GENERAL ADVICE NOTIFICATION

 This information is provided under the general advice provisions of ASIC (RG 244.38) and the Corporations Act (s949A(3).

The advice is provided by PE Capital Funds Management Ltd. (PECFM) as a Corporate Authorised Representative (CAR) of One Investment Administration Ltd. (OIA)

We are legally obliged to warn all clients that:

                     (a)  the advice has been prepared without taking account of the client's objectives, financial situation or needs; and

                     (b)  because of that, the client should, before acting on the advice, consider the appropriateness of the advice, having regard to the client's objectives, financial situation and needs; and

                     (c)  obtain a Product Disclosure Statement relating to the product and consider the Statement before making any decision about whether to acquire the product.

PECFM has taken all reasonable steps to ensure that all authorised representatives comply with these disclosure requirements, which are specifically referenced in the business procedures manual as well as ongoing training.

 

Risk Management Report

Prepared as a general advice declaration for stakeholders in PE Capital projects. 

The relationship of Risk and Return

Risk can be defined as the possibility that the actual return of an investment will be different to the expected return.

Rational investors expect to receive a higher return for increased risk. Therefore, the higher the return from an asset, generally speaking, the higher the associated risk. The opposite of this is usually conversely true as well. It is useful to distinguish between the risk which relates to all securities in a market and risk which applies to specific securities in a market. The risk specific to individual securities is diversifiable risk – as it may be diversified away. The risk that all securities in a market bear that cannot be diversified away is called systematic risk.

In many early stages of diversification, risk will reduce quite sharply, but it will not fall below some base level , which is the risk associated with factors common to the market in general.

There are two specific reasons why facilities need to consider risk:

  1. To a considerable extent, all investment considerations are devoted to finding investments which offer the best combination of probable benefits and probable risks, and
  2. Facilities and their advisers need to consider the maximum degree to which invested capital should be exposed to risk

Terms such as “reasonable expectations”, “probable return”, or “conservative estimate” are widely used. In many instances there is no guarantee that a particular investment will perform to expectation, or even to industry average.

 

The following sources of risk can be identified and researched:

OPERATIONAL RISK

CREDIT RISK

MARKET RISK

LIQUIDITY RISK

 

OPERATIONAL RISK

BUSINESS RISK – Such that the results may be disappointing, or even a loss of income or capital, sometimes brought about by inefficient management, bad trading policies, etc.

LEGAL RISK - The Risk Principle is an area of law closely tied to legal causation in negligence. It provides limits on negligence for harm caused unforeseeably.

POLITICAL RISK - Broadly, political risk refers to the complications businesses and governments may face as a result of what are commonly referred to as political decisions—or “any political change that alters the expected outcome and value of a given economic action by changing the probability of achieving business objectives.”. Political risk faced by firms can be defined as “the risk of a strategic, financial, or personnel loss for a firm because of such nonmarket factors as macroeconomic and social policies (fiscal, monetary, trade, investment, industrial, income, labour, and developmental), or events related to political instability

REPUTATIONAL RISK - Reputational risk, often called reputation risk, is a type of risk related to the trustworthiness of business. Damage to a firm's reputation can result in lost revenue or destruction of shareholder value, even if the company is not found guilty of a crime. Reputational risk can be a matter of corporate trust, but serves also as a tool in crisis prevention.[

 VOLATILITY RISK - Volatility risk is the risk of a change of price of a portfolio as a result of changes in the volatility of a risk factor. It usually applies to portfolios of derivatives instruments, where the volatility of its underlyings is a major influencer of prices.

SETTLEMENT RISK - Settlement risk is the risk that a counterparty does not deliver a security or its value in cash per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value per the trade agreement.

PROFIT RISK - Profit risk is a risk measurement methodology most appropriate for the financial services industry, in that it complements other risk management methodologies commonly used in the financial services industry: credit risk management and asset liability management (ALM). 

 

Profit risk is the concentration of the structure of a company’s income statement where the income statement lacks income diversification and income variability, so that the income statement’s high concentration in a limited number of customer accounts, products, markets, delivery channels, and salespeople puts the company at risk levels that project the company’s inability to grow earnings with high potential for future earnings losses.[3] Profit risk can exist even when a company is growing in earnings, which can cause earnings growth to decline when levels of concentration become excessive.

SYSTEMIC RISK - In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system.  It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". 

It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market.

 

 

CREDIT RISK

CONSUMER CREDIT RISK - Consumer Credit Risk (AKA Retail Credit Risk) is the risk of loss due to a customer's non re-payment (default) on a consumer credit product, such as a mortgage, unsecured personal loan, credit card, overdraft etc. (the latter two options being forms of unsecured banking credit).

CONCENTRATION RISK - Concentration risk is a banking term denoting the overall spread of a bank's outstanding accounts over the number or variety of debtors to whom the bank has lent money. This risk is calculated using a "concentration ratio" which explains what percentage of the outstanding accounts each bank loan represents. For example, if a bank has 5 outstanding loans of equal value each loan would have a concentration ratio of .2; if it had 3, it would be .333. Risk of default is an important factor in concentration risk. The basic issue raised by the concept of default risk is: does the risk of default on a bank's outstanding loans match the overall risk posed by the entire economy or are the bank's loans concentrated in areas of higher or lower than average risk based on their volume, type, amount, and industry. There are two types of concentration risk. These types are based on the sources of the risk. Concentration risk can arise from uneven distribution of exposures (or loan) to its borrowers. Such a risk is called Name Concentration risk. Another type is Sectoral Concentration risk which can arise from uneven distribution of exposures to particular sectors, regions, industries or products.

SECURITIZATION - Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said debt as bonds, pass-through securities, or Collateralized mortgage obligation (CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. Securities backed by mortgage receivables are called mortgage-backed securities, while those backed by other types of receivables are asset-backed securities.

CREDIT DERIVATIVE - In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself.[1] This entity is known as the reference entity and may be a corporate, a sovereign or any other form of legal entity which has incurred debt.[2] Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity.

 

 

MARKET RISK

INTEREST RATE RISK - Interest rate risk is the risk (variability in value) borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond's duration.

Asset liability management is a common name for the complete set of techniques used to manage risk within a general enterprise risk management framework.

Banks face four types of interest rate risk:

Basis risk

The risk presented when yields on assets and costs on liabilities are based on different bases, such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate. In some circumstances different bases will move at different rates or in different directions, which can cause erratic changes in revenues and expenses.

Yield curve risk

The risk presented by differences between short-term and long-term interest rates. Short-term rates are normally lower than long-term rates, and banks earn profits by borrowing short-term money (at lower rates) and investing in long-term assets (at higher rates). But the relationship between short-term and long-term rates can shift quickly and dramatically, which can cause erratic changes in revenues and expenses.

Repricing risk

The risk presented by assets and liabilities that reprice at different times and rates. For instance, a loan with a variable rate will generate more interest income when rates rise and less interest income when rates fall. If the loan is funded with fixed rated deposits, the bank's interest margin will fluctuate.

Option risk

It is presented by optionality that is embedded in some assets and liabilities. For instance, mortgage loans present significant option risk due to prepayment speeds that change dramatically when interest rates rise and fall. Falling interest rates will cause many borrowers to refinance and repay their loans, leaving the bank with uninvested cash when interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to repay slower, leaving the bank with more loans based on prior, lower interest rates. Option risk is difficult to measure and control.

Most banks are asset sensitive, meaning interest rate changes impact asset yields more than they impact liability costs. This is because substantial amounts of bank funding are not affected, or are just minimally affected, by changes in interest rates. The average checking account pays no interest, or very little interest, so changes in interest rates do not produce notable changes in interest expense. However, banks have large concentrations of short-term and/or variable rate loans, so changes in interest rates significantly impact interest income. In general, banks earn more money when interest rates are high, and they earn less money when interest rates are low. This relationship often breaks down in very large banks that rely significantly on funding sources other than traditional bank deposits. 

 

Large banks are often liability sensitive because they depend on large concentrations of funding that are highly interest rate sensitive. Large banks also tend to maintain large concentrations of fixed rate loans, which further increases liability sensitivity. Therefore, large banks will often earn more net interest income when interest rates are low.

CURRENCY RISK - Currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.

  • Transaction risk is the risk that exchange rates will change unfavourably over time. It can be hedged against using forward currency contracts;
  • Translation risk is an accounting risk, proportional to the amount of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency.
  • Currency risk has been shown to be particularly significant and particularly damaging for very large, one-off investment projects, so-called megaprojects. This is because such projects are typically financed by very large debts nominated in currencies different from the currency of the home country of the owner of the debt. Megaprojects have been shown to be prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost overruns, schedule delays, unforeseen foreign currency and interest rate increases, etc. – the costs of servicing debt becomes larger than the revenues available to do so. Financial restructuring is typically the consequence and is common for megaprojects. 

EQUITY RISK - Equity risk is the risk that one's investments will depreciate because of stock market dynamics causing one to lose money.

The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods. The standard deviation will delineate the normal fluctuations one can expect in that particular security above and below the mean, or average. However, since most investors would not consider fluctuations above the average return as "risk", some economists prefer other means of measuring it.

COMMODITY RISK - Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc. A commodity enterprise needs to deal with the following kinds of risks:

ECONOMIC RISK – The risk relating to changes in inflation rates, interest rates, current accounts, etc.

INFORMATION RISK – The risk that information on a particular investment or market may not be accurate.

 

 

LIQUIDITY RISK

REFINANCING RISK - In banking and finance, refinancing risk is the possibility that a borrower cannot refinance by borrowing to repay existing debt. Many types of commercial lending incorporate balloon payments at the point of final maturity; often, the intention or assumption is that the borrower will take out a new loan to pay the existing lenders.

SECURITY RISK - Credit/default: Default risk is generally accepted as a borrower’s inability to meet interest payment obligations on time. For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular security’s default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings.

However, the credit crisis of 2007–2008 has exposed a potential flaw in the securitization process – loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance and securitization, which doesn't encourage improvement of underwriting standards.

Event risk

Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess Fixed Income Sectors: Asset-Backed Securities spread, a rise in the default rate on the underlying loans above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer. 

Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. 

Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates.

Contractual agreements

Moral hazard: Investors usually rely on the deal manager to price the securitizations’ underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal's excess spread. 

Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction.