02: Risk theory and risk management Flashcards
What is the definition of risk?
- Risk is a conceptual abstraction - it does not exist per se
- There exists many terminologies of risk:
What is the perspective of risk:
risk vs. uncertainity?
- uncertainity/ambiguity: a tottally indefinable andor unexpected event
- Risk: an event that has a measurable probability
What is the perspective of risk:
exposure vs. uncertainty?
Exposure vs. uncertainty:
- some definitions only focus on the uncertainty (prob) of an event
–>Other also incorporate both the prob and its consequences (outcomes)
What is meant with the perspective of risk:
all outcomes vs. negative outcomes?
- Some definitions focus only on downside potential
- Others are more expansive and consider both upside and downside potential
What is the perspective of risk:
Probability vs. event?
- 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
What are the two components of risk?
1) Exposure
- 0 exposure: no effect on objectives
- exposure: nonzero effect on objectives
2) Uncertainty
- no uncertainity: if the event will happen surely
Our possible definition of risk?
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!
What is speculative and pure risks?
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
Measurement of risk:
What is risk metric?
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)
Measurement of risk: Risk measure?
A risk measure is a specific value (i.e., valuation of a given risk by the metric function)
What is the issue with risk metric?
Issue: Risk is a multifaceted concept that cannot always be captured by means of a single metric
What are the two risk dimensions?
- exposure
- Uncertainity
Quality of knowledge with regard to the two risk dimensions: the 4 cases with ex.
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
What is the relationship between risk and retunr?
(conflict of risk and reward)
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
What is the expected utiliity theory`?
- Inidivuals may have different risk attituted
- Theory: utility functions and the principle of maximizing expected utility (instead of outcome)
What are the 3 different risk preferences/utility functions=
Risk-averse:
- concave utility function (bauch)
Risk-neutral:
- line
Risk-seeking:
- convex utility function (hunger)
How has the role of risk management changed?
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
What is the expansion of risk managmenet? pure risk to?
- pure risk
- equity risk
- credit riks
- foreign exchange risk
- commodity price risk
- operational risk
- reputational risk
What is risk management?
- 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
What are the two domains of risk management?
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
Why manage risk? (Contra)
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.
