1. Chapter 10 An Overview of Risk Management

2. Contents 1. What is Risk? 2. Risk and Economic Decisions 3. The Risk-Management Process 4. The Three Dimensions of Risk Transfer 5. Risk Transfer and Economic Efficiency 6.Institutions for Risk Management 7. Portfolio Theory 8. Probability Distributions of Return 9. Standard Deviation to measure the Risk

3. What is Risk? Uncertainty that “matters” because it affects people’s welfare

4. Risk, some terms  Risk aversion: A characteristic of an individual who avoids risk  Risk Management: The process of formulating the benefit-cost trade-offs of risk reduction and deciding what action to take  Risk exposure: The particular type of risk because one’s job, business or pattern of consumption

5.  Speculators: Investors who take positions that increase their exposure to certain risks in hope of increasing their wealth  Hedgers: Take positions to reduce their exposures.

6. The Risk-Management Process  Risk identification  Risk assessment  Selection of risk-management techniques  Implementation  Review

7. Risk Identification Figuring out what the most important risk exposures are for the unit of analysis, be it a household, a firm, or some other entity.

8. Risk Assessment The quantification of the costs associated with the risks that have been identified in the first step of risk management

9. Risk-Management Techniques  Risk avoidance  Loss prevention and control  Risk retention: Absorbing risk by one’s own resources  Risk Transfer

10. Risk Avoidance A conscious decision not to be exposed to a particular risk. For example, avoiding certain lines of business because there are considered too risky.

11. Loss Prevention and Control Actions taken to reduce the likelihood or the severity of losses. For example, you can reduce your exposure to the risk of illness by eating well, getting plenty of sleep, and …

12. Risk Retention Absorbing the risk and covering losses out of one’s own recourses. For example, some people may decide to absorb the costs of treating illnesses by their own and do not buy health insurance.

13. Risk Transfer Transferring the risk to others. For example, selling a risky asset to someone else and buying insurance.

14. Risk management process (continued): Implementation Implementing the risk management techniques selected. The underlying principle: minimize the costs of implementation.

15. Review Risk management is a dynamic feedback process in which the decisions are periodically reviewed and revised.

16. Three Dimensions of Risk Transfer  Hedging  Insuring  Diversifying

17. Hedging One is said to hedge a risk when the action taken to reduce one’s exposure to a loss also causes one to give up the possibility of a gain.

18. Insuring Paying a premium to avoid losses. By buying an insurance you substitute a sure loss for the possibility of a larger loss.

19. Hedging versus Insuring When you hedge, you eliminate the risk of loss by giving up the potential for gain. When you insure, you pay a premium to eliminate the risk of loss and retain the potential for gain.

20. Diversifying Holding similar amounts of many risky assets instead of concentrating all of your investment in only one.

21. Portfolio Theory  Quantitative analysis for optimal risk management  Probability distributions is used to quantify the trade-off between risk and expected return  Mean of the distribution: Portfolio’s expected return  Standard deviation: Portfolio’s risk

22. Returns on GENCO & RISCO

24. Equations: Mean

25. Equations: Standard Deviation

26. Volatility: a measure of the riskiness of an asset An assets volatility is larger, the wider the range of possible outcomes and the larger the probabilities of those returns at the extremes of the range.