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Paper 4 - Risk Management

AIMS

There are two specific aims associated with this paper:

  • To achieve a sound appreciation of the theory and practical aspects of corporate governance
  • To develop an understanding of the main theories and frameworks associated with the management of both financial and non- financial risk.

OBJECTIVES

On completion of this paper, candidates should be able to:

  • Explain the drivers behind an organisation's appetite and consequent policy for managing risk
  • Identify the main types of financial risk and evaluate the mechanisms available for managing exposure to them
  • Discuss the various tools and techniques for identifying, measuring and communicating risk
  • Discuss the importance of internal control in the management of risk
  • Describe the various frameworks and codes enshrining good governance practice
  • Explain the role of individuals and committees in implementing and reporting on good governance.

POSITION WITHIN THE SYLLABUS

Candidates are expected to have a good knowledge of the issues underpinning financial strategy from subject area 3. Knowledge from subject areas 1 and 2 will be helpful, but not essential.

SYLLABUS CONTENT

1. General Risk Management

a. Risk policy

  1. identification of risks

  2. appetite for risk

  3. management style

b. Risk audit and risk mapping

c. Reporting of risk management.

2. Management of Financial Risk

a. Defining and measuring financial risk

b. Insurance

c. Evaluation of the main types of financial risk including:

  1. foreign exchange risk

  2. interest rate risk

  3. credit risk

  4. gearing

  5. cash flow.

d. Evaluation of the use of debt and equity

  1. cost of debt

  2. cost of equity

  3. WACC

  4. Capital Asset Pricing Model

e. Optimal Capital Structure

f. Dividend Policy

  1. Influences on dividend policy

  2. impact of dividends on company value

g. Treasury Management

  1. business risk

  2. market risk

  3. responsibilities

h. Definition and uses of derivatives including:

  1. futures

  2. options

  3. forwards

  4. interest and currency swaps

  5. caps

  6. collars and floors

  7. securitisation

  8. hedging and risk manipulation.

3. Corporate Governance

a. Theoretical perspectives on corporate governance

  1. triggers for the introduction of systematised corporate governance

  2. rationale for governance procedures

  3. stakeholders and shareholders

b. Key governance frameworks, codes and systems including:

  1. Greenberry Report

  2. Cadbury Report

  3. Hampel Report / The Combined Code

  4. Turnbull Report

  5. ABI Guideline Principles

  6. OECD Principles of Corporate Governance

c. Role of Executives in corporate governance

d. Role of Non-executives in corporate governance

e. Internal Control

  1. Internal Audit

  2. The Audit Committee

  3. The Remuneration Committee

f. Implementation of Corporate Governance

  1. Statutory requirements

  2. Stakeholder / shareholder expectations

  3. Best Practice

g. Reporting of corporate governance

  1. statutory requirements

  2. internal reporting.

KEY AREAS OF THE SYLLABUS

The key topics are:

  • The key drivers determining a business' general attitude to risk
  • The elements and impacts of financial and non financial risk
  • Techniques available to identify and quantify risk
  • Practical issues impacting the business' ability to manage risk
  • Rationale and mechanisms for the implementation of corporate governance
  • Responsibility, accountability, and reporting.

STUDY GUIDE

The Study Guide takes the syllabus content and expands it into study sessions of similar length.

These sessions indicate what the examiner expects of candidates for each part of the syllabus, and therefore gives you guidance in the skills you are expected to demonstrate in the examinations.

The time to complete each session will vary according to your individual capabilities and the time you have available to study. However, repeated coverage of the material is vital to ensure your understanding and recall of the subject. Be sure to practice questions from your textbook or past examination papers to consolidate your knowledge.

1. The Nature of Risk

Syllabus reference 1a, 1b

  • Describe and illustrate the components of risk
  • Explain the sources of information and the methods of identifying and analysing financial and non-financial risk
  • Explain the reasons for differing appetites for, and illustrate different styles of, managing risk.

2- 3

The Identification, Analysis and Reporting of Risk

Syllabus reference 1b, 2a, 3b, 3e, 3f, 3g

  • Distinguish between risk-based, procedural and other approaches to management
  • Define and illustrate the concept of materiality
  • Describe and illustrate the mechanisms, content and formats for the statutory and non-statutory reporting of risk and its management
  • Illustrate the application of risk analysis techniques including risk audit and risk mapping
  • Describe the role of the external and internal auditor in reporting the adequacy of risk management and corporate governance procedures.

4. Managing Financial Risk

Syllabus reference 2a, 2b

  • Explain the differences between financial and non-financial risk
  • Describe and illustrate methods of measuring financial risk.

5 - 7

Evaluating Financial Risks I

Syllabus reference 2b, 2c(i)

  • Identify and explain the interest and foreign exchange rate exposures potentially faced by a company
  • Describe the main instruments available to manage market volatility of these rates
  • Understand the workings of the foreign exchange markets
  • Discuss currency risks and their potential impact on companies
  • Explain the differences in quotations of spot and forward rates.

8 - 10

Evaluating Financial Risks II

Syllabus reference 2c(ii), 2c(iii)

  • Describe and illustrate the term structure of interest rates
  • Understand the meaning and importance of yield curves in financial risk management
  • Explain the main aspects of credit risk and its potential impact on a company
  • Explain the concept of gearing and the risks associated from the shareholders', lenders' and company's viewpoint.

11. Evaluating Financial Risks III

Syllabus reference 2c(iv), 2c(v), 2e

  • Discuss the notion of an optimal capital structure
  • Understand the importance of cash flow in a business
  • Explain and illustrate the importance of free cash flow
  • Discuss and illustrate the concept of over-trading and the risks associated with it.

12. Evaluating the uses of Debt and Equity

Syllabus reference 2d(i), 2d(ii)

  • Discuss the differences in the cost of debt and equity
  • Estimate a company's cost of redeemable and non-redeemable debt.

13 - 15

WACC and the Capital Asset Pricing

Model

Syllabus reference 2d(iii), 2d(iv),2e

  • Use CAPM and dividend valuation models to arrive at an estimate of a company's cost of equity
  • Describe what is meant by, and interpret, alpha and beta factors
  • Discuss and illustrate a company's weighted average cost of capital
  • Explain the practical problems associated with establishing a discount rate and the difficulties involved in estimating cost of capital
  • Illustrate the impact of different capital structures on the company's cost of capital.

16. Dividend Policy

Syllabus reference 2f, 1a

  • Describe the influences on corporate dividend policy
  • Discuss the alternative views of the effect of dividend policy on share price
  • Discuss the company's use of dividend policy as an indicator of future performance.

17. Treasury Management

Syllabus reference 2c(v), 2g, 1a

  • Explain and illustrate the differences between business risk and market risk
  • Discuss the role of the treasury function in relation to business and market risk
  • Understand the information needs of the treasury function
  • Explain how budgeting and control of cash flow can be used to manage short and medium term financial risk.

18 - 19

Definition of Derivatives and the use of Futures

Syllabus reference 2h(ii)

  • Define and illustrate the concept of derivative instruments
  • Discuss the advantages and disadvantages of the main derivative instruments
  • Describe the nature of futures contracts
  • Explain margin calls and the function of futures clearing houses
  • Describe the main interest rate and currency futures contracts.

20 - 21

Options

Syllabus reference 2h(iii), 2h(vi), 2h(vii)

  • Discuss the main elements of options including puts, calls, strike price, in on and out of the money situations
  • Discuss the difference between American and European options
  • Discuss the different methods of pricing options including Black-Scholes and Bi-nomial models.(NB: this will not require derivation or a detailed knowledge of the 'Greeks')
  • Describe the various forms of interest rate options including caps, collars and floors.

22 - 23

Forwards and Swaps

Syllabus reference 2h(v)

Understand the nature of forwards

  • Discuss how forward rate agreements are priced, traded and settled
  • Describe the nature and uses of interest rate and currency swaps
  • Discuss the various types of risk associated with swaps.

24. Hedging and Risk Manipulation

Syllabus reference 2h(ix)

Discuss and evaluate hedging strategies using for example but not exclusively:
  • Forward and foreign exchange contracts
  • Interest rate and currency futures
  • Swaps
  • Interest rate and currency options.

25. Theoretical Perspectives on Corporate Governance

Syllabus reference 3a

  • Understand the potential conflicts of interest between owners, managers, directors and other stakeholders
  • Explain the issues that triggered the introduction of systematised corporate governance procedures
  • Define and discuss the meaning of corporate governance from a variety of different national perspectives.

26 - 27

Key Governance Frameworks

Syllabus reference 3b

  • Understand the ongoing debate regarding governance, including the implications of the Cadbury, Greenbury, Hampel and Turnbull reports
  • Discuss the impact of the ABI Guideline Principles for both shareholders and directors
  • Understand the main areas covered by the OECD Principles of Corporate Governance.

28. Implications of Corporate Governance for Organisations

Syllabus reference 3c, 3d, 3e, 3f, 3g

  • Identify and discuss the roles of executives, non-executives, internal and external auditors, audit committees, remuneration committees etc in implementing good governance
  • Discuss the statutory requirements for the implementation and reporting of corporate governance procedures.