Chapter 10: An Overview of Risk Management

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Chapter 10 An Overview of Risk Management

• Objective
• Risk and Financial Decision Making
• Conceptual Framework for Risk
• Management
• Efficient Allocation of
• Risk-Bearing

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Contents

• What is Risk?
• Risk and Economic Decisions
• The Risk Management Process
• The Three Dimensions of Risk Transfer
• Risk Transfer and Economic Efficiency
• Institutions for Risk Management
• Portfolio Theory Quantitative Analysis for
  Optimal Risk Management
• Probability Distributions of Returns
• Standard Deviation as a Measure of Risk

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Roles of Risk Management

• One of the three analytical pillars to finance
• Risk allocation (redistribution)

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Concept of Risk

• Uncertainty that matters
• Illustration Preparing foods for your party
• Gains losses, upside potential downside
  possibility

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Risk Aversion

• A characteristic of an individuals preference in
  risk-taking situations
• Experiment
• Prefer lower risk given same expected value
• Decreasing marginal utility of income
• Rational behavior assumed to be risk-averse
• A measure of willingness to pay to reducing risk

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Risk Management

• The process of formulating the benefit-cost
  trade-offs of risk reduction and deciding on the
  course of action to take.
• The appropriateness of a risk-management decision
  should be judged in the light of the information
  available at the time the decision is made.
• Skill and lucky in risk management.

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Risk Exposure

• Particular types of risk one faces due to ones
  circumstances (job, business, and pattern of
  consumption, etc.)
• Illustrations
• the risk of a crop failure and the risk of a
  decline in the price for a farmer
• the risks of fire, theft, storm damage,
  earthquake damage for a house owner
• the currency risk for a person whose business
  involves imports or exports of goods

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Speculators and Hedgers

• Hedgers taking positions to reduce their
  exposures.
• Speculators taking positions that increase their
  exposure to certain risks in the hope of
  increasing their wealth.
• The riskiness of an asset or a transaction cannot
  be assessed in isolation or in abstract.

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Risks Facing Households

• Sickness, disability, and death
• Unemployment
• Consumer-durable asset risk
• Liability risk
• Financial-asset risk

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Risks Facing Firms

• Production risk and RD risk
• Price risk of outputs
• Price risk of inputs

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The Risk-Management Process

• A systematic attempt to analyze and deal with
  risk
• Steps
• Risk identification
• Risk assessment
• Selection of risk-management techniques
• Implementation
• Review

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Risk Identification

• Figuring out what the most important risk
  exposures are for the unity of analysis.
• The perspective of the entity as a whole
• Career and stock-market risk
• The net exposure to exchange-rate risk of a firm
  buying inputs and selling products abroad
• Price risk and quantity risk of farms

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Risk Assessment

• The quantification of the costs associated with
  the risks that have been identified
• Health-insurance and actuaries
• Professional investment advisors

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Risk-Management Techniques

• Risk avoidance
• Loss prevention and control
• Risk retention
• Risk transfer

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Implementation

• The basic principle is to minimize the costs of
  implementation.
• The lowest premium for health insurance
• The costs of investing in the stock market
  through mutual fund or a broker

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Review

• Risk management is a dynamic feedback process,
  in which decisions are periodically reviewed and
  revised.

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Risk Transfer and Economic Efficiency

• Transfering some or all of the risk to others is
  where the financial system plays the greatest
  role.

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Risk Transfer and Economic Efficiency

• Institutional arrangements for the transfer of
  risk contribute to economic efficiency in two
  fundamental ways.
• To reallocate existing risks to those most
  willing to bear the risks,
• To cause a reallocation of resources to
  production and consumption in accordance with the
  new distribution of risk-bearing.

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Efficient Bearing of Existing Risks

• A retired widow, whose sole source of income is
  100,000 in the form of a portfolio of stocks.
• A college student, who has a wealth of 100,000
  in a bank CD.
• The different attitudes towards future and risk.
• Exchange (swap) their assets.

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Relative Advantages and Risk AllocationInterest
Rate SWAP

• Firms with deferring degrees of credit have
  different costs of financing.

• The AAA corporation has the relative advantage of
  financing at the fixed rate, while the BBB
  corporation has the relative advantage of
  financing at the floating rate.
• However, BBB may want to finance at a fixed rate
  and AAA may prefer a floating one.
• How can we do?

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Borrowing at the Advantage Rate
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SWAP

• LIBOR-0.20
  11.70

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Credit Risk and Intermediation of Banks

• LIBOR-0.20(LIBOR-0.10)
  11.70(11.80)

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Risk and Resource Allocation

• A scientist discovers a new drug designed to
  treat the common cold.
• She requires 1,000,000 to develop, test and
  produce it.
• At this stage, the drug has a small probability
  of commercial success.
• Using her own money or setting up a firm?

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Risk and Resource Allocation

• risk pooling and sharing/specialization in the
  bearing of risks.
• By allowing people to reduce their exposure to
  the risk of undertaking certain business
  ventures, the function of the financial system to
  facilitate the transfer of risks may encourage
  entrepreneurial behavior that can have a benefit
  to society.

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Complete Markets for Risk

• A world in which there exist such a wide range of
  institutional mechanisms that people can pick and
  choose exactly those risks they wish to bear and
  those they want to shed.
• Kenneth Arrow, 1953
• A hypothetical, ideal world
• Limiting case for efficient risk allocation
• Separation production and risk bearing

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Acceleration of Financial Innovations

• Insurance, stock, and future markets (400 yrs)
• Debt or equity design of securities (400 yrs)
• The supply side
• New discoveries in telecommunications,
  information processing, and finance theory have
  significantly lowered the costs of achieving
  global diversification and specialization in the
  bearing of risks.
• The demand side
• Increased volatility of exchange rates,
  interest rates, and commodity prices have
  increased the demand for ways to manage risk.
• Complete markets not possible

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The Volatility of Exchange Rates
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The Volatility of Interest Rtes
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Real-world Limitations to Efficient Risk
Allocation

• Transactions costs
• Incentive problems
• moral-hazard having insurance against some risk
  causes the insured party to take greater risk or
  to take less care in preventing the event that
  gives rise to the loss.
• adverse selection those who purchase insurance
  against risk are more likely than the general
  population to be at risk

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Three Dimensions of Risk Transfer

• The simple way of risk transfer selling the
  asset that makes the owner exposed to risk.
• The three dimensions of risk transfer hedging,
  insuring, and diversifying.

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Hedging

• The action taken to reduce ones exposure to a
  loss but also causing the hedger to give up the
  possibility of a gain.
• Example farmers
• Other examples

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Insuring

• Paying a premium to avoid losses but retaining
  the potential for gain.
• Example import/export business
• Other examples health insurance, traveling to
  Jiuzhaigou.

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Diversifying

• Holding similar amounts of many risky assets
  instead of concentrating all of your investment
  in only one.
• Example investing in the biotechnology business
• initial capital 100,000
• probability of success 50
• uncertainty quadrupling the investment or losing
  the entire investment
• independence of successes

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Further Points on Diversification

• Reduce chances of either big gains or losses
• Perfect correlation do not reduce risk
• Aggregate uncertainty not reduced
• genius, dunce and average investors Good
  luck or skill?

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Basics of Portfolio Theory

• A quantitative analysis for optimal risk
  management.
• Solve the problem How to choose among financial
  alternatives so as to maximize investors given
  preferences.
• Optimal choice trade-offs between higher
  expected return and greater risk.

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Returns on GENCO RISCO
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Return Distribution Graph
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Expected Return Mean
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Risk Standard Deviation
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Volatility

• Standard deviation of returns.
• A measure of risk (or uncertainty) The first
  risk measure (Markowitz, 1952).
• Volatility is 0 no risk future return certain.
• Larger volatility gt wider range of returns gt
  more uncertain (greater risk).

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Probability Distribution of Return

• Observables history of prices or returns.
• Past implies future.
• Computable mean standard deviation.
• Unknown distribution of probability.
• Assumption Normal distribution of return (from
  discrete to continuous).
• Accuracy depends on assumption!

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Equation for Homogeneous Diversification with n
Stocks

• Investing equally in n stocks with the same
  standard deviation and correlation.
• The standard deviation of the portfolio is

• Correlation do not reduce risk.
• The smaller of correlation, the better.
• Risk reduction via right diversification.

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Summary Main Points

• Risk bad uncertainty
• Risk aversion prefer lower risk
• Risk measure volatility
• Portfolio many components
• Risk mgmt reduce risks at a reasonable cost
• Hedge, insure, diversify