Chapter 10

An Overview of Risk Management

Contents

1. What is Risk?2. Risk and Economic

Decisions3. The Risk-Management

Process4. The Three Dimensions

of Risk Transfer5. Risk Transfer and

Economic Efficiency

6.Institutions for Risk Management7. Portfolio Theory8. Probability

Distributions of Return

9. Standard Deviation to measure the Risk

What is Risk?

Uncertainty that “matters” because it affects people’s welfare

Risk, some terms

Risk aversion: A characteristic of an individual who avoids risk

Risk Management: The process of formulating the benefit-cost trade-offs of risk reduction and deciding what action to take

Risk exposure: The particular type of risk because one’s job, business or pattern of consumption

Speculators: Investors who take positions that increase their exposure to certain risks in hope of increasing their wealth

Hedgers: Take positions to reduce their exposures.

The Risk-Management Process

Risk identification

Risk assessment

Selection of risk-management techniques

Implementation

Review

Risk Identification

Figuring out what the most important risk exposures are for the unit of analysis, be it a household, a firm, or some other entity.

Risk Assessment

The quantification of the costs associated with the risks that have been identified in the first step of risk management

Risk-Management Techniques

Risk avoidance

Loss prevention and control

Risk retention: Absorbing risk by one’s

own resources

Risk Transfer

Risk Avoidance

A conscious decision not to be exposed to a particular risk. For example, avoiding certain lines of business because there are considered too risky.

Loss Prevention and Control

Actions taken to reduce the likelihood or the severity of losses. For example, you can reduce your exposure to the risk of illness by eating well, getting plenty of sleep, and …

Risk Retention

Absorbing the risk and covering losses out of one’s own recourses. For example, some people may decide to absorb the costs of treating illnesses by their own and do not buy health insurance.

Risk Transfer

Transferring the risk to others. For example, selling a risky asset to someone else and buying insurance.

Risk management process (continued): Implementation

Implementing the risk management techniques selected. The underlying principle: minimize the costs of implementation.

Review

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

Three Dimensions of Risk Transfer

Hedging

Insuring

Diversifying

Hedging

One is said to hedge a risk when the action taken to reduce one’s exposure to a loss also causes one to give up the possibility of a gain.

Insuring

Paying a premium to avoid losses. By buying an insurance you substitute a sure loss for the possibility of a larger loss.

Hedging versus Insuring

When you hedge, you eliminate the risk of loss by giving up the potential for gain. When you insure, you pay a premium to eliminate the risk of loss and retain the potential for gain.

Diversifying

Holding similar amounts of many risky assets instead of concentrating all of your investment in only one.

Portfolio Theory

Quantitative analysis for optimal risk management

Probability distributions is used to quantify the trade-off between risk and expected return

Mean of the distribution: Portfolio’s expected return

Standard deviation: Portfolio’s risk

Returns on GENCO & RISCO

State ofEconomy

Return onRISCO

Return onGENCO

Prob-ability

Strong 50% 30% 0.20

Normal 10% 10% 0.60

Weak -30% -10% 0.20

50%30%

10%-10%

-30%

Risco

Genco0

0.1

0.2

0.3

0.4

0.5

0.6

Probability

Return

Probability Distributions of Returns of Genco and Risco

Equations: Mean

%10

: Also

%1010.0

)10.0(2.010.06.03.02.0

...

1

332211

RISCO

GENCO

GENCO

r

r

r

n

iii

nnr

rP

rPrPrPrPrE

rP

Equations: Standard Deviation

2530.0

: Also

1265.0016.0

)10.010.0(2.010.010.06.010.030.02.0

...

222

1

2

2222

211

2

RISCO

GENCO

GENCO

r

r

r

n

irii

rnnrr

r

rP

rPrPrP

rErE

Volatility: a measure of the riskiness of an asset

An assets volatility is larger, the wider the range of possible outcomes and the larger the probabilities of those returns at the extremes of the range.

Distribution of Returns on Two Stocks

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

-100% -50% 0% 50% 100%

Return

Pro

bab

ilit

y D

ensi

ty

NORMCO

VOLCO

Two More Return Densities.

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

-100.00% -50.00% 0.00% 50.00% 100.00%

Return.

Pro

bab

ilit

y D

ensi

ty.

VOLCO

ODDCO