CFA Institute Investment Foundations Program: Chapter 18 – Risk Management (Part II)

In a previous article, we introduced the CFA Institute Investment Foundation Program (Read more here).  It is a free program designed for anyone who wants to enter or advance within the investment management industry, including IT, operations, accounting, administration, and marketing.  Candidates who successfully pass the online exam earn the CFA Institute Investment Foundations Certificate.

There are total of 20 Chapters in 7 modules, covering all the essential topics in finance, economics, ethics and regulations.  This series of articles will highlight the core knowledge of each chapter.

Chapter 18 provides an overview of the risk management. The learning outcome of chapter 18 is as follows:

·       Define risk and identify types of risk;

·       Define risk management;

·       Describe a risk management process;

·       Describe risk management functions;

·       Describe benefits and costs of risk management;

·       Define operational risk and explain how it is managed;

·       Define compliance risk and explain how it is managed;

·       Define investment risk and explain how it is managed;

·       Define value at risk and describe its advantages and weaknesses.

It is important to recognise that all companies must take risks in the course of their business activities to be able to create value. The restriction of activities to those that have no risk would not generate sufficient returns for shareholders or investors, who would thus be less willing to provide capital to companies or to invest their savings in the range of investments available.

Therefore, each company must determine the risks that should be exploited, which are often risks the company has expertise in dealing with and can benefit from. Companies must also determine the risks that should be mitigated or eliminated, which are often risks it has little or no expertise in dealing with. A risk management process that enables managers to distinguish between the risks that are most likely to provide opportunities and the risks that are most likely to be harmful helps companies generate superior returns. Risk response strategies can be classified into four “T” categories:

Tolerate. This strategy involves accepting the risk and its effect. In some cases, the risk is well understood and taking it provides opportunities to create value. In other cases, the risk must be taken because other risk response strategies are unavailable or too costly.

Treat. This strategy involves taking action to reduce the risk and its effect.

Transfer. This strategy involves moving the risk and its effect to a third party.

Terminate. This strategy involves avoiding the risk and its effect by ceasing an activity.

Risk management functions vary by company, but it is typical for companies in the investment industry to have a stand-alone risk management function with a senior head, often called the chief risk officer, who is capable of independent judgment and action. The chief risk officer often reports directly to the board of directors. The purpose of establishing a strong independent risk management function is to build checks and balances to ensure that risks are seriously considered and balanced against other objectives, such as profitability.

Despite the existence of specialist risk managers, risk management remains everyone’s responsibility. Risk managers assess, monitor, and report on risks, and in some cases, they may have an approval function or veto authority. But it is the members of the business functions, such as portfolio managers or traders, who “own” the risk of their deals. These employees have the most intimate knowledge of what they trade, and they must monitor their deals on a regular basis. The risk manager must ensure that all relevant risks are identified, but the final judgment on the business decision lies with the decision makers. Therefore, it is important for risk management to be part of the company’s corporate culture and to be fully integrated with core business activities.

Companies will often use a three-lines-of-defence risk management model, as illustrated below. 

Front-line employees and managers, through their daily responsibilities, form the first line of defence. The risk management and compliance groups operate as a second line of defence, assisting and advising employees and managers while maintaining a certain level of independence. An internal audit function then forms the third line of defence. Internal audit is an independent function. Internal auditors follow risk-based internal audit programmes, delving into the details of business processes and ensuring that information technology and accounting systems accurately reflect transactions. Proactive auditors may also advise managers on how to improve risk management, controls, and efficiency. Best practice suggests that internal auditors should report directly to the audit committee of the board of directors to ensure their independence. Thus, risk and audit committees of the board will often hear presentations from the heads of risk management, compliance, and internal audit.

Risk management provides a wide range of benefits to a company. It can help by

·       supporting strategic and business planning;

·       incorporating risk considerations in all business decisions to ensure that the company’s risk profile is aligned with its risk tolerance;

·       limiting the amount of risk a company takes, preventing excessive risk taking and potential related losses, and lowering the likelihood of bankruptcy;

·       bringing greater discipline to the company’s operations, which leads to more effective business processes, better controls, and a more efficient allocation of capital;

·       recognising responsibility and accountability;

·       improving performance assessment and making sure that the compensation system is consistent with the company’s risk tolerance;

·       enhancing the flow of information within the company, which results in better communication, increased transparency, and improved awareness and understanding of risk; and

·       assisting with the early detection of unlawful and fraudulent activities, thus complementing compliance procedures and audit testing.

Source: https://www.cfainstitute.org/en/programs/investment-foundations

The chief risk officer working at an investment management firm typically reports directly to the:

A shareholders.

B board of directors.

C chief investment officer.

 

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What the 1% Do and Not the 99%!

The rich are getting richer and the poor are getting poorer. Preston Ely, the founder of Real Estate Mogul shared in his article how he became richer and joined the 1 percent. He cited seven reasons but we list the key five below:

1. Be the best

“It’s a funny thing about life; if you refuse to accept anything but the best, you very often get it.” —W. Somerset Maugham

The 1 percent know people like to buy the best products and services possible. So they make it their goal to be the best and produce the best. You are going to have a hard time producing the best products and services if you, personally, are not the best. So if you’re not the best, don’t focus so much on your work. Focus on you. Sharpen your skills. Sharpen your mind.

2. Value production over playtime.

“The supreme accomplishment is to blur the line between work and play.” —Arnold J. Toynbee

We need playfulness and curiosity to fuel our creativity and motivation to work. Find work you enjoy, then work time becomes playtime. The 1 percent play all day. There are no weekends or weekdays, workdays or vacation days, Sundays or Mondays. They’re all the same. You know you’re living life the way it is intended to be lived when you look forward to work. You actually prefer work.

3. Have the 99 percent do your work for you

The 99 percent work and the 1 percent hire the 99 percent.

You don’t really have to do everything from operation to management by yourself. Many people are willing to do it for you. Spend your time to seek for new business opportunities instead.

4. Spend your money on things that make you more money

“If you don’t know how to care for money, money will stay away from you.” —Robert Kiyosaki

People who don’t know how to spend their money wouldn’t earn more money. Think wisely, which one is better: buy a Prada handbag or Prada shares?

5. Give as much money away as possible

“Give and it will be given to you.” — Luke 6:38a

The 1 percent give away more money than the entire 99 percent combined. The time to start doing this is right now no matter how much money you make or have or don’t make and don’t have. If you don’t do it now, you won’t do it when you’re a 1 percenter. And you have a much better chance of becoming a 1 percenter if you give now.

A mindset that always believes ‘you can do it’ is needed on the road to success. What else from the 1% do you think the 99% should learn and do? Comment below!

Reference:

Preston Ely, 7 Things the 1% Do That the 99% Don’t www.success.com

OPR Cut: Was That Necessary?

On January 22, 2020, Bank Negara Malaysia (“BNM”) cut its Overnight Policy Rate (“OPR”) by 25 basis points to 2.75%. Some were caught by surprise!

Was BNM signalling that 4^th quarter GDP (for 2019) will not be great? BNM says it is a “pre-emptive’ measure to contain uncertainty in the global sphere.

Some may argue that global economy may actually strengthen with Phase 1 trade agreement between the U.S. and China. Perhaps, a higher volume of trade will enhance Malaysia’s trade flows?

Central banks resort to lower interest rates in order to boost economic activity and hence GDP. Empirical evidence suggests rate cuts may not stimulate growth, especially if business outlook is cautious and domestic demand is tepid. Yields on Malaysian Government Securities (MGS) shed about 10 bps to 13 bps after the announcement. Exchange rate showed a marginal decline.

What if it had raised rates? What signal would that give? Mortgage rates would increase, savings and deposit rates will increase, credit card rates will increase, auto loans will increase in interest rate and stock market indices may decline. Savers are generally rewarded while borrowers are now negatively impacted. Investors in equities or projects may delay their investment because conditions are not favourable. Exchange rate, however, may appreciate against the U.S. dollar and reduce cost of food imports. (Malaysia imported nearly RM20 billion processed food in 2018 (The Star, June 5, 2019).

Now with the Coronavirus epidemic, tourists coming to Malaysia will drop, retail sales may decline, and investments could be deferred. So the “pre-emptive” move by BNM looks timely in light of recent developments. For China, the outbreak could cost more than 40 billion Yuan (USD 5.8 billion) and shave 1% off China’s 2020 GDP growth. For Australia, GDP may fall by USD2.3 billion and 20,000 full-time jobs could be at risk. This is after the horror of a bushfire season.

A 2004 analysis determined that SARS cost the world economy about USD40 billion, travel, trade and financial flows had direct and knock-on effects. Oil prices fell by 20% during the 2002-2003 SARS season.

What about Malaysia?

SARS in 2002-2003 impacted tourism by a third, hotel occupancy plunged, air travel was decimated, restaurants, cinemas and entertainment outlets struggled to remain in business. Growth was dented by 0.5% for Southeast Asian countries and China suffered 1-2% reduction in its growth rate (Centre for International Development). SARS caused a USD25 billion loss to China alone. Global impact by Australia’s Griffith University puts it at between USD30-100 billion. And now 20 years after SARS, we face another health emergency that will impact lives and the economy.

So what about the OPR cut?

It is a pre-emptive move but can consumption and investment step-up? Not with Coronavirus! People will remain cautious. The only parties likely to step-up are glove manufacturers and those producing N95 masks (or other medical aids). We need fiscal support to assist sectors impacted, stimulus for sectors encouraged and much needed reforms of “sacred” policies.

References:

1. Bank Negara’s puzzling pre-emptive move to cut OPR, Ranjit Singh, Focus Malaysia

2. SARS wiped $40 billion off world markets; what will coronavirus do? Martha C White, NBC News

3. Food security is important, Star Online, 5 June 2019

4. Coronavirus could cost Australia’s struggling economy billions, Daily Mail Online, 27 Jan 2020.

The Death of First Class?

Airlines’ first class today is far better than what we had ten years ago. More space, more privacy, and more comfort. But the decline of first class is accelerating this year. In 2008, British Airways had around 560,000 first class seats. By 2018, it had almost 100,000 less. In 2008, Delta offered almost 400,000 first class seats. Now, they have just over 200,000. First class is disappearing from airlines, but why?

If you are planning to spend your Christmas in London, this is how much you will pay for your ticket:

Travel Class	*Airfare for oneway (MYR)
First	17,703
Business	10,163
Premium Economy	5,314
Economy	2,434

*British Airways, Kuala Lumpur to London, 25/12/2019

The demand has fallen. One reason is the business class product has become good today. Passengers simply pay an affordable fare above economy but not as expensive as first class for a flat comfortable seat. For business travellers, many corporates could be concerned about employees’ convenience and productivity. Thus, they are willing to pay more to book better seats for their employees.

Malaysia Airlines recently rebranded their first suite as ‘business suite’. Business suite is an enhanced business class service at an attractive price point for passengers. Previous first class passengers can now opt for business suite with dedicated check-in counter, first class lounge, and a 50kg baggage allowance.

Some airlines offer ‘premium economy’, which is something quite different to the ‘economy plus’ option. Premium economy has its own cabin that provides more privacy for passengers. In addition, more legroom and better seats. Some airlines even provide priority boarding for premium economy passengers.

For frequent travellers, there is something far better than first class —— flight hailing. New shared ownership and ride hailing services are driving down the cost of private jets, and for the busy bigwig, it’s the perfect solution. Executives may value being able to schedule their flight times themselves rather than wait for a timetabled flight. And being processed through a private jet terminal is phenomenally faster. Smaller jets can land closer to the destinations too,  saving valuable business time.

There’s not much of a case for keeping first anymore. Airlines that do still offer first have two main reasons: (i) to provide upgrades from business class, an incentive for brand loyalty. But that case is now weakening, as most customers are happy in business. (ii) The ‘halo effect’, basking in the glow of its crowning glory. Take Emirates, for example; because their first class product is so very good, flyers begin to think economy on Emirates is somehow fancier as a result (Joanna Bailey, 2019).

The death of first class perhaps is good for majority of passengers. Why would you pay MYR 7,540 more when business is this good? If you really need more exclusivity, you will still be able to find it in some places: business suite, for instance. Replacing first class with business class perhaps could increase the number of passengers in a plane. From the environment point of view, this could reduce individual's carbon contribution. So yes, let’s welcome more business class on board!

Reference:

1. Gilbert Ott, Airlines Are Officially Ditching First Class, And Fast… www.godsavethepoints.com/

2. Joanna Bailey, First Class Is Disappearing From Airlines simpleflying.com/

3. Firdaus Hashim, Malaysia Airlines has rebranded the first class product offered on its Airbus A350-900s and A380s as 'Business Suite' www.flightglobal.com/

Happy Chinese New Year!

Year of the Rat (2020)

7 Key Trends That Will Change Supply Chain Management in 2020!

The supply chains for a variety of businesses has grown more complex. They are now smarter, faster, more consumer centric and sustainable. According to Accenture, 76% of supply chain managers see customization of services and products and faster fulfilment of orders as the two top-most consumer demands in the coming years. Higher expectation from the consumers impact every part of the supply chain. InVerita has summarised seven supply chain trends that will blow up in 2020:

1. Artificial Intelligence

Supply chain was one of the top areas where businesses are generating revenue from AI investment. The adoption of machine learning and other AI technologies provides new insights into a wide range of aspects, including logistics and warehouse management, collaboration, and supply chain management. AI enables the tracking and measurement of all the factors needed to improve demand forecasting accuracy. Having all this information could easily reshape warehouse management, with self-driving forklifts, automated sorting, and self-managing inventory systems.

2. IoT & Big Data

Through the installation of sensory devices on products, businesses can track their products movement and manage their inventory easily and automatically. The impact of these IoT trends in the supply chain is reduced costs and improved service delivery. The data is collected in a central system and can then be analysed to derive valuable insights.

3. Wearable Technology

Wearable devices, together with cloud technology, can allow workers to input and access data in real-time. Warehouse managers can leverage this tech to collect correct inventory data quickly as well as keep track of products manufactured, stored, and transported at any given time. These devices can also help companies to detect health issues in their workers as such promote their wellbeing.

4. Omnichannel Service Delivery

Omnichannel is a multi-channel sales approach that provides the customer with an integrated customer experience. The customer can be shopping online from a desktop or mobile device, or by telephone, or in a bricks and mortar store and the experience would be seamless. Omnichannel marketing can be a valuable asset for businesses that are looking to deliver a better customer experience.

5. Robotic Process Automation (RPA)

RPA involves automation of manual processes using the software. It’s a software robot that is programmed to mimic human actions. As such, RPA will be used to automate most of the repetitive warehouse tasks and fasten the process of order fulfilment.

6. Autonomous Driving

As the demand for delivery drivers grows and the supply of labor declines, businesses will be forced to turn to alternatives such as autonomous vehicles. Autonomous vehicles have the ability to impact supply chains through cost savings, improved efficiency, and increased safety.

7. Augmented Reality (AR) & Virtual Reality (VR)

AR and VR in retail helps to improve customer engagement and involvement. In supply chains, AR improves the order picking process. By using smart glasses, employees can see exactly where items should fit on carts while they are picking orders. AR and VR could help managers to get a real time look at any site at any time to ensure that processes are running as planned. This is particularly important when key personnel aren’t able to be on site.

These advancing technologies are reshaping the supply chain, not in the future but now! Technologies will enhance the speed, dynamics, and resilience of internal, as well as, external supply chain operations, which will, in return, strengthen customer relationships and increase revenue flow. Therefore, companies should be aware of ongoing changes and constantly be on the lookout of innovative solutions in order to stay competitive.

Reference

1. inVerita, 7 supply chain trends that will blow up in 2020 https://medium.com/

2. Andrew Arnold, How AR And VR Are Revolutionizing The Supply Chain www.forbes.com/

3. Lucy Benton, 6 Ways AI Is Impacting The Supply Chain https://supplychainbeyond.com/

Are US Drug Prices High?

Drug prices in the United States are in the extreme. Many drugs cost more than $120,000 a year. A few are even closing in on $1 million. The Department of Health and Human Services (HHS) estimates that Americans spent more than $460 billion on drugs—16.7 percent of total health-care spending—in 2016, the last year for which there was definitive data. On average, citizens of other rich countries spend 56 percent of what Americans spend on the exact same drug.

HHS estimates that over the next decade, drug prices will rise 6.3 percent each year, while other health-care costs will rise 5.5 percent. Basic economic principles suggest that drug prices should be going down, not up. For most drugs, manufacturing volumes are increasing, and little new research is being conducted on those already on the market.

Peter Bach, a researcher at Memorial Sloan Kettering, and his colleagues compared prices of the top 20 best-selling drugs in the United States to the prices in Europe and Canada. They found that the cumulative revenue from the price difference on just these 20 drugs more than covers all the drug research and development costs conducted by the 15 drug companies that make those drugs. To be more precise, after accounting for the costs of all research—about $80 billion a year—drug companies had $40 billion more from the top 20 drugs alone, all of which went straight to profits, not research. More excess profit comes from the next 100 or 200 brand-name drugs.

But the one company that invests the most in research and development in the world is not a drug company. It’s Amazon. The online retailer spends about $20 billion a year on R&D, despite being renowned for both low prices and low profits. Among the 25 worldwide companies that spend the most on research and development—which is more than $5 billion a year—seven are pharmaceutical manufacturers, but eight are automobile or automobile-parts companies with profit margins under 10 percent. Amazon’s operating margin is under 5 percent. Meanwhile, the top 25 pharmaceutical companies reported a “healthy average operating margin of 22 percent” at the end of 2017, according to an analysis by GlobalData.

If you watch television, you know part of the answer to where this extra money is going: sales and advertising. Of the 10 largest pharmaceutical companies, only one spends more on research than on marketing its products.

Pharmaceutical companies often claim that the research costs of unsuccessful drugs also have to be taken into account. After all, 90 percent of all drugs that enter human testing fail. But most of these failures occur early and at relatively low costs. About 40 percent of drugs fail in preliminary Phase I studies, which assess a drug’s safety in humans and typically cost just $25 million a drug. Of the drugs that clear this first phase of testing, about 70 percent fail during Phase II studies, which assesses whether a drug does what it is supposed to do. The research costs of these studies are still relatively low compared with overall R&D costs—on average, under $60 million a study (Ezekiel, J. Emanuel, 2019).

It’s the same in Malaysia. There is no price control mechanism for pharmaceuticals. Drug prices are not regulated and it is left to market forces to determine the prices. According to the Star (19 Jun 2019), medicine prices and profit margins for both innovator and generic drugs have been observed to be higher in Malaysia than in other countries, sometimes by as much as 400%!

In May 2019, Health Minister Datuk Seri Dr Dzulkefly Ahmad said the ministry will use External Reference Pricing (ERP) to benchmark drug prices in Malaysia, choosing the three lowest prices and averaging them to determine the ceiling price. The problem is prices in different markets are not comparable. This is because different regions have differences in the burden of disease, indications, willingness and ability (income) to pay. Also, controlling medicine price may not make a significant impact to reduce healthcare costs. This is because based on statistics of out-of-pocket healthcare spending by private patients, only 14% of the spending is from medicine. Therefore, private healthcare centres may recover the loss of revenue from medicines by shifting their source of revenue to other healthcare services, such as consumables, medical devices and hospital bed charges.

What can we do?

Drug prices should be more transparent. A declaration of wholesale prices in a free market will allow the government to establish a baseline price, which would encourage even more competition among drug manufacturers. Patients usually pay for their medicines at the centres they are seeking healthcare. With higher price visibility, patients can compare and choose where to get their medicines.

Reference:

1. Ezekiel, J. Emanuel, Big Pharma’s Go-To Defense of Soaring Drug Prices Doesn’t Add Up, www.theatlantic.com

2. Medicines price control will have negative repercussions, 4 Oct 2019, MalaysiaKini

3. Should drug prices be regulated or decided by competition? 19 Jun 2019, TheStar

Battery Recycling: A Potential Market in China?

The global auto market is not growing, in fact it is shrinking. Auto sales peaked in 2017 at nearly 86 million on a trailing-12-months basis; right now in 2019, sales are closer to 76 million (Bullard, 2019).

But electric vehicles (EV) is a growth market. China’s sales of “alternative energy vehicles” — mostly electric, with some hybrids and a small number of natural gas combustion engines — are nearly 1.5 million. The contrast between EV sales and all auto sales in China is shown as follows:

Source: Bloomberg

China has already begun owning the EV market. Albanese and Landess from BloombergNEF used Automaker EV Exposure Score analysis to evaluate the market players. The score weights electric passenger vehicle sales volumes, revenue, and current and future model count, then assigns greater value to pure electric as opposed to plug-in sales. From their analysis, of the top 10 automakers, nine are Chinese:

 Top 10 automakers by BloombergNEF electric passenger vehicle exposure score

Source: BloombergNEF

One of the issues brought by growing EV market is the transition to battery power will dramatically increase the thirst for raw materials, including copper, nickel and cobalt. For a country like China, it has to import large amounts of lithium every year, over 85% of the total is imported from foreign countries. The demand has pushed up prices almost fourfold in three years. Another issue is the environmental problem caused by Lithium-ion batteries. Lithium-ion batteries can be highly toxic if damaged. Extracting the lithium and materials needed to produce them can harm the surrounding environment (Akihide Anzai, 2019). But China is coming up with a solution — recycling.

China has benefited from around a decade of mobile phone manufacturing. This enabled it to perfect lithium-ion battery recycling as part of a growing handset refurbishing industry. Three out of four phones that are sent for refurbishing go to China, according to Hans Eric Melin, director of Circular Energy Storage Research.

Last September, Beijing issued its first set of industry guidelines for EV battery recycling, including a white list of five recycling companies. Among them is Shenzhen-based GEM. As one of the biggest battery recyclers in China, the company handles over 3 million tons of waste resources each year. The company produces 20% of the country's reclaimed cathode materials for lithium-ion batteries by volume.

The Chinese Government is targeting new-energy vehicle sales of 2 million in 2020 and 7 million in 2025. According to the China Automotive Technology and Research Center, the volume of used batteries in China will total between 120,000 tons and 200,000 tons in 2018-2020. And that figure will increase to 350,000 tons in 2025, according to local media. Given a growing number of used batteries, battery recycling is a potential market in China.

Reference:

1. Nathaniel Bullard, China Is Winning the Race to Dominate Electric Cars, Bloomberg

2. Akihide Anzai, China scrambles to tap EV battery recycling opportunity, Nikkei Asian Review

3. Jason Deign, How China Is Cornering the Lithium-Ion Cell Recycling Market, www.greentechmedia.com

Why Do Airlines Collapse?

2018-2019 were troubling years for aviation. Multiple carriers have gone out of business. But for some more established carriers, revenue and passenger loads are strong. However, competition from low-cost carriers and price sensitivity result in airlines failing due to small market movements. Input costs like fuel to wages may vary sharply, leaving a carrier in dire straits.

Jet Airways (India), Iceland’s WOW and Thomas Cook have all gone bust. Northwest to Continental were absorbed by Delta and United respectively. Air2there, a New Zealand carrier closed in July 2018; Air Costa Rica closed in July 2019 after two years; Air Link, an Australian carrier closed after 47 years in operation; NextJet, a 16-year-old Swedish carrier closed in May 2018 and so too Sparrow, another Swedish carrier, declared bankrupt in June 2018. (And that’s not the full list).

But why did they collapse?

One of the most difficult things in running an airline is projecting accurately the costs involved. Very little, in terms of overheads, is fixed. Fuel costs are a significant expense for airlines and variations will make budgeting really tough. Fuel costs constituted 23.5% of total expenses in 2018. Any variation upward could “break the camel’s back”. Reuters says labour costs have surpassed fuel in 2016. IATA estimated airlines lose USD5 billion globally due to rising employment costs.

In many markets, supply exceeds demand. Overcapacity means the weakest will not survive. An example of that was Monarch in 2017. Flights may have grown but fares have dropped – putting pressure on margins.

Rapid growth of networks, fleet and services is usually another reason. It doesn’t mean one does not grow but growth has to be in a measured way. Primera Air is an example of too fast too soon. Then there is ATC (air traffic controllers) strikes which ruined carriers operating on a shoe string.

Getting new investors to avert an adverse situation could be a problem. When talks break down, airlines have no choice but to close – WOW Air, Cobalt and Thomas Cook are examples. The trick is to build a cash-pile in good times, grow measuredly and try to project several scenarios on costs and revenue over very short-term periods. Then perhaps one could reasonably fly through a turbulence.

What about MAS? That’s another story!

Reference:

1. Joanna Bailey, Why Have So Many Airlines Collapsed In The Past Year? https://simpleflying.com/

2. James Asquith, The Biggest Airlines To Ever Go Bankrupt www.forbes.com

CFA Institute Investment Foundations Program: Chapter 18 – Risk Management (Part I)

In a previous article, we introduced the CFA Institute Investment Foundation Program (Read more here).  It is a free program designed for anyone who wants to enter or advance within the investment management industry, including IT, operations, accounting, administration, and marketing.  Candidates who successfully pass the online exam earn the CFA Institute Investment Foundations Certificate.

There are total of 20 Chapters in 7 modules, covering all the essential topics in finance, economics, ethics and regulations.  This series of articles will highlight the core knowledge of each chapter.

Chapter 18 provides an overview of the risk management. The learning outcome of chapter 18 is as follows:

·       Define risk and identify types of risk;

·       Define risk management;

·       Describe a risk management process;

·       Describe risk management functions;

·       Describe benefits and costs of risk management;

·       Define operational risk and explain how it is managed;

·       Define compliance risk and explain how it is managed;

·       Define investment risk and explain how it is managed;

·       Define value at risk and describe its advantages and weaknesses.

This chapter puts the emphasis on the types of risks that companies in the investment industry (investment firms) and people working for these companies face. It is important for companies to develop a structured process that helps them recognise and prepare for a wide range of risks. Although risk management is sometimes viewed as a specialist function, a good risk management process will encompass the entire company and filter down from senior management to all employees, giving them guidance in carrying out their roles.

Risk arises out of uncertainty. It can be defined as the effect of uncertain future events on a company or on the outcomes the company achieves. One of these outcomes is the company’s profitability, which is why the effects of risk on profit and rates of return are often assessed.

There are three risks to which companies in the investment industry are typically exposed and that are discussed in this chapter:

Operational risk, which refers to the risk of losses from inadequate or failed people, systems, and internal policies and procedures, as well as from external events that are beyond the control of the company but that affect its operations. Examples of operational risk include human errors, internal fraud, system malfunctions, technology failure, and contractual disputes.

Compliance risk, which relates to the risk that a company fails to follow all applicable rules, laws, and regulations and faces sanctions as a result.

Investment risk, which is the risk associated with investing that arises from the fluctuation in the value of investments. Although it is an important risk for investment professionals, it is less important for individuals involved in support activities, so it receives less coverage than operational and compliance risks in this chapter.

A structured risk management process generally includes five steps: setting objectives, detecting and identifying events, assessing and prioritising risks, selecting a risk response, and controlling and monitoring activities.

It is important for a company to build a risk matrix and select key risk measures to prioritise risks and warn when risk levels are rising.  Depending on their expected level of frequency and severity, risks will receive different levels of attention:

Green. Risks in the green area should not receive much attention because they have a low expected frequency and a low expected severity.

Yellow. Risks coded yellow are either more likely but of low severity, or more severe but unlikely. They should receive a little more attention than risks in the green area, but less attention than risks in the orange area.

Orange. Risks in the orange area have a higher expected frequency or higher expected severity than risks coded yellow, so they should be monitored more actively.

Red. Risks coded red should receive special attention because they have a relatively high expected frequency and their effect on the company would be severe.

Black. Risks in the black area are highly unlikely but would have a catastrophic effect. These risks are sometimes called “black swans”, which is in reference to the presumption in Europe that black swans did not exist and is a belief that persisted until they were discovered in Australia in the 17th century. These risks are usually not identified until after they occur.

Source: https://www.cfainstitute.org/en/programs/investment-foundations

A risk matrix classifies risks according to:

A market, credit, and liquidity risk exposures.

B operational, compliance, and investment risk exposures.

C the expected level of frequency of the event and the expected severity of its consequences.

 

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