RSK4803 TOPIC 1: RISK MANAGEMENT
RSK4803 RISK FINANCING
TOPIC 1: RISK MANAGEMENT
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Open Rubric
RSK4803 TOPIC 1: RISK MANAGEMENT
TABLE OF CONTENTS
TOPIC 1: RISK MANAGEMENT .............................................................................................................. 1
STUDY UNIT 1: LESSONS NOT LEARNED ............................................................................................ 3
STUDY UNIT 2: ENTERPRISE RISK MANAGEMENT ............................................................................. 8
STUDY UNIT 3: CAPITAL IN ENTERPRISES ........................................................................................ 16
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RSK4803 TOPIC 1: RISK MANAGEMENT
TOPIC 1: RISK MANAGEMENT
AIM
The aim of this topic is to provide an overview of risk management and the role of risk financing in the risk
management process.
LEARNING OUTCOMES
At the end of this topic, you should be able to
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compare the roles and responsibilities of risk management and top/executive management
determine the types of risk management failures
evaluate the alternatives that enterprises can consider to prepare for future crises
explain the acronym “VUCA”
incorporate risk in the strategic planning process
critically evaluate the requirements to develop a strategic risk management culture
critically evaluate the requirements to implement a strategic risk management process
explain the ERM evolution
evaluate the conceptual framework of ERM
explain the measures, models and tools of ERM
argue the importance of integrating ERM and governance
argue the importance of creating transparency regarding an enterprise’s large exposures
evaluate the importance of applying knowledge management to ERM
explain the integrated corporate ERM framework
criticise the use of decision trees in the context of ERM
explain the concept of a strategy map
explain the concept of scenario analysis
evaluate the use of scenario-based strategy maps
define risk capital
argue the economic cost of capital
explain how the cost of capital can influence capital allocation and capital budgeting
argue the purpose of capital of an enterprise
distinguish between operational, risk and signalling capital
discuss the interrelationship of firm capital and firm risk
explain the sources of capital.
evaluate the standard model of the capital structure
define WACC
define TACC
discuss the model flow of the Deutsche Bank Liability Structure Model
evaluate the benefits of debt
evaluate the cost of debt
criticise the effects of credit downgrades on the enterprise
TOPIC CONTENT
Study unit 1: Lessons NOT learned
Study unit 2: Enterprise risk management
Study unit 3: Capital in enterprises
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RSK4803 TOPIC 1: RISK MANAGEMENT
OVERVIEW
We begin this module by trying to understand why apparently well-managed enterprises ran in to serious
financial problems and while of some of them were able to recover, others were not that fortunate. Although
we mostly use examples of international enterprises, the principles remain the same, irrespective where
the enterprise resides. We refer to newspaper articles about state-owned enterprises (SOEs) in South
Africa, but as these are still disasters in the making, we cannot include the reports on the final outcome of
investigations. There are parallels between the underlying causes of the demise of private enterprises and
SOEs; however, the (re)action to corporate failures is normally brutal and swift. In contrast, the eventual
losses of SOEs in South Africa are palmed off to the “taxpayer”, which is an euphemism for in effect
stealing from the poorest of the poor, as funds that could have been utilised for, for example the upliftment
of communities, improved health services or education, are now used to enrich politically well-connected
families or to bail out inefficient (and most probably corrupt activities of) entities.
The next study unit introduces the concept of enterprise risk management. The other modules in this
qualification covered the risk types such as operational, credit and market risk, but as this module is
focused on the financing of enterprise risks, it is important to have a deeper understanding of how the
enterprise is governed, capitalised, and finance pre-loss and post-loss events. The risk appetite of the
enterprise is also important as it will eventually drive the outcomes of decisions.
The last study unit in this topic covers the concept of capital, risk capital and capital budgeting. The
underlying principle is that capital is not a free good and in unlimited supply. It is therefore important for
the enterprise to have a good understanding of its cost of capital to determine which projects to accept or
reject. Again, the risk appetite and a very good understanding of the risks of the enterprise are critical in
the process as the enterprise needs to optimise spending, i.e. getting the most “bang for their buck”.
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RSK4803 TOPIC 1: RISK MANAGEMENT
STUDY UNIT 1: LESSONS NOT LEARNED
AIM
The aim of this study unit is to provide an overview of events that led to the demise of a number of
enterprises.
KEY CONCEPTS
Risk management
VUCA
LEARNING OUTCOMES
At the end of this study unit you should be able to
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compare the roles and responsibilities of risk management and top/executive management
determine the types of risk management failures
evaluate the alternatives that enterprises can consider to prepare for future crises
explain the acronym “VUCA”
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RSK4803 TOPIC 1: RISK MANAGEMENT
LEARNING MATERIAL
Managing a large organisation is complex and requires the management of the organisation to be aware
of all the risks that the organisation may face. Management is quite often bombarded with a whole basket
of risks, as risks very seldom manifest in isolation. A solution to one problem can also easily create new
problems and may make it even more difficult to resolve the situation.
The different problems that an organisation may experience are best illustrated with reference to examples
of instances of where management was up to the task of managing the crisis or was experiencing severe
stress in an effort to recover the business. Refer to the following discussions on prominent failures or
organisations that are currently experiencing problems.
1. Examples of crises experienced by organisations
A number of different risks can be identified in the following three examples. It is also clear from the
examples that one risk, if not managed properly, can lead to other risks.
1.1.
Suspending the principles of financial management and governance – transforming
energy the Eskom way
We think that one can safely assume that most South Africans are acutely aware of the negative
publicity surrounding Eskom, and also have an understanding of the looming financial crisis in Eskom.
Read the following documents and focus on the period 2008 to current.
https://www.parliament.gov.za/storage/app/media/PBO/Analysis_of_Eskom_finances_Report_to_SC
OA_presented_8_March_2017.pdf
http://meridianeconomics.co.za/wp-content/uploads/2017/11/CoalGen-Report_FinalDoc_ForUpload1.pdf
http://www.gsb.uct.ac.za/files/Eskom%20Enquiry%20Booklet%20Sept%202017.pdf
Visit the Eskom website for full information on Eskom’s latest financial results.
Self-assessment 1.1
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What was the board’s contribution to the ongoing crisis?
How was it possible that executive management was able to hide the real situation of Eskom?
How important is it for the board and management to understand the business?
How do you think did the external auditors fulfil their obligations towards its stakeholders?
How would you have evaluated internal audit’s role in the sequence of events?
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1.2.
We have a turbo-arbitrageur – leave him alone, he is making us money
The collapse of Barings Bank has to a large extent became the benchmark “for bank failures and rogue
traders” . Despite popular opion, we think the demise of Barings was not caused by the action of a “lone
wolf” who gamed the system for own gain. The story is much more complicated than that.
Read the following article: Nick Leeson and the Collapse of Barings Bank: Socio-Technical Networks
and the ‘Rogue Trader'. Available at:
http://journals.sagepub.com/doi/abs/10.1177/1350508406063491?journalCode=orga
Self-assessment 1.2
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What was management’s contribution to the incident(s)?
How important is it for the board and management to understand the business?
How well, do you think, did the external auditors fulfil their obligations towards its stakeholders?
How would you evaluate the effectiveness of the bank supervision of the Bank of England?
How would you have evaluated internal audit’s role in the sequence of events?
What are the parallels that can be drawn between Nick Leeson and Markus Jooste, from Steinhoff
International?
1.3.
HIH – gross deception of the investing public through highly shonky, technical accounting
Read the article “The HIH Collapse: A costly catalyst for reform” authored by Gregor Alan.
This article discusses the case of an Australian Insurer, HIH, that failed in 2001. Available at:
http://ro.uow.edu.au/cgi/viewcontent.cgi?article=1478&context=lawpapers
Self-assessment 1.3
Consider the following questions after reading the article:
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What was the board’s contribution towards the downfall?
How was it possible that executive management was able to hide the real situation of HIH?
How important is it for the board and management to understand the business?
How well, do you think, did the external auditors fulfil their obligations towards its stakeholders?
How would you have evaluated internal audit’s role in the sequence of events?
What are the parallels that can be drawn between HIH and Steinhoff? (given the limited information
available).
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1.4.
Comair 2004 – the planes that would not fly
Comair is a subsidiary of Delta Air Lines. The airline experienced an IT incident on 24 December 2004,
when the company’s crew-scheduling system failed.
https://www.oig.dot.gov/sites/default/files/sc2005051.pdf
Self-assessment 1.4
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What was top management’s contribution towards the incident?
How does this case study differ from the other case studies in this study unit?
What should management have done differently?
As can be seen from the examples above, an organisation faces numerous risks that can be identified and
classified into different categories.
1.5.
Risk management failures: What are they and when do they happen?
Download the following article:
R Stulz. 2008. Risk Management Failures: What are they and when do they happen? Journal of Applied
Corporate Finance Vol. 20 No. 4:28-51.
Study the following sections of the article:
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Was the collapse of LTCM a risk management failure?
A taxonomy of risk management failures
Risk metrics and risk management failures
Mismeasurement of known risks
Mismeasurement stemming from overlooked risks
Ignored known risks
Unknown risks
Communication failures
Failures in monitoring and managing risks
Lessons from failure (or how to prepare for the next crisis)
Conclusion
Self-assessment 1.5
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Argue the case that LCTM’s demise was caused by a risk management failure.
Compare the roles and responsibilities of risk management and top/executive management.
Discuss the types of risk management failures.
Discuss the alternatives that enterprises can consider to prepare for future crises.
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1.6.
What a difference a word makes: Understanding threats to performance in a VUCA world
Download the following article:
Bennett, N & James Lemoine, GJ. 2014. What a difference a word makes: Understanding threats to
performance in a VUCA world. Business Horizons 57:311–317.
Study the following sections of the article:
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Living in a VUCA world
What do these terms mean … and what do they mean for your company?
Final thoughts
Self-assessment 1.6
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Explain the acronym “VUCA” and illustrate with examples from your own enterprise.
Discuss complexity in the context of this article and draw a comparison with the R7 billion write-down
of Woolworths Ltd with their subsidiary in Australia.
SUMMARY
This study unit gave some examples of where enterprises experienced material losses that either led to
the demise of the enterprise or caused significant hardship to stakeholders. When you read wider than
just the prescribed articles (and we trust you will), it will become clear that failures at this scale are seldom
caused by one event. Quite often it is a series of small events that becomes larger as time goes by, but
stakeholders nonetheless appear to be “surprised” when the main event eventually happens. The next
study unit will cover the concept of enterprise risk management (ERM).
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RSK4803 TOPIC 1: RISK MANAGEMENT
STUDY UNIT 2: ENTERPRISE RISK MANAGEMENT
AIM
The aim of this study unit is to give an overview of the interaction between enterprise risk management
and the capital of the enterprise.
KEY CONCEPTS
Strategic risk
Integrating risk into strategic planning
Strategic risk management culture
Strategic risk management process
Enterprise risk management
Knowledge management
Risk modelling
Scenarios
Decisions trees
Strategy maps
LEARNING OUTCOMES
At the end of this study unit, you should be able to
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incorporate risk in the strategic planning process
critically evaluate the requirements to develop a strategic risk management culture
critically evaluate the requirements to implement a strategic risk management process
explain the ERM evolution
evaluate the conceptual framework of ERM
explain the measures, models and tools of ERM
argue the importance of integrating ERM and governance
argue the importance of creating transparency regarding an enterprise’s large exposures
evaluate the importance of applying knowledge management to ERM
criticise the integrated corporate ERM framework
evaluate the use of decision trees in the context of ERM
explain the concept of a strategy map
explain the concept of scenario analysis
evaluate the concept of scenario-based strategy maps
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RSK4803 TOPIC 1: RISK MANAGEMENT
LEARNING MATERIAL
This study unit is mostly based on prescribed articles. The articles are available in the UNISA library at no
charge. Although some of the articles may also be available for free on the internet, we strongly
recommend that you use the facilities of the library.
2.1.
The business case for strategic risk management
Download the following article:
McMillan, C & Overall, J. 2016. Wicked problems: turning strategic management upside down. Journal of
Business Strategy 37(1):34–43.
Study the following sections of the article:
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Introduction
The new paradigm: wicked problems
Strategic nature of wicked problems
Managing problem-solving models with strategic alignment
Conclusion
Self-assessment 2.1
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Discuss the weaknesses of the conventional doctrines of strategic management.
Define “wicked” problems.
Do a comparison of the characteristics between conventional and wicked problems.
Discuss the categories of wicked problems.
When does strategic misalignment arise?
2.2.
When the chain breaks
Download the following article:
When the chain breaks. 2006. The Economist. Availlable at: http://www.economist.com/node/7032258
Read the following sections of the article:
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Being too lean is a dangerous thing
The many faces of risk
The cost of failure
The limits to leanness
Self-assessment 2.2
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Compare the risk cultures of Nokia and Ericsson.
Evaluate Nokia’s strategic risk management philosophy.
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RSK4803 TOPIC 1: RISK MANAGEMENT
2.3.
Understanding and managing complexity risk
Download the following article:
Bonabeau, E. 2007. Understanding and managing complexity risk. MITSloan Management Review
48(4):62-68.
Study the following sections of the article:
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Introduction
How complexity breeds fragility
The inevitability of disaster
What really causes failures?
Forestalling fatal flaws
From the bottom up: predict and act
Diversity-based testing
Robust designs
Regarding simplicity
Self-assessment 2.3
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Evaluate the statement “how complexity breeds fragility” and illustrate with examples from your own
experience.
Discuss the question “What really causes failures?”
2.4.
Strategic thinking at the top
Download the following article:
Ellen F. Goldman. 2007. Strategic thinking at the top. MITSloan Management Review 48(4):75-81.
Study the following sections of the article:
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Introduction
Define strategic thinking
Ten contributing experiences
The overall developmental process
Pattern 1: The development of understanding
Pattern 2: The practice of rational planning
Pattern 3: The completion of a hierarchy of challenges
Self-assessment 2.4
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What was the purpose of the research?
Discuss what strategic thinking is not.
Discuss the contributing experiences to develop a person’s ability to think strategically.
Discuss the practice of rational planning.
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2.5.
Integrating risk into strategic planning
The concept of strategic risk management is not new. Organisations are constantly assessing the risks
they face and taking steps to adjust to changing circumstances. The causes of change are infinite, such
as mergers and acquisitions, the selling or purchasing of new assets, taking on or reducing debt, increasing
or reducing their workforce or changes to legislation.
Organisations, however, quite often struggle to deal well with strategic risks. This may also arise because
many leaders struggle to know how to engage in genuine strategic risk thinking. They find themselves
dealing with risk registers full of operational risks. This becomes very frustrating for executive leaders and
for governing bodies, who struggle to find, understand and manage the strategic risks to the organisation’s
long-term success.
It is possible to lift the risk conversation to a strategic level by looking for risks to an organisation’s purpose
rather than to its objectives or what it is aiming to do. By first creating a shared purpose and then testing
for risks to that purpose, a risk conversation that was operational can be elevated to a strategic level.
A strategic conversation about risk is also created when an organisational development focus is taken.
This is for two reasons. First, in the long term, sustainable success can only be driven by capability and
because of this, responses to (treatments for) strategic risks almost invariably include steps to adapt or
develop capability to better match future needs. Second, capability development work is inherently focused
on the long term, since it takes time for new attitudes (culture) to develop and for individuals and systems
to be able to perform at a new level. It is strategic work, and its purpose is always to reduce the risk of
failure.
2.6.
Developing a strategic risk management culture
To implement strategic risk management successfully, the organisation needs to have a proper risk
management culture. A strategic risk management culture and mindset focus on examining how well a
business strategy will perform under different scenarios and events. The requirements to establish a risk
management culture are as follows:
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Support by top management through word and action of risk management is a high priority. Oversight
responsibility needs to be communicated to all staff.
Organisational lines of responsibility and authority need to be established.
A cross-functional view of risk is needed to break down organisational and functional barriers.
The enterprise-wide nature of risk management must be considered, taking into account management
styles and skill requirements.
Measurement of risk and exposure on an enterprise-wide basis is a key component of effective risk
management.
A clear set of corporate objectives and strategies, which include an acceptable approach towards risk
management should be established. The gains from managing risk should be clear and measurable.
Financial and non-financial incentives must be aligned with the risk management objectives.
Training and support for risk management must be provided.
Remuneration of staff must be market-related.
Risk managers should be regarded as a valuable resource which can provide independent, objective
input on matters arising from business strategies.
Risk management is not a once–off function. A continuous management function and the emphasis of
risk management must be proactive to prevent losses and risk events from occurring.
Total involvement of all employees in risk management.
Upward reporting process with the aim of disclosure or decision required.
Downward communication on risk management decisions.
Risk ownership – the line/business managers are regarded as the risk owners.
Common risk language.
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2.7.
The strategic risk assessment process
A strategic risk review differs from a conventional bottom-up approach and also differs from typical
strategic risk work carried out directly by executive teams and by boards of directors:
 Risks are assessed to purpose rather than to objectives.
 The use of risk maps rather than risk registers opens the conversation even further and allows for a
level of interaction and challenge that is not possible when dealing with text-based risk descriptions.
 Strategic external and internal scenarios are easily incorporated into the risk conversation, through the
risk maps.
 Offline, systemic risk analysis methods are applied to help leaders understand the effects of risk
interrelationships and shared root causes. However, the most powerful drivers are often subtle,
complex and hidden and are seldom identified using a "standard' risk analysis method.
 The end of a systemic strategic risk review is the identification and prioritisation of response strategies
for risk as a whole, rather than a focus on managing individual risks. This offers many advantages from
a strategic perspective since it optimises risk management efforts for the organisation as a whole.
 Systemic risk is likely to identify risks related to capability, including those risks driven by the internal
culture and the way in which leaders operate.
The advantages of taking a systemic approach to strategic risk include:
 A strategic risk conversation is easily created, based upon a focus on achieving purpose rather than
objectives.
 The understanding achieved is greatly enhanced by using risk maps for discussion, challenge and
review.
 It is likely to find and to deal with subtle, hidden sources of risks that have previously not been dealt
with well.
 The influences of risk interrelationships and shared risk sources are incorporated.
 Risk responses are strategic rather than operational and deal with root causes and drivers of risk as a
whole, rather than seeking to fix one risk at a time.
 A strategic risk review can be tailored to be a quick once-off conversation at the executive team or
board level or to be an exhaustive process based upon raw data and analysis.
2.8.
Beyond risk mitigation: Enhancing corporate innovation with scenario planning
Download the following article:
Worthington, WJ, Jamie D. Collins, JD & Hitt, MA. 2009. Beyond risk mitigation: Enhancing corporate
innovation with scenario planning. Business Horizons (52):441–450.
Study the following sections of the article:
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Response-oriented innovation
Exogenous shock
Scenario planning
Organisational learning
Corporate innovation
An opportunity to innovate
Self-assessment 2.8
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Discuss the benefits of using scenario planning and illustrate with examples from your enterprise.
Argue the importance of incorporating exogenous shocks in the external environment assessment.
Describe the scenario planning process.
Explain how enterprises can use exogenous shocks as opportunities for innovation.
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RSK4803 TOPIC 1: RISK MANAGEMENT
2.9.
Overview of enterprise risk management
Download the following document:
Overview of Enterprise Risk Management – Casualty Actuarial Society
Available at: https://www.casact.org/area/erm/overview.pdf ERM.pdf
Study the following sections in the document:
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The ERM Evolution
ERM definition and conceptual framework
ERM language, measures, models and tools
Practical considerations in implementing ERM
Appendix B: A continuum of risk modelling methods
Read the following sections:
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ERM case studies
Self-assessment 2.9
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Define ERM.
Discuss the ERM evolution.
Discuss the risk management process and illustrate with a diagram.
Draw a diagram of the continuum of methods for modelling risk.
Discuss capital management as an application for treating or exploiting risks.
2.10.
Creating synergy by integrating enterprise risk management and governance
Download the following article:
Hinrichs, J. 2009. Creating synergy by integrating enterprise risk management and governance. Journal
of Risk Management in Financial Institutions 2(2):155–164.
Study the following sections in the document:
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Introduction
Why is it importante to integrate ERM and governance?
Creating transparency regarding one’s largest risk exposures
Conclusion
Self-assessment 2.10
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Discuss the indicators that can be used to evaluate if an enterprise has integrated ERM and
governance.
How can the enterprise increase transparency regarding the largest risk exposures?
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RSK4803 TOPIC 1: RISK MANAGEMENT
2.11.
Applying knowledge management to enterprise risk management: is there any value in
using KM for ERM?
Download the following article:
Rodriguez, E & Edwards, JS. 2009. Applying knowledge management to enterprise risk management: Is
there any value in using KM for ERM. Journal of Risk Management in Financial Institutions 2(4):427–437.
Study the following sections in the document:
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Introduction
What does the literature say abouth the problem?
Conclusion
Self-assessment 2.11
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What are the similarities between ERM and KM?
How does this study define a risk management information system?
2.12.
Optimal enterprise risk management and decision making with shared and dependent risks
Download the following article:
Ai, J, Brocket, PL & Wang, T. 2017. Optimal enterprise risk management and decision making with
shared and dependent risks. Journal of Risk and Insurance 84(4):1127–1169.
Study the following sections in the document:
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Introduction
The integrated corporate ERM decision framework
ERM decision making for a hypothetical financial services conglomerate
Conclusion
You will not be examined on the mathematical models in this article; however, ensure that you can follow
the decision trees.
Self-assessment 2.12
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Discuss the concept of an integrated ERM decision framework.
Explain the decision tree approach.
What are the strengths of a decision tree approach?
Why is discretisation important in the decision tree approach?
2.13.
Scenario-based strategy maps
Download the following article:
Buytendijk, F, Hatch, T & Micheli, P. 2010. Scenario-based strategy maps. Business Horizons. (53):335—
347.
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Study the following sections in the document:
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Linking present and future
Strategy maps
Scenario analysis
Scenario-based strategy maps
Example: Tier One Talent
Conclusion
Self-assessment 2.13
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Explain the concept of a strategy map.
Explain the concept of scenario analysis.
How does scenario analysis differ from other planning methods?
What are the weaknesses of scenario analysis?
Explain the concept of scenario-based strategy maps.
SUMMARY
The purpose of this study unit was to introduce strategic and enterprise risk management as aspects that
the enterprise must consider in the risk management process. Integrating risk management with the
strategic planning process can have significant advantages for all enterprises, as it not only assists in
identifying risks or constraints when formulating a strategic plan for the organisation but may also give an
additional benefit in that it can identify possible competitive advantages for the enterprise. This study unit
also discussed the implementation of ERM by using models, scenarios and strategy maps.
REFERENCE
Beasley, M & Frigo, M. 2010. ERM and Its Role in Strategy Planning and Strategy Execution, in Enterprise
risk management: Today’s leading research and best practices for tomorrow’s executives, edited by J
Fraser & B Simkins. Hoboken: Wiley.
Manex. Strategic Risk Management. 2018. Available at: http://www.manex.com.au/general/strategic-riskmanagement (accessed on 09 /01/2018).
Young, J. 2018. 2nd revised edition. Operational Risk Management: The practical application of a
qualitative approach. Pretoria: Van Schaik.
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STUDY UNIT 3: CAPITAL IN ENTERPRISES
AIM
The aim of this study unit is to explain the theory and concept of capital in enterprises.
KEY CONCEPTS
Capital
Risk capital
Capital allocation
Capital budgeting
LEARNING OUTCOMES
At the end of this study unit, you should be able to
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define risk capital
argue the economic cost of capital
explain how the cost of capital can influence capital allocation and capital budgeting
argue the purpose of capital of an enterprise
distinguish between operational, risk and signalling capital
discuss the interrelationship of firm capital and firm risk
explain the sources of capital.
evaluate the standard model to the capital structure
define WACC
define TACC
discuss the model flow of the Deutsche Bank Liability Structure Model
evaluate the benefits of debt
evaluate the cost of debt
discuss the effects of credit downgrades on the enterprise
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RSK4803 TOPIC 1: RISK MANAGEMENT
LEARNING MATERIAL
This study unit is mostly based on prescribed articles. The articles are available in the UNISA library at no
charge. Although some of the articles may also be available for free on the internet, we strongly
recommend that you use the facilities of the library.
You may find that these articles refer to terminology or concepts that you do not know or understand if
your accounting or financial management background is limited. There are numerous textbooks, articles
and YouTube videos that will assist in providing the necessary background.
3.1.
Introduction
The word “capital” has become an emotional term in South Africa. Without delving into the
communist/socialist versus capitalist ideologies, one has to remember that no entity, whether a private
enterprise or state-owned enterprise, can function without funds (capital). People conveniently forget or
ignore the fact that – in the case of a private enterprise – owners and investors took their own money or
borrowed money to start a new business. The funds/capital/equity were used to purchase assets and
equipment, pay rent and salaries to produce goods and services to make a profit and in doing so, ensure
the sustainability of the enterprise.
In the private sector, the funds can be generated by the savings of the owner/investors, initial public
offerings for shares in the enterprise or via the issuing of corporate bonds, or bank loans. The principle is
that the owners must be able to convince potential investors or lenders that the enterprise is feasible and
that they will receive a return on their investment. If they can convince the potential investors/lenders, the
enterprise may have a chance. Otherwise, it may be game over even before they started. As demonstrated
in the Steinhoff saga in 2017/2018, the reaction of investors and analysts can be severe when irregularities
are detected in private enterprises.
In contrast to the private sector, the capital for state-owned enterprises (SOEs) is provided or guaranteed
by the state. In well-run SOEs, for instance, Singapore Airlines, the enterprise is able to sustain itself for
very long periods. In South Africa, the various credit downgrades, commissions of inquiry and fraud
investigations of SOEs paint a different picture. If you are one of the lucky few in South Africa who has a
job, you will be given the opportunity to generously contribute towards the “recapitalisation” of SAA,
PRASA, ESKOM, CEF in the form of higher taxes. This is known as "moral hazard": and we shall discuss
the concept at a later stage.
The purpose of this study unit is to demonstrate that capital is not free, and that management must make
informed decisions about the cost and the risk before committing the firm.
3.2.
Theory of risk capital in financial firms
Download the following article:
Merton, RC & Perold, AF. 1993. Theory of risk capital in financial firms. Journal of Applied Corporate
Finance Fall (6)3:16-32.
Study the following sections in the document:
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Introduction
Measuring risk capital
Accounting for risk capital in the calculation of profits
The economic cost of risk capital
Hedging and risk management
Capital allocation and capital budgeting
Summary and conclusions
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RSK4803 TOPIC 1: RISK MANAGEMENT
Self-assessment 3.2
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Define risk capital.
Discuss the economic cost of capital.
Explain how the cost of capital can influence capital allocation and capital budgeting.
3.3.
Integrating risk management and capital management
Download the following article:
Shimpi, P. 2002. Integrating Risk Management and Capital Management. Journal of Applied Corporate
Finance Winter (14)4: 27-40.
Study the following sections in the document:
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Introduction
The role of corporate capital
Models of capital structure
The insurance model
The changing function of risk management
Self-assessment 3.3
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What is the purpose of the capital of an enterprise?
Distinguish between operational, risk and signalling capital.
Discuss the interrelationship of firm capital and firm risk.
Explain the sources of capital.
Explain the standard model to the capital structure.
Explain the insurative model.
Define WACC.
Define TACC.
3.4.
Risk management, risk capital and the cost of capital
Download the following article:
Doherty, NA. 2005. Risk Management, Risk Capital, and the Cost of Capital. Journal of Applied Corporate
Finance Summer (17)3:119-123.
As all good academics do when they disagree with certain theories or findings, they write a paper about it.
Look at how the different arguments are presented and (dis)proved.
Study the following sections in the document:
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Introduction
Cost of capital
Contrasting the insurative and conventional models
Which model?
Conclusion
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RSK4803 TOPIC 1: RISK MANAGEMENT
Self-assessment 3.4
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What are the weaknesses identified in the insurative model?
What are the learnings of the insurative model?
3.5.
Risk management and the cost of capital for operating assets
Download the following article:
O’Brien, TJ. 2006. Risk Management and the Cost of Capital for Operating Assets. Journal of Applied
Corporate Finance (18)4:105-109.
Study the following sections in the document:
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Introduction
Paid-in risk capital
Risk transfer by insurance
Adjusting the WACC for risk management
Operating investments and enterprise risk management
Conclusion
Self-assessment 3.5
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Explain why the overall WACC is not the proper hurdle rate for the operating assets of the enterprise
where an active risk management strategy is used.
What is meant by the deadweight cost associated with the possibility that the enterprise will get into
financial trouble, or perhaps even default?
3.6.
Toward a more complete model of optimal capital structure
Download the following article:
Heine, R & Harbus, F. 2002. Toward a More Complete Model of Optimal Capital Structure. Journal of
Applied Corporate Finance. Spring (15):1.31-45.
Study the following sections in the document:
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Introduction
Measurement of shareholder value under “normal” volatility
Primary decision variables and typical findings
Optimal capital structure adjusted for liquidity requirements
Conclusion
Appendix: Model flow
Self-assessment 3.6
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Discuss the model flow of the Deutsche Bank Liability Structure Model.
Discuss the benefits of debt.
19
RSK4803 TOPIC 1: RISK MANAGEMENT
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Discuss the cost of debt.
What is the business effects of credit downgrades?
3.7.
Linking strategic and tactical planning systems for asset and liability management
Download the following article:
Mulvey, John M, Madsen, C & Morin, F. 1999. Linking strategic and tactical planning systems for asset
and liability management. Annals of Operations Research 85(17):249–266.
Study the following sections in the document:
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Introduction to total integrated risk management (focus on the concept and process and not the maths)
Linking strategic and tactical planning systems (focus on the concept and process and not the maths)
Conclusions
Self-assessment 3.7
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Explain the three primary elements of a strategic financial planning system.
SUMMARY
The purpose of this study unit was to introduce the concept of capital. Capital is critical to provide the
means to finance the operations of an enterprise, irrespective of whether it is a private enterprise or SOE.
Access to capital is also critical to ensure the financial sustainability of the enterprise after a major loss.
In this topic, we discussed a few failures of different types of enterprises and the effect of risk and
uncertainty. The next topic will give an overview of decision theory in the context of this module.
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UNISA 2019
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