Risk management project
Chapter -3
Topics Covered
Risk Aversion and Risk Management by Individuals and Corporations
Overview of Risk Aversion
Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with a more certain, but possibly lower, expected payoff.
Risk aversion ==> prefer certain outcome to an uncertain outcome with the same expected value
Risk Aversion
Risk aversion describes how people react to conditions of uncertainty and has implications for investment decisions.
In the realm of finance and economics, Risk Aversion is a concept that addresses how people will react to a situation with uncertain outcomes.
It attempts to measure the tolerance for risk and uncertainty.
A risk-averse, or risk avoiding person would take the guaranteed payment of 50, or even less than that (40 or 30) depending on how risk averse they are.
A risk neutral person would be indifferent between taking the gamble or the guaranteed money.
Risk Aversion- Nature of a Person
- Risk Aversion is the behavior of human ( Investor and Consumer) A person said to be;
Risk Averse- ( Certainty Equivalent)
Risk Neutral- Bet and certain payoff.
Risk Loving – More than certainty Equivalent or Zero.
Expected value- Average payoff gamble
Certainty Equivalent- Guarantee of payoff
Risk Premium- The difference between expected value and Certainty Equivalent.
Definition of 'Risk Averse'
Definition: A risk averse investor is an investor who prefers lower returns with known risks rather than higher returns with unknown risks. In other words, among various investments giving the same return with different level of risks, this investor always prefers the alternative with least interest.
Description: A risk averse investor avoids risks. S/he stays away from high-risk investments and prefers investments which provide a sure shot return. Such investors like to invest in government bonds, debentures/bonds and index funds.
Definition of 'Risk Neutral’
- Risk neutral is a term used to describe the mental framework of a person when deciding where to allocate money. Given two investment opportunities, for example, a risk-neutral investor only looks at the potential gains of each investment, and ignores the potential downside risk.
Description an investor is deciding between two investments. One is a high-growth technology company that is not yet profitable but has seen large capital gains in the short term. The other company, similar to Disney, is a mature firm with stable earnings, profits and dividends but does not provide the upside potential of the tech stock.
Definition of 'Risk Lover'
- Definition: Risk lover is a person who is willing to take more risks while investing in order to earn higher returns. When it comes to taking risk for earning returns, different people have different attitudes. Some are risk lovers, some risk averse and some are neutral towards risk.
- Description: Generally investments giving lower returns come with lower risks as well. On the other hand, investments giving higher returns involve higher risks.
- Example: A risk-averse person would prefer investing in fixed deposits, bonds, etc. as they involve lesser risk, whereas a risk lover would prefer investing his money in stocks as they have the potential to give higher returns than fixed deposits.
Individual decision-making
Under
Uncertainty
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Individual decision-making Under Uncertainty
- A person is given the choice between two scenarios, one with a guaranteed payoff and one without. In the guaranteed scenario, the person receives $50.
- In the uncertain scenario, a coin is flipped to decide whether the person receives $100 or nothing.
- The expected payoff for both scenarios is $50, meaning that an individual who was insensitive to risk would not care whether they took the guaranteed payment or the gamble. However, individuals may have different risk attitudes
Risk Attitudes of An Individual
- Risk-averse (or risk-avoiding) - if he or she would accept a certain payment (certainty equivalent) of less than $50 (for example, $40), rather than taking the gamble and possibly receiving nothing.
- Risk-neutral - if he or she is indifferent between the bet and a certain $50 payment.
- Risk-loving (or risk-seeking) - if he or she would accept the bet even when the guaranteed payment is more than $50 (for example, $60).
- The average payoff of the gamble, known as its expected value, is $50. The dollar amount that the individual would accept instead of the bet is called the certainty equivalent, and the difference between the expected value and the certainty equivalent is called the risk premium. For risk-averse individuals, it becomes positive, for risk-neutral persons it is zero, and for risk-loving individuals their risk premium becomes negative.
What Are You – Risk-loving, Averse or Neutral?
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Individuals Are Likely Risk Averse!
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Want to avoid if possible:
Losing property
Losing health, dying prematurely, or out-surviving own asset
Becoming liable for someone else’s loss
Risk-averse persons (entities) wish to have someone else to bear the consequence, even if the cost of transfer is higher than the expected cost of the risk.
John’s Case
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John
Is a reasonable person
Received an inheritance of $10,000 from an uncle
Unsure of what to do with the money for investment purpose
Decision-making theories
Expected value (function)
Expected utility (function)
Risk-averse expected utility (function)
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Risk Decisions and the Expected Value
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Risk Decisions and Expected Value
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The combination of above mentioned options clearly indicates to all types of risk attitudes of persons have investments choices.
John’s decision will be on the base of risk aversion theory or depends his risks attitudes.
Risk Premium=???? 5200-Faisal
- Certainty equivalent = $700
- Expected return =$3000
- Risk premium= $3000-$700= $2300
- JONE MONEY=10000.00
- RETURN ON MUTUAL FUND =13000-10000=3000
Case – Now, Maria!
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- Maria
- Is risk averse
- Owns a home worth $150,000
- Has $50,000 in a savings account
- The earthquake
- Probability of 10% in any given year
- An earthquake will totally destroy her house
- XYZ Insurance Company
- Fully indemnifies the insured for earthquake-related loss
- Charges a premium equaling the expected value of the loss that is, actuarially fair premium
Maria’s Case
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The insurance company is a risk-neutral entity.
Thus, employs the expected value concept to price risks
Two outcomes in Maria’s case
No earthquake no loss= 90%
Earthquake total loss = 10%
Expected value of the risk
So, XYZ Insurance charges $15,000 to all persons facing this type of loss exposure.
Corporations decision-making Under
Uncertainty
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Alternative Meanings of Information
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Certainty: we have perfect information about future outcomes
Risk: we know what future outcomes are possible and we can attach probabilities to each outcome
Uncertainty: we do not know the precise nature of the outcomes or their probabilities
Alternative Meanings of Information
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Decision-makers have different ‘attitudes to risk’
RISK NEUTRAL - values gains and losses equally
RISK AVERSE - values losses more highly than gains
RISK LOVER - values gains more than losses
Techniques for Coping with Uncertainty
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If we do not know the possible outcomes, there is little we can do
If we know the possible outcomes, but not their probabilities, a number of techniques are possible
Reasons to Risk Management by Corporations
Dynamic and complex business environment
Global Customers
Fluctuating Exchange rates
Increasing raw material/transport prices
Changing regulations
Reduced raw material availability
Complex logistics
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Dynamic business environment:
Global Company, domino effect of changes around the world.
Magnified speed of change
Exchange rates, laws and regulations crossing borders, raw material availability
Changing risk arena: controls have traditionally focussed on physical and financial assets. Increasing organisational value in intangibles (reputation, people, knowledge, intellectual property); these intangible assets are also at risk, and the organisation therefore has to respond to these risks.
Increased attention for risks : Internal: both Internal (AUD) and External audit (KPMG) have opted for a risk based approach. External :partly driven by a number of incidents involving large multinational companies (Exxon Valdez, Brent Spar, Barings, BASF (competition compliance), etc) and partly by increasing corporate governance requirements (Turnbull in the UK, KontraG in Germany) and other external requirements (ref. Risk Factors section in our 20-F filing).
Structured/pro-active risk management approach; integrated in the business, positive (accepting the need for (intelligent) risk taking), clarity as to the risk appetite and risk boundaries of the company, driven by empowered management (as compared to specialists), more explicit (show me) than the current implicit (trust me) approach.
Broader responsibility to shareholders & stakeholders (product stewardship, sustainable development, PPP (people, planet & profit)) is directly related to sound risk management.
Risk Management
The board of directors and management must appropriately select and manage the risks that a corporation takes as it seeks to increase the per share value of its stock.
Three key risks:
Counterparty risk
Interest rate risk
Liquidity risk
Risk Management
Counterparty credit risk (CCR) is the risk that the counterparty to a transaction could default before the final settlement of the transaction's cash flows.
An economic loss would occur if the transactions or portfolio of transactions with the counterparty has a positive economic value at the time of default. Unlike a firm's exposure to credit risk through a loan, where the exposure to credit risk is unilateral and only the lending bank faces the risk of loss,
CCR creates a bilateral risk of loss: the market value of the transaction can be positive or negative to either counterparty to the transaction. The market value is uncertain and can vary over time with the movement of underlying market factors.
Risk Management
Interest rate risk: risk that a shift in interest rates will adversely affect either company’s assets or liabilities
If a corporation has $100 million of floating rate debt outstanding, a rise in interest rates will increase company’s interest expense burden.
If interest rate increases, value of investor’s fixed rate bonds will be reduced (since bond prices rise when interest rates fall and vice versa).
A fundamental principle of bond investing is that market interest rates and bond prices generally move in opposite directions. When market interest rates rise, prices of fixed-rate bonds fall. this phenomenon is known as interest rate risk.
To mitigate this risk, balance duration (weighted average cash flows) and mix of fixed/floating interest rate instruments between assets and liabilities
easier for large financial firms to do than for smaller and non-financial firms
Risk Management
Liquidity risk: possibility that firm will not have sufficient cash on hand or immediately available credit to pay its bills as they come due
- Some possible causes:
- Accounts receivable go bad (due to counterparty risk)
- Lenders get nervous and call loan before due date
- Unexpected order which necessitates emergency purchase of inventory
- To mitigate this risk, keep higher cash balances
- Cash is expensive
- Without sufficient profitability, raising equity to provide that cash is also expensive
- Keeping cash rather than re-investing can be costly
- Nevertheless, a failure to have sufficient cash can cause financial distress or bankruptcy
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Dynamic business environment:
Global Company, domino effect of changes around the world.
Magnified speed of change
Exchange rates, laws and regulations crossing borders, raw material availability
Changing risk arena: controls have traditionally focussed on physical and financial assets. Increasing organisational value in intangibles (reputation, people, knowledge, intellectual property); these intangible assets are also at risk, and the organisation therefore has to respond to these risks.
Increased attention for risks : Internal: both Internal (AUD) and External audit (KPMG) have opted for a risk based approach. External :partly driven by a number of incidents involving large multinational companies (Exxon Valdez, Brent Spar, Barings, BASF (competition compliance), etc) and partly by increasing corporate governance requirements (Turnbull in the UK, KontraG in Germany) and other external requirements (ref. Risk Factors section in our 20-F filing).
Structured/pro-active risk management approach; integrated in the business, positive (accepting the need for (intelligent) risk taking), clarity as to the risk appetite and risk boundaries of the company, driven by empowered management (as compared to specialists), more explicit (show me) than the current implicit (trust me) approach.
Broader responsibility to shareholders & stakeholders (product stewardship, sustainable development, PPP (people, planet & profit)) is directly related to sound risk management.