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What is Risk? And why should we bother?
MGMT 7760
Risk Management
• Risk
– Variability that can be quantified in terms of probabilities.
(reserving ‘variability that cannot be quantified at all’ for
‘uncertainty’)
Aparna Gupta
• Risk is everywhere – future cannot be predicted
• The intuitive commonsense of Risk-Reward
coupling
Lally School of Management
Office: PITTS 3206
Email: guptaa@rpi.edu
Phone: x2757
– No risk; no reward
– Taking on more risk is sensible only if it results in greater
likelihood of greater reward!
– Appetite for risk determines what reward one seeks
• And the good news is – Risk can be Managed
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Types of Risk – The LIST!
An Example – The Racer’s profitability
• Risk: volatility of returns leading to ‘unexpected
losses’ with higher volatility indicating higher risk.
• Volatility of returns is directly or indirectly affected by
numerous variables – called risk factors, and
interaction between risk factors.
• Systematic risk factors categories:
• Dord Motors is considering whether to introduce a new model:
The Racer.
• The management is trying to assess the prospects for this
new model.
• Problem is: costs – fixed and variable, future sales and prices
are all risky
• Understanding their impact on the project’s profitability is a
difficult, but important, task.
• How should the management proceed?
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Market risk,
Credit risk,
Liquidity risk,
Operational risk,
Legal risk, Regulation risk, and Reputation risk,
Business risk, and Strategic risk.
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The Risk Management Process
An Example – The Racer’s profitability
Identify Risk Exposures
Measure and Estimate
Risk Exposures
Assess Effects of
Exposures
• The Model: management has determined that profitability of
The Racer will depend on the following risks:
– Fixed cost of developing The Racer is equally likely to be either $3 or
$5 billion.
– Variable Cost per Car
Find ways to Shift or
Trade Risks
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Assess Costs and Benefits
of Risk Mgmt Instruments
Year 1: equally likely to be $5000 or 8000.
Year 2: 1.05*(Year 1 Variable Cost)
Year 3: 1.05*(Year 2 Variable Cost)
Form a Risk Management Strategy
Avoid
Mitigate
Transfer
Keep
Evaluate
Performance
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Assessing The Racer’s profitability (contd.)
– Sales
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• The outcome of the simulation analysis suggests:
Average Sales in Year 1 are estimated to be 200,000, with a standard
deviation of 50,000. Normal distribution is chosen.
Average Sales of Year 2 and 3 are expected to be at the Sales level of the
previous year, with a standard deviation of 50,000.
– Pricing
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What is the risk in The Racer’s profitability?
Year 1 Price = $13,000
Year 2 Price = 1.05{(Year 1 Price) + $30*(% by which Year 1 Sales exceed
expected Year 1 Sales)}
Year 3 Price = 1.05{(Year 2 Price) + $30*(% by which Year 2 Sales exceed
expected Year 2 Sales)}
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The expected NPV of The Racer project is -$593,768,706.
With more than 60% probability The Racer is going to be unprofitable.
Losses may exceed $1 billion with 40% probability
Profits may exceed $1.8 billion with 10% probability
• Based on the above risk exposure, the management needs
to decide their risk management strategy – avoid it, mitigate it,
transfer it, keep it.
• We will do an exercise based on this later.
• The management needs to bring all these elements together
to assess the profitability of The Racer.
• We will do this in Excel....
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