Risk and Risk Management P V Viswanath Based

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

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

Risk Management w 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. w The appropriateness of a risk-management decision should be judged in the light of the information available at the time the decision is made. w 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. w Similarly, if you bought a lottery ticket, and your ticket won, that doesn't make the lottery ticket purchase a good one. w 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 3

Business Risks w Production Risk n n 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 w Price risk of outputs n 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. w Price risk of inputs n The risk that input prices will change because of increased demand. Interest rates could rise and make capital costlier. P. V. Viswanath 4

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

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

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

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