02: Risk theory and risk management

Question 1

What is the definition of risk?

Answer 1

• Risk is a conceptual abstraction - it does not exist per se
• There exists many terminologies of risk:

Question 2

What is the perspective of risk:
risk vs. uncertainity?

Answer 2

• uncertainity/ambiguity: a tottally indefinable andor unexpected event
• Risk: an event that has a measurable probability

Question 3

What is the perspective of risk:
exposure vs. uncertainty?

Answer 3

Exposure vs. uncertainty:
- some definitions only focus on the uncertainty (prob) of an event

–>Other also incorporate both the prob and its consequences (outcomes)

Question 4

What is meant with the perspective of risk:
all outcomes vs. negative outcomes?

Answer 4

• Some definitions focus only on downside potential
• Others are more expansive and consider both upside and downside potential

Question 5

What is the perspective of risk:
Probability vs. event?

Answer 5

• Risk is an untoward event which was not expected and which leads to undesired outcomes
• Risk is the possibility that the actual (or realized) result may deviate from the expected result

Question 6

What are the two components of risk?

Answer 6

1) Exposure
- 0 exposure: no effect on objectives
- exposure: nonzero effect on objectives

2) Uncertainty
- no uncertainity: if the event will happen surely

Question 7

Our possible definition of risk?

Answer 7

Risk is a possible event or scenario in the future and has both exposure and uncertainity

• Exposure: an event to which one is exposed to -> conveys risk, otherwise not
• Uncertainity: An event that is not certain has risk, otherwise if certain no risk!

Question 8

What is speculative and pure risks?

Answer 8

Speculative risks
- Upside and downside potential: Involve the opportunity for either a loss or gain
- Insurance products will usually not cover speculative risk (e.g., gambling)

Pure risks:
- Downside potential only: Outcome is only a loss or no change
- Pure risks are the key subjects of the insurance industry

Question 9

Measurement of risk:
What is risk metric?

Answer 9

A risk metric is a function that measures risk

• Choice of the risk metric is one of the cornerstones of risk management

A variety of risk metrics have been developed to express risk:
Examples:
- Standard deviation (σ) of a distribution (return or other objectives)
- Value-at-Risk (VaR):
- Measures the worst expected loss over a given time interval at a given
confidence level (under normal conditions)

Question 10

Measurement of risk: Risk measure?

Answer 10

A risk measure is a specific value (i.e., valuation of a given risk by the metric function)

Question 11

What is the issue with risk metric?

Answer 11

Issue: Risk is a multifaceted concept that cannot always be captured by means of a single metric

Question 12

What are the two risk dimensions?

Answer 12

• exposure
• Uncertainity

Question 13

Quality of knowledge with regard to the two risk dimensions: the 4 cases with ex.

Answer 13

Exposure: unkown and Uncertainity unknown
–>terrorist acts

Exposure: unknown and Uncertainity known
- e.g. supplier defaults

Exposure: known and Uncertainity known
–>e.g. transportation risks

Exposure known and Uncertainity unknown
–>e.g. an important customer terminates a contract

Question 14

What is the relationship between risk and retunr?
(conflict of risk and reward)

Answer 14

Risk and return (usually) come together: in order to achieve returns (above the risk-free rate) one has to take risks
–>Good risk management may eliminate “unnecessary” risk for the level of retunr you choose

Question 15

What is the expected utiliity theory`?

Answer 15

• Inidivuals may have different risk attituted
• Theory: utility functions and the principle of maximizing expected utility (instead of outcome)

Question 16

What are the 3 different risk preferences/utility functions=

Answer 16

Risk-averse:
- concave utility function (bauch)

Risk-neutral:
- line

Risk-seeking:
- convex utility function (hunger)

Question 17

How has the role of risk management changed?

Answer 17

1960: focus on insurance
- Insurance of “pure risks” situations where there is nothing to gain (loss or no loss outcome)

1970/1980ies: Financial risk management and hedging
- Focus on financial risks: credit risk, equity risk, foreign exchange (FX) risk, interest rate risk, commodity price risk
- Toolbox:Derivatives (forwards and futures, options, swaps) and corresponding evaluation methods (the Black-Scholes-Merton model)

1990ies and beyond: Enterprise-wide risk management
- Increasingly holistic approach: Attempt to incorporate all risks faced by an organization: Financial risks, operational risks, supply chain risks, reputational risks
- Recent changes in legislation: BASEL accords (banking), Sarbanes-Oxley (SOX) act, KontraG (Germany)

Scope of risk management became broader

Question 18

What is the expansion of risk managmenet? pure risk to?

Answer 18

• pure risk
• equity risk
• credit riks
• foreign exchange risk
• commodity price risk
• operational risk
• reputational risk

Question 19

What is risk management?

Answer 19

• Risk management is a discipline for living with the possibility that future events may cause adverse effects
• Involves: Identifying, measuring/assessing, managing, and controlling risk

Question 20

What are the two domains of risk management?

Answer 20

Ex ante: Before a risk materializes
- The overall goal is to change the distribution of future outcomes (e.g., cash flows) in such a way as to align the level of risk (however measured) to the desired risk appetite
- Risk appetite: The amount of risk a firm is willing to accept

– Ex post: After a risk has materialized
- “Firefighting”
- Crisis management

Question 21

Why manage risk? (Contra)

Answer 21

Argument against manage risk:

• Example: If one buys all stocks in the S&P500 index, exposure is only to index movements.

->Contrast: Buying a single stock exposes to both index movements and stock-specific fluctuations.

• Investors have the DIY Alternative: Investors can diversify portfolios and hedge independently.
• Perception: Shareholders may not prioritize managing nonsystematic or firm-specific risk.
• Value Creation Doubt: Risk management may not appear to add significant value.