Principles of
Risk Management
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Objective
•Risk and Financial Decision Making
•Conceptual Framework for Risk
Management
•Efficient Allocation of
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Risk-Bearing
How close can you sail
without sinking the ship?
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Is Risk Relative ... ?
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Is Risk Relative ... ?
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Risk-Return Concept means ...
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Contents
• What is Risk?
• The Risk-Management Process
• Portfolio Theory: Quantitative Analysis for
Optimal Risk Management
– Probability Distributions of Returns
• Standard Deviation as a Measure of Risk
• Moral Hazard, Principal Agent Problem and
Adverse Selection
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What is Risk?
• Uncertainty
– An unrealized event is uncertain for an
observer at a given time if he/she does not
know its outcome at that time
– I enter a sealed bid on a public contract
• The value of my bid is certain to me
• Before unsealing, my bid is uncertain to you
• After unsealing, my bid is known to you
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Uncertainty that matters
• Risk is uncertainty that “matters” to the
observer
– You manage “Black pink” and have a choice
between two contracts for the concert hall
• 1 Pay the hall owner $2 for each ticket sold
• 2 Pay a specified lump-sum for the hall that
has a lower expected cost than (1)
What is the risk?
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Contractual Outcomes
• “Ticket sales” is the “risk that matters”
– While each fan may be certain about
attending or not attending, management is
not fully informed, and is at risk because
• if sales are in fact higher than a certain
number, it is more profitable if it selected
choice 2
• if sales are in fact lower than a certain
number, it is more profitable if it selected
choice 1 9
What is risk?
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Strategies for Controlling Risk
• Black Pink’s management has several strategies for reducing
cost-uncertainty
– Do research to determine the number of fans and the
percentage of fans who will attend
– For a fee, obtain the right to select between contract 1
and 2 at a later date
– Hedge with contracts to third parties, (radio station,
concessionaires, contractors, …)
– Let’s look at each strategy
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Naming the Strategies:
Research
• The first strategy is purchasing
information by research
– There is a cost associated with collecting
information, but information enables one to
make better-informed decisions
– Information is often collected incrementally,
and a decision is made at each step whether
to continue collecting further information
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Naming the Strategies:
Insurance or Option
• The second strategy entails purchasing
the right to make a choice before a
specified time
– Having the right to take an action when
information becomes clearer can be valuable
– In this case, the option is the right to delay
selection of the exact contractual terms
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Naming the Strategies:
Hedging
• The third strategy creates secondary
contracts that reduce overall exposure to
the risk created by the primary contract
– A primary fixed-fee rental contract creates a
forward position in (unknown) future sales
– Blackpink’s management may offset this risk
by requiring its concessionaires to enter into
fixed rental fee contracts rather than % of
sales contracts 22
What is Risk? Risk Aversion
• Black Pink’s ultimate contracting strategy
will depend upon its level of risk aversion
• Risk aversion
– A measure of an individual’s willingness to
pay for a reduction in exposure to risk
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What is Risk? Upside-Down
• Black Pink has a choice of contracts, and
each has an upside and a downside,
depending on the variable that controls
the “risk that matters”
• Upside: favorable outcome
• Downside : unfavorable outcome
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What is Risk? Both Upside
and Downside
• Some risks are more complex. A
computer mother-board manufacturer
that
– underestimates demand will lose current
sales and market share
– overestimates demand will own an inventory
with a market price that is being eroded by
rapid technological obsolescence
• Any deviation is unfavorable
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RISK
Risk: which of following cases are considered as risk?
1. A person attempted to commit suicide by jumping in front of
a running bullet train. But he is still alive.
2. You invested in ABC shares with annual expected profit of
15%. At the end of the one-year investment period, your
realized profit is 20%.
3. You invested in ABC shares with annual expected profit of
15%. At the end of the one-year investment period, your
realized profit is 14%.
Risk
Risk
The
uncertainty
of achieving Systematic Unsystemati
the risk c risk
expected
return
What is Risk? Risk-Controlling Tools
• Many tools that may be used to reduce
risk may also be used to increase risk
– If you insure your house against fire, you are
reducing your risk (Hedger)
– If I insure your house against fire, I am
increasing my risk (Speculator)
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2. Risk and Economic Decisions
• Risk exposure of households:
– Sickness, disability, & death risks
– Unemployment risk
– Consumer-durable asset risk
– Liability risk
– Financial asset risk
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Risk exposure of firms
• Input/output channels
strike, boycott, embargo, war, safety, supply/ demand
• Loss of production facilities
fire, legislation, civil action, strike, nationalization, war
• Liability risk
customer, employee, community , environment
• Price risks
input, output, foreign exchange, interest rate
• Competitor risk
technology, intellectual property, economic
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Government:
– Major calamities
• weather, forest fires, riots
– Guarantees
• exports, small business loans, deposit
insurance, student loans
– Interventions
• bank failures, strategic firm failures, crop
failures
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3.The Risk-Management Process
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3.The Risk-Management Process
• Risk identification
• Risk assessment
• Selection of risk-management techniques
• Implementation
• Review
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3.The Risk-Management Process
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Risk identification
• Some risks are commonly under-
identified, and so are not hedged
– disability coverage is often too low
• Some risks that do not exist are ‘hedged’
– life insurance is often over-prescribed
• Some risks offset each other
– Short in one asset, long in another
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Sources of risk
Physical environment
Social environment
Political environment
Legal environment
Operating environment
Economic environment
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Risk identification methods
• Brainstorming
• Interview
• Checklists
• Structured “what-if” technique (SWIFT)
• Scenario analysis
• Fault Tree Analysis (FTA)
• Bow Tie Analysis
• Direct observations
• Surveys… 37
Risk assessment
• Impact of risk rating
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Risk assessment
• Impact of risk rating
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Risk assessment
• Likelihood rating
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Risk assessment
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Risk management techniques
Selection of risk-management
techniques
• Risk avoidance
• Loss prevention and control
• Risk retention
• Risk transfer
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Selection of risk-management
techniques
• Risk avoidance
- Avoid the risk or the circumstances which
may lead to losses in another way, includes
not performing an activity that could carry
risk
- Avoidance may seem the answer to all
risks but avoiding risks also means losing
out on the potential gain
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Selection of risk-management
techniques
• Risk retention
- Risk retention implies that the losses
arising due to a risk exposure shall be
retained or assumed by the party or the
organization.
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Selection of risk-management
techniques
• Loss prevention and control
- Risk can be controlled by avoidance or by
controlling losses. Avoidance implies that either
a certain loss exposure is not acquired or an
existing one is neglected. Loss control can be
exercised in two ways – (i) Create the plan and
(ii) Risk Control.
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Implementation
• Risk transfer means that the expected
party transfers whole or part of the
losses consequential to risk exposure to
another party for a cost
• The insurance contracts fundamentally
involve risk transfers. Apart from the
insurance device, there are certain other
techniques by which the risk may be
transferred.
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Implementation
• Risk transfer requires finding a suitable
transfer vehicle at an acceptable price
– Obtain competitive quotations and look at
alternative ways to hedge
– Consider the mix of upside to downside risk
• Options shed downside risk, while
maintaining upside potential (at a price)
• Futures shed both down- and up-side risks
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Implementation
• Some risks may be shed only imperfectly
– A specialty rice grower may be able to lower
but not eliminate risk using cereal futures
– A seed grower may not be able to
significantly reduce price risk
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Review
• Management of risk should be an
ongoing systematic activity because risk
exposure changes as people mature
• Maintaining flexibility will enable you to
react more appropriately to change
– Term life insurance with an annual
renewable term is more flexible than policies
without this clause
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4.The Three Dimensions of Risk Transfer
• Hedging
• Insuring
• Diversifying
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Hedging
• A risk is hedged when the action taken to
reduce adverse risk exposure also causes
the loss of unexpected gain
– A farmer who sells her crop before it is
harvested reduces the risk of lower prices,
but lose the right to increased prices and
yields
– (Note: We sometimes use “hedge” to include “insure”)
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Insuring
• Insuring is the payment of a premium to
avoid losses
• Insurance is not hedging because you
maintain ownership in the upside
potential
– A farmer has the right, but not the obligation
to sell soy to the government at a set price
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Diversifying
• Diversification means holding similar
amounts of risky assets instead of a
larger amount of a single risky asset
– I have identified 10 corporations that each
have an expected return µ = 0.15, a
standard deviation s = 0.20, and are
correlated with each other with rho = 0.9
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Standard Deviations of Portfolios
0.20
0.19
0.18
s = 0.2000
Standare Deviation
0.17
s = 0.1421
0.16
0.15
0.14
0.13
0 1 2 3 4 5 6 7 8 9 10
Portfolio Size
s* = 0.1342
Theoretical Minimum 70
Observation
• Most of the diversification is obtained by
including just a few stock in the portfolio
• Risk can only be reduced to a fixed level
that depends on the correlation
• Progressively adding one more new stock
has a diminishing affect on risk
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Asymmetric information
• Asymmetric information (Information asymmetry): The imbalance in
information between two parties of a transaction (borrowers are more
informed in most cases)
• Adverse selection
§ Asymmetric information occurs before the transaction is done.
§ The buyers purchase the products that they should not buy, or the sellers sell
the products to the one that they should not sell to
§ Eg: Bank lends to the firm that has no ability to repay the debt (Potential
borrowers most likely to produce adverse outcomes are ones most likely to seek
loans and be selected)
• Moral hazard
§ Asymmetric information occurs after the transaction is done
§ After the transactions of financial products and services, one party of the
transaction has incentives to engage in activities that go against the terms of
transaction, making the other party suffer from unwanted outcomes
§ Eg. After getting the loan (money) from the bank, borrower has incentives to
engage in undesirable (immoral) activities making it more likely that it won’t pay
loan back
Incentive Problems
• Incentive problems that occur when one
party to a financial transaction has
information that the other party does
not, or when one party is an agent and
makes decisions for another
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Moral Hazard
• A situation in which 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.
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• Moral-Hazard
– Adam enters into an insurance contract with Carmel.
Adam pays Carmel a premium of $10,000. Carmel
will reimburse Adam’s costs should a fire damage his
business during the next year, but pay nothing
otherwise. Adam believes he can reduce the
probability of fire by installing a cheap sprinkler.
Without the contract he would certainly install the
unit, but he gains nothing by installing the unit with
the insurance contract in force.
– Adam is exposed to a moral hazard. Adam is taking
less care of his assets now that Carmel has assumed
the risk of their loss
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Adverse Selection
• A type of incentive problem in which
those who purchase insurance against
risk are more likely to be at risk than the
general population.
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• Adverse Selection
– Carmel has identified 100 businesses that fall into the
category of having a flood on average once every
200-years. Based on this estimate, Carmel sets a
premium based on 1% of the insured amount.
– Adam’s business is one of the 100, and he accepts
the contract believing that his business premises are
subject to flood about every 50-years.
– Dillip’s business is another of the 100, but he does
not accept the contract because he believes that
there is almost no chance of flood damaging his
business
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Q&A. Part1
1. Smokers who have high probability of getting lung cancer buy the health insurance
2. Bank lends out to the firm with hidden low performance
3. You bought a car and buy a car insurance for protecting you from suffering a huge cost incurring
when your car get damaged. After 1 month of insurance contract, you accidentally get your car
crashed.
4. You buy a life insurance and then intend to jump right in front of the bullet train to death to get
the insurance.
5. Bank A buys a deposit insurance, then A loosens its lending conditions and provide loans to risky
firms to earn interest rates
6. Lan has a big debt and this motivates her to buy a life insurance and then kill herself
7. After buying a life insurance, Lan gets into troubles with a big debt of her mom. She then decides
to commit suicide to release majority of the financial burden for her younger sister
8. After buying a life insurance, Lan gets into troubles with a big black credit of her mom from bad
guys (gangsters) (the owners of her mom’s debt) in her village. She then is killed by one of the
guys and her younger sister is able to receive insurance benefit from her life insurance to pay part
of the debt.
Principal-Agent Problem
• A situation arising when agents do not
make the same decisions that the
principals would have made if the
principals knew what the agents knew
and were making the decisions
themselves.
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• Principal-Agent Problems
– Adam is the real-estate agent marketing Carmel’s
house that’s worth $200,000 for a 6% commission
– Adam’s agency has a multiple-listing agreement with
other agencies, whereby listing agents receive 2.5%,
and selling agents receive 3.5%
– Bernadette wishes to buy the home for only 90% of
its market value, $180,000.
– Adam urges Carmel to accept the offer. Why?
• Adam will receive only $5,000 if the house is sold by
another agency at full value [(0.06-0.035)x$200,000]
• Adam makes $10,800 if Adam can persuade Carmel to
sell at the lower price
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