September 2017 Paper 1 - Q2(i)

[AKS01]

Hi,

This question is on the disadvantages of managing risks at the business unit level. The Examiners report states the following which I don't fully understand

• Risk analysis involves allocation of capital to support the risks retained by each business unit, this approach is likely to mean that the group is not making best use of its available capital
• For example, different business units of Conglomerate Group (CG) might carry out the same activities in different locations or they may carry out different activities in the same or different locations. They may operate in different countries or in different markets

How do these examples suggest they are not making best use of their capital?

• Identical risks in different business units may have different risk-adjusted cost of capital resulting in risk vs reward inefficiencies

I am not sure what is meant by this point?

Thanks in advance!

 

[Steve Hales]

How do these examples suggest they are not making best use of their capital?

There's no recognition of diversification benefits. So the capital amounts required to cover the risks from each business unit are summed together - even if the risks are negatively correlated.

I am not sure what is meant by this point?

For example, two business units might face the same risk but require different levels of capital to cover them because they price the risk differently. It would be more efficient for the business unit that requires the least amount of capital to carry the risk.

Hope that helps.

 

[AKS01]

Thanks Steve. That makes sense