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Finance School of Management
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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Finance School of Management
10.1 What is Risk?
10.2 Risk and Economic Decisions
10.3 The Risk Management Process
10.4 The Three Dimensions of Risk Transfer
10.5 Risk Transfer and Economic Efficiency
10.6 Institutions for Risk Management
10.7 Portfolio Theory,Quantitative Analysis for
Optimal Risk Management
10.8 Probability Distributions of Returns
10.9 Standard Deviation as a Measure of Risk
Contents
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Finance School of Management
Roles of Risk Management
?One of the three analytical,pillars” to
finance
?Risk allocation (redistribution)
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Finance School of Management
Concept of Risk
Uncertainty that is,bad”
?Illustration,preparing foods for party
?Gains or losses:,upside” potential or
“downside” possibility
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Finance School of Management
Risk Aversion
Prefer lower risk given same expected value
? Diminishing marginal utility of income
? A measure of willingness to pay to reducing risk
? A characteristic of one’s preference in risk-taking
situations
? Rational behavior assumed to be risk-averse
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Finance School of Management
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-mgmt decision,
judged in the light of the information available
? Skill or lucky of a decision-maker?
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Finance School of Management
Risk Exposure
Particular types of risk one faces due to one’s
circumstances
? Illustrations,
– Farmer,a crop failure and a decline in the price
– house owner,fire,theft,storm or earthquake damage,a
decline of house price
– Importer/exporter,change of currency exchange rate
?Assessing risk exposure in context
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Finance School of Management
Speculate and Hedge
?Speculate,taking positions that increase
exposures to certain risks
?Hedge,measures that reduce risk exposures
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Finance School of Management
Risks Exposure for Households
1,Sickness,disability,and death
2,Unemployment
3,Consumer-durable asset risk
4,Liability risk
5,Financial-asset risk
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Finance School of Management
Risks Facing Firms
1,Production risk
2,Price risk of outputs
3,Price risk of inputs
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Finance School of Management
Risk-Management Process
A systematic attempt to analyze and deal with risk
? Five Steps
– Risk identification
– Risk assessment
– Selection of risk-management techniques
– Implementation
– Review
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Finance School of Management
Risk Identification
Discover an entity’s most important risk exposures
? view the entity as a whole,
– Person,career and stock market risk
– The net exposure to exchange-rate risk,buying inputs and
selling products abroad
– Farmer,price risk and quantity risk
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Finance School of Management
Risk Assessment
Quantifying risk exposures and costs of risks
? Not trivial to do,
– Health,insurance and actuaries
– Financial assets,professional investment advisors
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Finance School of Management
Risk-Management Techniques
1,Risk avoidance
2,Loss prevention and control
3,Risk retention
4,Risk transfer
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Finance School of Management
Implementation
?principle,minimize implementation costs
?Review - dynamic,feedback” process,
reviewed and revised periodically
– health insurance,the lowest premium
– Investing in many stocks,buy stocks yourself
or through mutual fund
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Finance School of Management
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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Finance School of Management
Reallocate Existing Risks
?A retired widow,$100,000 in stocks
?A college student,$100,000 in a bank CD
? Problem,both are risk inappropriate
? Solution,exchange (swap) their assets (via
financial system)
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Finance School of Management
Risk and Resource Allocation
A scientist discovers a new drug,but needs $1
million to develop,test,and produce it
? Problem,probability of drug’s commercial
success is small (or risk of failure is big)
? Solution,setting up a firm (risk pooling and
sharing)
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Finance School of Management
Function of the Financial System
?bank and insurance firm,specialization in the
bearing of different risks
reduce exposures to the risk of
undertaking biz ventures => encourage
entrepreneurial behavior that can have a
benefit to society
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Finance School of Management
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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Finance School of Management
Evolution of Markets for Risks
?Insurance,stock,and future markets (400 yrs)
?Debt or equity,design of securities (400 yrs)
?The supply side,New technologies and finance
theory lowered the costs of achieving global
diversification and specialization in risks bearing
?The demand side,higher volatility of exchange
rates,interest rates,and commodity prices demanded
new ways to manage risk,options & swap markets
Complete markets,not possible
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Finance School of Management
Real-world Limitations
?Transactions costs,services not free
?Incentive problems (Arrow,1963,1965)
– Moral hazard,the insured party may take greater
risk or to take less care in preventing loss
– adverse selection,insurance purchasers are more
likely than the general population to be at risk
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Finance School of Management
Incentive Problems,Examples
?Fire insurance,m-h
?Life annuities,a-s
?Renting & leasing of automobiles,m-h
& a-s
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Finance School of Management
Three Dimensions of Risk Transfer
1,Hedging
2,Insuring
3,diversifying
if selling the risky asset is not an option
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Finance School of Management
Hedging
?The action taken to reduce exposure to a loss
?also give up the potential of a gain
Farmers,sell crops in the futures market
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Finance School of Management
Insuring
?Paying a premium to cover losses
?but retaining the potential for gain
Personal,health,auto,life insurances
Stock owner,buy put options
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Finance School of Management
Diversifying
?holding many risky assets instead of one
?Limit exposure to single loss
investing in biotech business
– initial capital,$100,000
– probability of success,50%
– uncertainty,$400,000 or nothing
– independence of successes
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Finance School of Management
More on Diversification
?Reduce chances of either big gain or loss
?Perfect correlation,do not reduce risk
?Aggregate uncertainty,not reduced
Be aware of trading gurus,luck or skill (?)
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Finance School of Management
Portfolio Theory
?A quantitative analysis tool (probability of
future) 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
Harry Markowitz,1952
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Finance School of Management
Distribution of Return
State of the
economy
Return (%)
(Genco)
Return (%)
(Risco)
Probability
(future)
Strong 30 50 0.20
Normal 10 10 0.60
Weak -10 -30 0.20
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Finance School of Management
Return Distribution,Graph 50%
30%
10%
- 1 0 %
- 3 0 %
R i s c o
G e n c o
0
0, 1
0, 2
0, 3
0, 4
0, 5
0, 6
P r o b a b i l i t y
R e t u r n
P r o b a b i l i t y D i s t r i b u t i o n s o f R e t u r n s o f G e n c o a n d R i s c o
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Finance School of Management
Expected Return,Mean
? ?
%10
,a n d
%10
)10.0(2.010.06.03.02.0
...
1
332211
?
?
???????
?
?????
?
?
R I S C O
G E N C O
r
r
n
i
ii
nnr
rP
rPrPrPrPrE
?
?
?
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Finance School of Management
Risk,Standard Deviation
? ?? ?? ?
? ? ? ? ? ?
? ?
? ? ? ?
%30.25
,a n d
%65.12
)10.010.0(2.010.010.06.010.030.02.0
...
222
1
2
22
22
2
11
2
?
?
??????????
??
???????
??
?
?
R I S C O
G E N C O
r
r
n
i
rii
rnnrr
r
rP
rPrPrP
rErE
?
?
?
???
?
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Finance School of Management
Volatility
?Standard deviation of returns
?A measure of risk (or uncertainty)
?Volatility is 0,no risk; future return certain
?Larger volatility => wider range of returns =>
more uncertain (greater risk)
The first risk measure (Markowitz,1952)
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Finance School of Management
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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Finance School of Management
Normal Distribution,Graph
50%
30%
10%
- 1 0 %
- 3 0 %
R i s c o
G e n c o
0
0, 1
0, 2
0, 3
0, 4
0, 5
0, 6
P r o b a b i l i t y
R e t u r n
P r o b a b i l i t y D i s t r i b u t i o n s o f R e t u r n s o f G e n c o a n d R i s c o
D i s t r i b u t i o n o f R e t u r n s o n T w o S t o c k s
0, 0
0, 5
1, 0
1, 5
2, 0
2, 5
3, 0
3, 5
- 1 0 0 % - 5 0 % 0% 50% 100%
R e t u r n
P
r
o
b
a
b
i
l
i
t
y
D
e
n
s
i
t
y
N O R M C O
V O L C O
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Finance School of Management
? ? ???
2
11
n
nn
ns t o c kp o r t
???
Volatility of Portfolio
Investing equally in n stocks with the
same volatility and correlation,
?Perfect correlation,do not reduce risk
?The smaller of correlation,the better
?Risk reduction via right diversification
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Finance School of Management
Portfolio Volatility,Graph
S t a n d a r d D e v i a t i o n s o f P o r t f o l i o s
0, 1 3
0, 1 4
0, 1 5
0, 1 6
0, 1 7
0, 1 8
0, 1 9
0, 2 0
0 1 2 3 4 5 6 7 8 9 10
P o r t f o l i o S i z e
S
t
a
n
d
a
r
e
D
e
v
i
a
t
i
o
n
? = 20%
? = 14.21%
?* = 13.42%
Theoretical Minimum
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Finance School of Management
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