Operational risk operational risk considers a wide

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Operational Risk Operational risk considers a wide range of “non-financial” problems such as inadequate computer systems (technology risk), insufficient internal controls, incompetent management, fraud (e.g., losses due to intentional falsification of information), human error (e.g., losses due to incorrect data entry or accidental deletion of a file), and natural disasters. Within a financial institution, the leveraged nature of derivatives transactions makes them susceptible to operational risk. Additionally, the difficulty in accurately valuing complicated derivatives transactions adds to operational risk. A very robust system of internal controls is required within an entity or else there is a risk of significant losses due to various operational risks. Legal and Regulatory Risk In practice, legal and regulatory risk is highly integrated with operational and reputation risk. Within a two-way financial transaction, an example of legal risk would be one party suing the other party in an attempt to nullify or terminate the transaction. From an investing perspective, an example of regulatory risk could be a change in tax law that increases the tax rate of certain types of income, thereby lowering the after-tax investment
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©2015 Kaplan, Inc. Page 9 Topic 1 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 1 returns for many investors, or changes in regulations that involve further areas of compliance, thereby increasing compliance costs for an entity. Business Risk For the purposes of this topic, we will consider business risk from a financial perspective. In this regard, business risk revolves around uncertainty regarding the entity’s income statement, although, in practice, there is a substantial amount of integration with strategic and reputation risk. From an income statement perspective, revenues may be uncertain because of the uncertainty surrounding the demand for products and/or the price that should be set. Production and administration costs may also be uncertain. Business risk may arise because the actual product demand is significantly lower than anticipated or the marketplace’s toleration of a selling price is much lower than expected. In addition, there may be production cost overruns or unexpected costs that substantially increase total expenses. Either way, the decreased revenues and/or the increased costs may be significant enough that the entity suffers financial losses. From a non-financial (i.e., operational) perspective, a manufacturing company may experience business risk due to testing, production, or shipping delays. The result would be lost sales and/or substitution to competitors’ products by consumers. Strategic Risk Strategic risk can be thought of in the context of large new business investments, which carry a high degree of uncertainty as to ultimate success and profitability. For example, an entity could spend millions of dollars developing a new product that ultimately fails in the marketplace because consumers find it unsuitable for their needs.
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