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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School of Management
Finance
Contents









What is Risk?
Risk and Economic Decisions
The Risk Management Process
The Three Dimensions of Risk Transfer
Risk Transfer and Economic Efficiency
Institutions for Risk Management
Portfolio Theory: Quantitative Analysis for Optimal
Risk Management
Probability Distributions of Returns
Standard Deviation as a Measure of Risk
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Roles of Risk Management

One of the three analytical “pillars” to finance

Risk allocation (redistribution)
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Concept of Risk

Uncertainty that matters

Illustration: Preparing foods for your party

Gains & losses, “upside” potential & “downside”
possibility
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Risk Aversion

A characteristic of an individual’s preference in
risk-taking situations
− Experiment
Prefer lower risk given same expected value
 Decreasing marginal utility of income
 Rational behavior assumed to be risk-averse
 A measure of willingness to pay to reducing risk

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Risk Management

The process of formulating the benefit-cost tradeoffs of risk reduction and deciding on the course of
action to take.
− The appropriateness of a risk-management decision
should be judged in the light of the information available
at the time the decision is made.
− Skill and lucky in risk management.
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Risk Exposure

Particular types of risk one faces due to one’s
circumstances (job, business, and pattern of consumption,
etc.)

Illustrations
– the risk of a crop failure and the risk of a decline in the
price for a farmer
– the risks of fire, theft, storm damage, earthquake damage
for a house owner
– the currency risk for a person whose business involves
imports or exports of goods
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School of Management
Speculators and Hedgers

Hedgers: taking positions to reduce their exposures.

Speculators: taking positions that increase their
exposure to certain risks in the hope of increasing
their wealth.

The riskiness of an asset or a transaction cannot be
assessed in isolation or in abstract.
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Risks Facing Households

Sickness, disability, and death

Unemployment

Consumer-durable asset risk

Liability risk

Financial-asset risk
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Risks Facing Firms

Production risk and R&D risk

Price risk of outputs

Price risk of inputs
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The Risk-Management Process

A systematic attempt to analyze and deal with risk

Steps
–
–
–
–
–
Risk identification
Risk assessment
Selection of risk-management techniques
Implementation
Review
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Risk Identification
Figuring out what the most important risk exposures
are for the unity of analysis.
 The perspective of the entity as a whole

– Career and stock-market risk
– The net exposure to exchange-rate risk of a firm buying
inputs and selling products abroad
– Price risk and quantity risk of farms
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Risk Assessment

The quantification of the costs associated with the
risks that have been identified

Health-insurance and actuaries

Professional investment advisors
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Risk-Management Techniques

Risk avoidance

Loss prevention and control

Risk retention

Risk transfer
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Implementation

The basic principle is to minimize the costs of
implementation.
– The lowest premium for health insurance
– The costs of investing in the stock market through
mutual fund or a broker
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Review

Risk management is a dynamic “feedback”
process, in which decisions are periodically
reviewed and revised.
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School of Management
Risk Transfer and Economic Efficiency

Transfering some or all of the risk to
others is where the financial system plays
the greatest role.
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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
Efficient Bearing of Existing Risks




A retired widow, whose sole source of income is $100,000
in the form of a portfolio of stocks.
A college student, who has a wealth of $100,000 in a bank
CD.
The different attitudes towards future and risk.
Exchange (swap) their assets.
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Finance
School of Management
Relative Advantages and Risk Allocation:
Interest Rate SWAP

Firms with deferring degrees of credit have different costs of
financing.
LIBOR：London Interbank Offered Rate



Basis：0.01%
The AAA corporation has the relative advantage of financing at
the fixed rate, while the BBB corporation has the relative
advantage of financing at the floating rate.
However, BBB may want to finance at a fixed rate and AAA may
prefer a floating one.
How can we do?
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Borrowing at the Advantage Rate
AAA
Corp.
BBB
Corp.
LIBOR
+0.5%
11%
investors
investors
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SWAP
11.20%
AAA
Corp.
BBB
Corp.
LIBOR
LIBOR
+0.5%
11%
investors
investors
LIBOR-0.20％
11.70％
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Credit Risk and Intermediation of Banks
11.20%
AAA
Corp.
11.15%
11%
BBB
Corp.
LIBOR
11.25%
LIBOR
+0.05%
LIBOR
-0.05%
bank
investors
LIBOR-0.20％（LIBOR-0.10％）
LIBOR
+0.5%
investors
11.70％（11.80％）
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Finance
School of Management
Risk and Resource Allocation




A scientist discovers a new drug designed to treat the
common cold.
She requires $1,000,000 to develop, test and produce it.
At this stage, the drug has a small probability of
commercial success.
Using her own money or setting up a firm?
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Finance
School of Management
Risk and Resource Allocation


risk pooling and sharing/specialization in the bearing of
risks.
By allowing people to reduce their exposure to the
risk of undertaking certain business ventures, the
function of the financial system to facilitate the
transfer of risks may encourage entrepreneurial
behavior that can have a benefit to society.
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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
Acceleration of Financial Innovations



Insurance, stock, and future markets (400 yrs)
Debt or equity: design of securities (400 yrs)
The supply side
New discoveries in telecommunications, information processing,
and finance theory have significantly lowered the costs of achieving
global diversification and specialization in the bearing of risks.

The demand side
Increased volatility of exchange rates, interest rates, and
commodity prices have increased the demand for ways to manage
risk.

Complete markets: not possible
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Percentage change
The Volatility of Exchange Rates
(a) The composite exchange rate to US dollar
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Changes in basis points
The Volatility of Interest Rtes
(b) The changes of rate of return on composite long-term investment grade bond
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School of Management
Real-world Limitations to Efficient
Risk Allocation

Transactions costs

Incentive problems
– moral-hazard: 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.
– adverse selection: those who purchase insurance against
risk are more likely than the general population to be at
risk
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Finance
School of Management
Three Dimensions of Risk Transfer

The simple way of risk transfer: selling the asset
that makes the owner exposed to risk.

The three dimensions of risk transfer: hedging,
insuring, and diversifying.
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Hedging

The action taken to reduce one’s exposure to a loss
but also causing the hedger to give up the
possibility of a gain.

Example: farmers

Other examples
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Insuring

Paying a premium to avoid losses but retaining
the potential for gain.

Example: import/export business

Other examples: health insurance, traveling to
Jiuzhaigou.
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Diversifying
Holding similar amounts of many risky assets
instead of concentrating all of your investment in
only one.
 Example: investing in the biotechnology business

– initial capital: $100,000
– probability of success: 50%
– uncertainty: quadrupling the investment or losing the
entire investment
– independence of successes
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Further Points on Diversification

Reduce chances of either big gains or losses

Perfect correlation: do not reduce risk

Aggregate uncertainty: not reduced

“genius”, “dunce” and “average” investors: Good
luck or skill?
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Finance
School of Management
Basics of Portfolio Theory
A quantitative analysis 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.

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Returns on GENCO & RISCO
Return on
RISCO
Return on
GENCO
Probability
(future)
Strong
50%
30%
0.20
Normal
10%
10%
0.60
Weak
-30%
-10%
0.20
State of
Economy
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Return Distribution: Graph
Probability Distributions of Returns of Genco and Risco
0.6
0.5
0.4
Probability
0.3
0.2
0.1
0
Genco
50%
30%
Return
10%
Risco
-10%
-30%
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Expected Return: Mean
 r  E  r   P1r1  P2 r2  P3 r3  ...Pn rn
 P r
n
  Pr
i i
i 1
r
 0.2  0.3  0.6  0.10  0.2  (0.10)
r
 0.10  10%
GENCO
GENCO
Also :
 rRISCO  10%
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Risk: Standard Deviation

 r  E r  E r 2

 P1 r1   r   P2 r2   r   ...  Pn rn   r 
2
2
2
  Pi ri   r 
n
2
i 1
 rGENCO  0.2  0.30  0.102  0.6  0.10  0.102  0.2  (0.10  0.10) 2
 rGENCO  0.016  0.1265
Also :
 rRISCO  0.2530
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Volatility
Standard deviation of returns.
 A measure of risk (or uncertainty): The first risk
measure (Markowitz, 1952).
 Volatility is 0: no risk; future return certain.
 Larger volatility => wider range of returns => more
uncertain (greater risk).

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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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Distribution of Returns on Two Stocks
3.5
Probability Density
3.0
2.5
NORMCO
2.0
VOLCO
1.5
1.0
0.5
0.0
-100%
-50%
0%
50%
100%
Return
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Two More Return Densities.
1.8
1.6
Probability Density.
VOLCO
1.4
ODDCO
1.2
1.0
0.8
0.6
0.4
0.2
-100.00%
-50.00%
0.0
0.00%
50.00%
100.00%
Return.
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Equation for Homogeneous
Diversification with n Stocks


Investing equally in n stocks with the same standard
deviation and correlation.
The standard deviation of the portfolio is
 port   stock
1 nn  1


2
n
n
– Correlation: do not reduce risk.
– The smaller of correlation, the better.
– Risk reduction via right diversification.
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Standard Deviations of Portfolios
0.20
Standare Deviation
0.19
 = 0.2000
0.18
 = 0.1421
0.17
0.16
0.15
0.14
0.13
0
1
2
3
4
5
6
7
8
Portfolio Size
* = 0.1342
Theoretical Minimum
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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
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