brm - week 4 full size.pdf

8/2/2019 BRM - Week 4 Full Size.pdf

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Australian School of Business


Business Risk Management Week 4

Measuring Financial Risk - 1


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Recap - A Definition of Risk

Risk is a condition in which there is a possibility of anadverse 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 aportfolio as a result of differences in the environment

between now and some future point in time.

Dembo p35


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Factors in MeasuringFinancial Risk

Possibility or Probability of a riskevent

The likely Quantum of the Lossarising as a consequence of the riskevent

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


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The 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 ofconcern to the risk manager) will generally haveinadequate data

Measuring probability cannot be divorced fromquestions of severity eg An estimate of the probability of fire is of little use if

it does not discriminate between small and large fires


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The Second Factor:Measuring Severity - Crockford

Trivial RisksPart of normal operations

Minor RisksEffects can be borne in a single accounting period

Major Risks

Too great in a single accounting periodWhat is the significance of this concept?

Catastrophic Risks

May lead to the failure of the organisation


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Relationship BetweenFrequency and Severity

Crockford (in fig 5) suggests a relationshipbetween the frequency of losses and the

severity (quantum) of loss.

As severity rises, frequency tends to fall

How can this be explained?


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Australian School of BusinessLeads to the Typical Distribution of Loss Events in

terms of Frequency and Loss Consequences

Frequency

ofLoss

es

$ Amount of Losses (increasing losses)


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This Suggests that RiskManagement Requires:

The need for a comprehensive way of assessingthe potential impacts of risk events

both favourable and unfavourable

The need for a way of discriminating the extent ofsuch 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 aims in Dembos paper


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Dembos Concept of Regret

The reaction to making a wrong decision where wrong isdetermined by actual outcomes in relation to informationavailable 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 foroutcomes

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


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Regretand the Measurement of Risk

Outcomes are not symmetricalwe need to consider our response to both positive andnegative 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 Dembospaper)

but it may also be what we expected the outcome of ourdecision to be


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Regret& Risk Measurement (cont)

Regret is about alternative choicesthe amount of risk has to do with the outcome/s of

decisions

Risk has to do with our attitudesattitudes towards risk relative risk aversion


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Measuring Regret

The difference between the choice madeand 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


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Significance of Risk as anOption

If the loss profile of risk is a put option

means that risks may be able to be insured

This may or may not involve traditional insuranceactivities

If we can value the option (its premium)

then we can calculate the risk

What affects the value of an option?


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The Determinants of an OptionsValue?

The 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


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Australian School of BusinessThe Significance of Incorporating an

Assessment of Return

Dembo argues that in a unified risk managementframework, 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 CallOption implies buying the right (investing) to obtain or receive the benefits of a

possible return


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The last factor Risk Attitude

Our attitude towards risk also affectsthe final decision Risk averse

Risk neutral Risk seeking

Dembo identifies this by Lambda

Thus we can rewrite the risk baseddecision formula for a favourable

decision as:

)(

RU


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Adopting a Risk BasedApproach Affects decisions by:

Preventing strategy formulation looking only atthe likely outcome

Considering the range of outcomes, our decision

might be different depending on our view aboutrisk

We cannot effectively look at decisions unless we focus

on both Our view of risk is in turn affected by the potential

volatility of outcomes

These in and of themselves are imbedded in thedistribution of possible outcomes as follows:


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Australian School of BusinessNext Week will examine how we can analyse

the structure of the risk distribution

$ Amount of Losses

Frequ

ency

ofLosses

brm - week 4 full size.pdf

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