Risk and Risk Management

1. Risk and Risk Management P.V. Viswanath Based on Bodie and Merton

2. Uncertainty and Risk • Uncertainty exists whenever one doesn’t know what will happen in the future • Risk is uncertainty that “matters” because it affects people’s welfare. • People are exposed to risk because they hold an asset or because they have agreed to engage in a transaction. • Risk aversion is the desire to avoid exposure to risk. • People who are risk averse are willing to pay to avoid exposure to risk. P.V. Viswanath

3. Risk Management • Risk Management is the process of deciding on the costs and benefits of avoiding risk exposure and deciding on the optimal amount of risk exposure. • The appropriateness of a risk-management decision should be judged in the light of the information available at the time the decision is made. • For example, if you bought theft insurance for your car and your car didn't get stolen during the policy period, that doesn't make the insurance purchase a bad decision. • Similarly, if you bought a lottery ticket, and your ticket won, that doesn't make the lottery ticket purchase a good one. • The riskiness of a particular asset or transaction must be evaluated in the context of all other assets and transactions that the decision maker is involved in. P.V. Viswanath

4. Business Risks • Production Risk • Risk that machines will break down • Deliveries of raw materials will not arrive on time • Workers will not arrive on time • New technology will make the firm’s equipment obsolete • Price risk of outputs • The risk that output prices will change because of change in consumer preferences or competitor actions. For example, decreased foreign demand could reduce output prices. • Price risk of inputs • The risk that input prices will change because of increased demand. Interest rates could rise and make capital costlier. P.V. Viswanath

5. Techniques for Risk Reduction • Risk avoidance • A conscious decision not to hold the asset or engage in the transaction that generates risk exposure • Loss prevention and control • Actions taken to reduce the likelihood or severity of losses; e.g. checking equipment regularly. • Risk Retention • Consciously absorbing the consequences of the risk exposure. • Risk transfer • Selling the risk to others; e.g. buying insurance or credit default swaps. P.V. Viswanath

6. Three Dimensions of Risk Transfer • Hedging • An action taken to reduce one’s exposure to a loss also causes one to give up the possibility of a gain – futures contracts. • Insuring • Paying a premium to avoid losses; buying insurance or options • Diversifying • Holding similar amounts of many risky assets instead of concentrating on a single one; limiting exposure to any single asset. P.V. Viswanath

7. Factors affecting efficient risk allocation • Transactions costs • Costs of establishing and running institutions such as insurance companies or securities exchanges and the costs of writing and enforcing these contracts. • Incentive Problems • Moral Hazard • Occurs ex-post; sellers of risk will take suboptimal actions. • Adverse Selection • Occurs ex-ante; sellers of risk will not reveal the full nature of the risk that they want to sell. P.V. Viswanath

8. Securities used for Risk Transfer • Futures Contracts • Forward Contracts • Options Contracts • Debt • Equity • Credit Default Swaps • Interest Rate Swaps • Commodity-linked bonds P.V. Viswanath