supplier is unable to deliver a raw material shipment on time. Effect on risk:

• Action on likelihood
• Action on impact
• Action on proximity

(4) Avoid the risk - The risk is avoided entirely, perhaps by taking a different approach or by abandoning a course of action.

Example of Avoiding a Risk: The pharmacetical company Novartis abandoned an R&D project due to risks around finding a cost effective synthesis route. Later Speedel, who had a more flexiblity in selecting a partner for solving synthesis problems took on the project. Effect on risk:

• Action on likelihood
• Action on impact
• Action on proximity

(5) Limit or reduce the risk - Safeguards are put in place to limit or reduce the potential impact of a risk or the likelihood of the risk occuring.
Example of actions taken to limit or reduce a risk:

• Authorising project expenditure by phase for example authorising expenditure on a feasibility phase rather than on the whole project.
• Safety barriers, signage and warning lights
• Backing up databases.
• Failover and redundancy processes in data centres.

8. State the best Risk Mitigation Strategy.

Risk mitigation strategies are designed to eliminate, reduce or control the impact of known risks intrinsic with a specified undertaking, prior to any injury or fiasco. With these strategies in place, risks can be foreseen and dealt with. Some strategies may be economically unfeasible for successful risk management. Generally, risks are taken on when strategies can be designed that reduce the risk level to “as low as reasonably practicable." These strategies are balanced with efforts to reduce or eliminate the associated hazard (such as time, cost or complexity). The best mitigation strategy may lower the risk probability, the severity of outcome, or reduce the organization’s exposure to the risk. More than one mitigation strategy may be employed to attain optimal results.

The four types of risk mitigating strategies include risk avoidance, acceptance, transference and limitation.

• Avoid: In general, risks should be avoided that involve a high probability impact for both financial loss and damage.
• Transfer: Risks that may have a low probability for taking place but would have a large financial impact should be mitigated by being shared or transferred, e.g. by purchasing insurance, forming a partnership, or outsourcing.
• Accept: With some risks, the expenses involved in mitigating the risk is more than the cost of tolerating the risk. In this situation, the risks should be accepted and carefully monitored.
• Limit: The most common mitigation strategy is risk limitation, i.e. businesses take some type of action to address a perceived risk and regulate their exposure. Risk limitation usually employs some risk acceptance and some risk avoidance.