Professional Level – Essentials Module, Paper P1
Governance, Risk and Ethics June 2012 Answers
1 (a) Risk appetite
Explanation
Risk appetite describes the willingness of an entity to become exposed to an unrealised loss (risk). It is usually understood to
mean the position taken with regard to two notional preferences: risk aversion and risk seeking. Both preferences are
associated with different levels of returns: those that are risk-seeking favour higher risks and higher returns with the converse
being true for the risk averse.
Risk-averse entities will tend to be cautious about accepting risk, preferring to avoid risk, to share it or to reduce it. In
exchange, they are willing to accept a lower level of return. Those with an appetite for risk will tend to accept and seek out
risk, recognising risk to be associated with higher net returns.
Risk appetite and selection
The Jayland option has a higher political risk, a threat to the integrity of the company (by paying the bribe) and an element
of reputation risk. There is also a risk arising from the lack of business culture in Jayland and a possibility that it will be more
difficult to maintain normal operations there than in Pealand. Offset against these risks is the potential return of $2 billion
over ten years, which is twice that of the Pealand option.
The Pealand option has negligible political risk but a slightly higher risk that internal controls will be difficult to implement. It
has a much lower likelihood of reputation risk and there is no risk connected with bribery. The return is half that of the Jayland
option (for an approximately equal investment value).
The two options offer two different risk and return profiles: the Jayland option offers a higher return but a higher risk profile
and the Pealand option offers a lower return but also a lower risk profile. If the company has a higher risk appetite it is more
likely to choose Jayland and if it has a lower risk appetite it is likely to select the Pealand option.
(b) AAA seven-step model
