one report

Australian School of Business Australian School of Business

Business Risk Management Week 4

Measuring Financial Risk - 1

Australian School of Business

Recap - A Definition of Risk

• Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for”  Vaughan, p8

• (Financial) “Risk is a measure of the potential changes in the value that will be experienced by a portfolio as a result of differences in the environment between now and some future point in time.”  Dembo p35

Australian School of BusinessFactors in Measuring Financial Risk

• Possibility or Probability of a risk event

• The likely Quantum of the Loss arising as a consequence of the risk event

As a consequence the measurement of risk requires an assessment of these two factors.

Australian School of BusinessThe First Factor: Measuring Probability

• Crockford suggests that: –This will be never more than an estimate –Better data will help in arriving at a better

estimate • But infrequent or large losses (which are really of concern to the risk manager) will generally have inadequate data

–Measuring probability cannot be divorced from questions of severity • eg An estimate of the probability of fire is of little use if it does not discriminate between small and large fires

Australian School of BusinessThe Second Factor: Measuring Severity - Crockford

• Trivial Risks – Part of normal operations

• Minor Risks – Effects can be borne in a single accounting period

• Major Risks – Too great in a single accounting period – What is the significance of this concept?

• Catastrophic Risks – May lead to the failure of the organisation

Australian School of BusinessRelationship Between Frequency and Severity

• Crockford (in fig 5) suggests a relationship between the frequency of losses and the severity (quantum) of loss. –As severity rises, frequency tends to fall

• How can this be explained? • Crockford therefore suggests that Severity

can be used a surrogate for the measurement of risk. – This is helpful but not a complete answer

Australian School of BusinessLeads to the Typical Distribution of Loss Events in terms of Frequency and Loss Consequences

F re

q u

en cy

o f L

o ss

es

$ Amount of Losses (increasing losses)

Pure Losses

Australian School of Business Risk Measurement highlights the difference in the

approaches of the Risk Manager & the Insurer

• The insurer focuses on: – the replacement of assets subject to loss (restitution) – also assumes a focus on the loss itself, rather than on

the event • The risk manager focuses on:

– events which affect desired or expected outcomes – not all unfavorable outcomes can be insured against – insurance does not necessarily protect against all

adverse outcomes – a consideration of potential favourable outcomes is

required as well

Australian School of BusinessThis Suggests that Risk Management Requires:

• The need for a comprehensive way of assessing the potential impacts of risk events –both favourable and unfavourable

• The need for a way of discriminating the extent of such impacts in the event that they arise

• The need to link these assessments to our tolerance of risk to assist with business decisions

• These are the some of the aims of Dembo’s paper

Australian School of Business

Dembo’s Concept of Regret

• The reaction to making a wrong decision where wrong is determined by actual outcomes in relation to information available at the time the decision was made. David Bell (Dembo p79)

• Potential surprise • Frustration or despair when bad things happen • Regret has to do with recognising the possible consequences

of our decisions – Why the focus on decisions?

• Regret has to do with poor outcomes – Thus involves our expectations or benchmarks – Relates to actual outcomes compared to expected or hoped for

outcomes – Relates to the information available at the time of making the decision

Australian School of Business Regret and the Measurement of Risk

• Outcomes are not symmetrical – we need to consider our response to both positive and

negative outcomes – Our response to positive outcomes will differ from negative

(unfavourable) outcomes • Risk of loss must be related to a benchmark

– this may be what we started with (as set out in Dembo’s paper)

– but it may also be what we expected the outcome of our decision to be

Australian School of Business Regret & Risk Measurement (cont)

• Regret is about alternative choices – the amount of risk has to do with the outcome/s of

decisions • Risk has to do with our attitudes

– attitudes towards risk – relative risk aversion

Australian School of Business

Measuring Regret

• The difference between the choice made and the benchmark

• The Regret function looks like a put option • Regret should replicate the amount of the

cost to insure the risk of downside • Measuring Regret will also help us evaluate

the effect of risk on our decision/s

Australian School of BusinessSignificance of Risk as an Option

• The loss profile of risk is a put option –this means that risks may be able to be insured

• This may or may not involve traditional insurance activities

• Entering into an insurance policy is analogous to purchasing an option – the buyer of insurance has the right to make a claim

• If we can value the option (its premium) –then we can calculate the risk

• What affects the value of an option?

Australian School of Business The Determinants of an Option’s

Value? • The value of the underlying asset

– The closer to “intrinsic” value the more valuable

• Time – The longer the time horizon the more valuable the option – The value of an option will decline as it approaches maturity

(expiry) - time decay

• Risk Free Rate – To account for the time value associated with the initial investment

• Volatility – The higher the volatility of the value of the underlying asset the

more valuable

Australian School of BusinessThe Significance of Incorporating an Assessment of Return

• Dembo argues that in a unified risk management framework, when making decisions, we balance Risk (R) and Return (U) – such that U > R (or at least equal to) in order to proceed

• Return is the risk (or possibility) of outcomes exceeding our benchmark

• Dembo shows that Return or Upside is a Call Option – implies buying the right (investing) to obtain or receive the

benefits of a possible return

Australian School of Business

The last factor – Risk Attitude

• Our attitude towards risk also affects the final decision

– Risk averse – Risk neutral – Risk seeking

• Dembo identifies this mathematically by Lambda • Thus we can rewrite the risk based decision

formula for a favourable decision as:

)(

RU 

Australian School of BusinessAdopting a Risk Based Approach Affects decisions by:

• Preventing strategy formulation from focusing only on the likely outcome

• Considering the range of outcomes, our decision might be different depending on our view about risk – We cannot effectively look at decisions unless we focus

on both Risk and Return • Our measure of risk is in turn affected by the

potential volatility of outcomes – The potential volatility of outcomes are imbedded in the

distribution of possible outcomes as follows:

Australian School of Business Next Week will examine how we can analyse the structure of the “risk” distribution

$ Amount of Losses

Fr eq

ue nc

y of

L os

se s

Note: This is a typical distribution of losses from “pure’ risks