Syllabus A. Role Of The Senior Financial Adviser A2. Financial strategy formulation

A2fg. Risk mitigation, hedging and diversification strategies 8 / 9

Syllabus A2fg)

f) Develop a framework for risk management, comparing and contrasting risk mitigation, hedging and diversification strategies.

g) Establish capital investment monitoring and risk management systems.

The risk framework

All projects are risky.

When a capital investment programme commences, a framework for dealing with this risk must be in place.

This framework must cover:

  1. risk awareness

  2. risk assessment and monitoring

  3. risk management (i.e.strategies for dealing with risk and planned responses should unprotected risks materialise)

1) Risk awareness

In appraising most investment projects, reliance will be placed on a large number of estimates.

For all material estimates, a formal risk assessment should be carried out to identify:

  • potential risks that could affect the forecast

  • the probability that such a risk would occur.

Risks may be:

  1. strategic

  2. tactical

  3. operational

Once the potential risks have been identified, a monitoring process will be needed to alert management if they arise.

2) Risk assessment and monitoring

A useful way to manage risk is to identify potential risks (usually done in either brainstorming meetings or by using external consultants) and then categorise them according to the likelihood of occurrence and the significance of their potential impact.

Decisions about how to manage the risk are then based on the assessment made.

These assessments may be time consuming and the executive will need to decide:

  • how they should be carried out

  • what criteria to apply to the categorisation process and

  • how often the assessments should be updated.

The essence of risk is that the returns are uncertain.

As time passes, so the various uncertain events on which the forecasts are based will occur.

Management must monitor the events as they unfold, reforecast predicted results and take action as necessary.

The degree and frequency of the monitoring process will depend on the significance of the risk to the project’s outcome.

3) Risk management

Strategies for dealing with risk

Risk can be either accepted or dealt with.

Possible solutions for dealing with risk include:

  1. mitigating the risk 

    – reducing it by setting in place control procedures

  2. hedging the risk 

    – taking action to ensure a certain outcome

  3. diversification 

    – reducing the impact of one outcome by having a portfolio of different ongoing projects.

Well-diversified portfolios

Shareholders holding well-diversified portfolios will have diversified away unsystematic or company specific risk, and will only face systematic risk,

ie risk that can not be diversified away.

Therefore a company can not reduce risk further by undertaking diversification within the same system or market.

However, further risk reduction may occur if the diversification is undertaken by the company, on behalf of the shareholders, into a system or market where they themselves do not invest.

Some studies indicate that even shareholders holding well-diversified portfolios may benefit from risk diversification where companies invest in emerging markets.