Risk and Risk Management
P.V. Viswanath
Based on Bodie and Merton
Uncertainty and Risk
 Uncertainty exists whenever one doesn’t know what
will happen in the future
 Risk is uncertainty that “matters” because it affects
people’s welfare.
 People are exposed to risk because they hold an asset or
because they have agreed to engage in a transaction.
 Risk aversion is the desire to avoid exposure to risk.
 People who are risk averse are willing to pay to avoid
exposure to risk.
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Risk Management
 Risk Management is the process of deciding on the costs and
benefits of avoiding risk exposure and deciding on the
optimal amount of risk exposure.
 The appropriateness of a risk-management decision should
be judged in the light of the information available at the time
the decision is made.
 For example, if you bought theft insurance for your car and
your car didn't get stolen during the policy period, that
doesn't make the insurance purchase a bad decision.
 Similarly, if you bought a lottery ticket, and your ticket won,
that doesn't make the lottery ticket purchase a good one.
 The riskiness of a particular asset or transaction must be
evaluated in the context of all other assets and transactions
that the decision maker is involved in.
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Business Risks
 Production Risk
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Risk that machines will break down
Deliveries of raw materials will not arrive on time
Workers will not arrive on time
New technology will make the firm’s equipment obsolete
 Price risk of outputs
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The risk that output prices will change because of change in
consumer preferences or competitor actions. For example, decreased
foreign demand could reduce output prices.
 Price risk of inputs
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The risk that input prices will change because of increased demand.
Interest rates could rise and make capital costlier.
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Techniques for Risk Reduction
 Risk avoidance
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A conscious decision not to hold the asset or engage in the
transaction that generates risk exposure
 Loss prevention and control
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Actions taken to reduce the likelihood or severity of losses; e.g.
checking equipment regularly.
 Risk Retention
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Consciously absorbing the consequences of the risk exposure.
 Risk transfer
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Selling the risk to others; e.g. buying insurance or credit default
swaps.
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Three Dimensions of Risk Transfer
 Hedging
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An action taken to reduce one’s exposure to a loss also
causes one to give up the possibility of a gain – futures
contracts.
 Insuring
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Paying a premium to avoid losses; buying insurance or
options
 Diversifying
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Holding similar amounts of many risky assets instead of
concentrating on a single one; limiting exposure to any
single asset.
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Factors affecting efficient risk allocation
 Transactions costs
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Costs of establishing and running institutions such as
insurance companies or securities exchanges and the
costs of writing and enforcing these contracts.
 Incentive Problems
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Moral Hazard
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Occurs ex-post; sellers of risk will take suboptimal actions.
Adverse Selection
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Occurs ex-ante; sellers of risk will not reveal the full nature of the
risk that they want to sell.
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Securities used for Risk Transfer
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Futures Contracts
Forward Contracts
Options Contracts
Debt
Equity
Credit Default Swaps
Interest Rate Swaps
Commodity-linked bonds
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