To be honest, I missed this theme when I prepared for P1 June 2013. Reading the opentuition forum I discovered that the same question was in past paper P1 June 2011. Unfortunately, I didn't pratice all past papers. My knowledge of statistics helped me to find the right answer.
Briefly explain ‘related’ and ‘correlated’ risks. Explore the correlation between legal risk and reputation risk for Hoppo if it were to cancel its contract with Red Co.
Related risks are the risk which vary because of the presence of another risk. They do not exist independently.
Correlated risks is a particular example of related risks.
Risks are positively correlated, if the one rises, then the another also rises and vice versa. That means they vary in the same direction.
Risks are negatively correlated, if the one rises, then the another falls and vice versa. That means they vary in opposite direction.
Legal risk is a risk of potential loss of legal proceedings.
Legal risk for Hoppo arises from the decision to cancel the contract with Red Co. It is likely that Red Co would sue Hoppo for loss of future earnings, despite the terms of the contract being legally ambiguous.
Reputation risk is the current and prospective impact on earnings and capital arising from negative public opinion.
Reputation risk for Hoppo also arises from the decision to cancel the contract with the main supplier of very rare TY-13. The cancellation and its impact would be widely reported because of Hoppo’s international profile and that this may result in some unfavourable publicity.
Both legal and reputation risks arise. They are positively correlated.
Related and correlated risks
Question 1, part a), 10 marks (18 minutes)Briefly explain ‘related’ and ‘correlated’ risks. Explore the correlation between legal risk and reputation risk for Hoppo if it were to cancel its contract with Red Co.
Related risks are the risk which vary because of the presence of another risk. They do not exist independently.
Correlated risks is a particular example of related risks.
Risks are positively correlated, if the one rises, then the another also rises and vice versa. That means they vary in the same direction.
Risks are negatively correlated, if the one rises, then the another falls and vice versa. That means they vary in opposite direction.
Legal risk is a risk of potential loss of legal proceedings.
Legal risk for Hoppo arises from the decision to cancel the contract with Red Co. It is likely that Red Co would sue Hoppo for loss of future earnings, despite the terms of the contract being legally ambiguous.
Reputation risk is the current and prospective impact on earnings and capital arising from negative public opinion.
Reputation risk for Hoppo also arises from the decision to cancel the contract with the main supplier of very rare TY-13. The cancellation and its impact would be widely reported because of Hoppo’s international profile and that this may result in some unfavourable publicity.
Both legal and reputation risks arise. They are positively correlated.
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