Risk and the Financial Sector

What Risk and the Financial Sector covers

Risk and the Financial Sector is examined in Paper 1, Markets and how they work, and in Paper 3, The economic environment and business. It covers risk and uncertainty in business decisions, economic shocks and their impact on firms, exchange rate risk and forward markets, insurance and the management of business risk, mobilising savings and lending for business investment, assessing creditor risk and lending to individuals, payments, equity markets and the exchange of goods and services, the central bank: the MPC, monetary policy and financial regulation and the Global Financial Crisis and banking regulation.

The 9 subtopics

Each one has its own page.

• Risk and uncertainty in business decisionsRisk against uncertainty and why only risk can be insured, examples of each, risk-averse decision-makers and risk premiums, expected value and calculating it, the entrepreneur as bearer of uncertainty, uncertainty and investment, reducing risk and diversification, higher borrowing costs for small firms, and uncertainty in overseas markets.Open →
• Economic shocks and their impact on firmsEconomic shocks, demand-side and supply-side shocks and examples, the effect of an adverse supply shock on prices and output, long international supply chains, symmetric and asymmetric shocks, building resilience, just in time against resilience, energy price rises, uneven effects on firms, recessions in trading partners, permanent loss of capacity, and opportunities from shocks.Open →
• Exchange rate risk and forward marketsExchange rate risk for exporters invoicing in dollars, forward exchange contracts, hedging against speculation, spot and forward rates, currency options, natural hedges, calculating hedged receipts and the difference a hedge makes, commodity forward markets, the role of speculators, and the drawbacks of hedging.Open →
• Insurance and the management of business riskHow insurance manages risk, premiums and how insurers set them, the law of large numbers, the insurance a manufacturer holds, business interruption insurance, compulsory employers' liability insurance, moral hazard and how insurers limit it, adverse selection and how insurers reduce it, uninsurable risks, and insurance as an encouragement to enterprise.Open →
• Mobilising savings and lending for business investmentFinancial intermediation, maturity transformation and the vulnerability it creates, risk transformation, cheaper bank lending, working capital and growing firms, bank finance for working capital and invoice factoring, debt against equity finance, collateral, gearing, bank lending and productive capacity, and credit crunches.Open →
• Assessing creditor risk and lending to individualsAssessing creditor risk and what banks examine before lending, higher rates for riskier borrowers, credit ratings and downgrades, asymmetric information, adverse selection and moral hazard in lending, reducing information problems, forms of lending to individuals, mortgages against unsecured loans, the loan-to-value ratio and calculating it, and lending and aggregate demand.Open →
• Payments, equity markets and the exchange of goods and servicesHow the financial sector enables exchange, payments and clearing systems, trade credit, letters of credit for exporters, equities, primary and secondary share markets, initial public offerings, reasons to float and the drawbacks of a listing, why share prices matter to listed companies, and equity market bubbles.Open →
• The central bank: the MPC, monetary policy and financial regulationThe Monetary Policy Committee, its membership and meetings, Bank Rate, what the committee considers and why it targets inflation two years ahead, responding to high inflation, independence and credibility, forward guidance, the Financial Policy Committee, macroprudential and microprudential regulation and their tools, stress tests, the lender of last resort and moral hazard, and banker to the banks.Open →
• The Global Financial Crisis and banking regulationSub-prime mortgages and their rapid growth, securitisation and weaker lending standards, too big to fail and moral hazard, the collapse of interbank lending and the credit crunch, speculation and asset bubbles, bank culture and bonuses, capital requirements, ring-fencing, deposit guarantee schemes, the costs of tighter regulation, and the crisis's effects on government finances, households and firms.Open →

What you need to know

Answer each one before you reveal it.

Take Risk and the Financial Sector further

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Commonly confused

Pairs that lose marks when they are blurred together.

• Hedging vs Speculation

  Hedging: taking an offsetting position to remove an exposure the firm already has, in order to reduce its risk. Speculation: Deliberately taking on an exposure the firm did not have, in the hope of profiting from a price movement.

• Liquidity problem vs Solvency problem

  Liquidity problem: a bank cannot turn its assets into cash quickly enough to meet withdrawals, even though they are worth more than what it owes. Solvency problem: A bank's liabilities exceed the value of everything it owns, so lending it cash for a few days cannot save it.

• Primary market vs Secondary market

  Primary market: the part of the financial system in which newly issued shares are sold and the money raised goes to the company. Secondary market: The part of the financial system in which shares already in issue are traded between investors, with the company receiving nothing.

Questions from this topic

Each one with the model answer underneath.

1. 1

   Distinguish between risk and uncertainty.

   Model answer

   With risk the range of possible outcomes and their probabilities can be estimated, usually from past data, whereas with uncertainty the outcomes or their probabilities cannot be quantified at all.

2. 2

   Why can a risk be insured but an uncertainty cannot?

   Model answer

   An insurer needs a probability in order to calculate an expected loss and set a premium, and where no probability can be estimated no premium can be priced.

3. 3

   Give one example of a business risk and one example of business uncertainty.

   Model answer

   A fire at a warehouse is a risk because its likelihood can be estimated from records, while whether an unfamiliar technology will make the firm's product obsolete is an uncertainty because there is no basis for a probability.

4. 4

   What is meant by a risk-averse decision-maker?

   Model answer

   A risk-averse decision-maker prefers a certain outcome to a gamble with the same expected value, and so requires additional expected return before accepting the gamble.

5. 5

   Define a risk premium.

   Model answer

   A risk premium is the additional return an investor or lender requires in order to accept a riskier project or a less creditworthy borrower.

6. 6

   How is the expected value of a business decision calculated?

   Model answer

   Each possible outcome is multiplied by its probability and the resulting figures are added together to give the average outcome the firm would obtain if the decision were repeated many times.

What is inside Levo

Six ways to work the same material.

Risk and the Financial Sector revision questions

What does Risk and the Financial Sector cover in Edexcel A-Level Economics B?

9 subtopics: risk and uncertainty in business decisions, economic shocks and their impact on firms, exchange rate risk and forward markets, insurance and the management of business risk, mobilising savings and lending for business investment, assessing creditor risk and lending to individuals, payments, equity markets and the exchange of goods and services, the central bank: the mpc, monetary policy and financial regulation and the global financial crisis and banking regulation. Each one has its own page with questions and model answers.

How is Risk and the Financial Sector organised?

By the Edexcel 9EB0 specification, subtopic by subtopic, so it matches the order you are taught it in.