Financial Risk Management PDF

FINANCIAL RISK MANAGEMENT RISK Risk refers to the chance that some unfavorable event will occur. There is risk whenever future outcomes are not completely certain. 2 RISK MANAGEMENT is the process of measuring or...

FINANCIAL RISK MANAGEMENT RISK Risk refers to the chance that some unfavorable event will occur. There is risk whenever future outcomes are not completely certain. 2 RISK MANAGEMENT is the process of measuring or assessing risk and developing strategies to manage it. It is a systematic approach in identifying, analyzing and controlling areas with a potential for causing unwanted change. According to the International Organization of Standardization (ISO 3100), risk management is the identification, assessment and prioritization of risks followed by a coordinated and economical application of resources to minimize, monitor and control the probability and/or impact of unfortunate events and to maximize the realization of opportunities. 3 RISK MANAGEMENT ISO identifies the basic principles of risk management, and that risk management should: 1. Create value 2. Address uncertainty and assumptions 3. Be an integral part of the organizational processes and decision-making 4. Be dynamic, iterative, transparent, tailorable, and responsive to change 5. Create capability for continuous improvement 6. Be systematic, structured, and continually or periodically reassessed. 4 RISK MANAGEMENT PROCESS According to ISO, the risk management process has the following steps: 1. Establishing the context. This involves identification of risks; planning the risk management process; mapping out the social scope, identity and objectives of stakeholders and basis upon risk will be evaluated; establishing a framework; and developing risks analysis and mitigation or solution of risks. 2. Identification of potential risks. This begins with the analysis of the source of problem or the problem itself. 3. Risk assessment. After identifying the risk, the next thing to do is to evaluate the potential severity of impact and the probability of occurrence of the risk. 5 ELEMENTS OF RISK MANAGEMENT Ideal risk management should minimize spending of manpower or other resources and the same time minimizing the effect of risks. The performance of assessment methods should include the following elements: 1. Identification, characterization and assessment of threats. 2. Assessment of the vulnerability of critical assets to specific threats 3. Determination of the risk 4. Identification of ways to reduce identified risks 5. Prioritization of risk reduction measures based on a strategy 6 POTENTIAL RISK TREATMENT As suggested in ISO 3100, once risks have been identified and assessed, techniques to manage them should be applied. The following are the four categories of risk: 1. Risk Avoidance. This includes performing an activity that could carry risk. However, avoiding risks would also mean losing the opportunity to earn that accepting (retaining) the risk may have allowed. 2. Risk Reduction. This is also referred as risk optimization which involves reducing the severity of loss or the likelihood of the loss from occurring. 3. Risk Sharing. This means sharing with another party the burden of loss or the benefit of gain and the measures to reduce a risk. 4. Risk Retention. This involves accepting the loss or benefit of gain from a risk when it occurs. 7  INVESTMENT RISK The required return of an investment increases as the risk of the investment increases. An investor would probably require risk premium as compensation for taking the uncertainty associated with the investment. Some of the factors that contribute to the investment uncertainty are the following: 1. Business risk. This refers to the uncertainty about the rate of return caused by the nature of the business. 2. Financial risk. This is determined by the firm’s capital structure or sources of financing. 3. Liquidity risk. This is associated with the uncertainty created by the inability to sell the investment quickly for cash. 4. Default risk. This is related to the probability that some or all of the initial investment will not be returned. 5. Interest rate risk. This is the risk that fluctuations in interest rates will cause fluctuations to the value of the investment. 6. Management risk. This is the risk associated with the decisions made the management and board of directors of the firms. 7. Purchasing power risk. This is the risk that the value of the return from investment has declined as a result of inflation. 8 The most used Techniques and Models in assessing investment alternatives under risk or uncertainty are as follows: 1. Probability 2. Value of Information 3. Sensitivity Analysis 4. Simulation 5. Decision Tree 6. Standard deviation and Coefficient of Variation 7. Project Beta 9 THE SIX 1. Clearly define the problem at STEPS IN hand. 2. List the possible alternatives. DECISION 3. Identify the possible outcomes or MAKING states of nature. 4. List the payoff (typically profit) of each combination of alternatives and outcomes. 5. Select one of the mathematical decision theory models. 6. Apply the model and make your decision. 10 John Thompson is the founder and president of Thompson Lumber Company, a profitable firm located in Portland, Oregon. The problem that John Thompson identifies is whether to expand his product line by manufacturing and marketing a new product, backyard storage sheds. John decides that his alternatives are to construct (1) a large new plant to manufacture the storage sheds, (2) a small plant, or (3) no plant at all (i.e., he has the option of not developing the new product line). Thompson determines that there are only two possible outcomes: the market for the storage sheds could be favorable, meaning that there is a high demand for the product, or it could be unfavorable, meaning that there is a low demand for the sheds. 11 Because Thompson wants to maximize his profits, he can use profit to evaluate each consequence. John Thompson has already evaluated the potential profits associated with the various outcomes. With a favorable market, he thinks a large facility would result in a net profit of $200,000 to his firm. This $200,000 is a conditional value because Thompson’s receiving the money is conditional upon both his building a large factory and having a good market. The conditional value if the market is unfavorable would be a $180,000 net loss. A small plant would result in a net profit of $100,000 in a favorable market, but a net loss of $20,000 would occur if the market was unfavorable. Finally, doing nothing would result in $0 profit in either market. 12 STEPS 1. Clearly define the problem at hand. whether to expand his product line by manufacturing and marketing a new product, backyard storage sheds. 2. List the possible alternatives. to construct: (1) a large new plant to manufacture the storage sheds, Alternative is defined as a course of (2) a small plant, or action or a strategy that the decision (3) no plant at all (i.e., he has the option of not developing the new maker can choose. product line). 3. Identify the possible outcomes or two possible outcomes: states of nature. the market for the storage sheds could be favorable, meaning that there is a high demand for the product, or States of nature are those outcomes over which the decision maker has it could be unfavorable, meaning that there is a low demand for little or no control. the sheds. 13 STEPS 4. List the payoff of each combination John Thompson has already evaluated the potential profits associated with of alternatives and outcomes. the various outcomes. Payoffs or profits conditional values With a favorable market, he thinks a large facility would result in a net profit of $200,000 to his firm and if the market is unfavorable would be a are the values assigned to different $180,000 net loss. outcomes from a decision and may be positive or negative. A small plant would result in a net profit of $100,000 in a favorable market, but a net loss of $20,000 would occur if the market was Ex: profit or loss, total sales, total unfavorable. return on investment, and Finally, doing nothing would result in $0 profit in either market. interest earned PAY-OFF (DECISION) TABLE Presents the outcomes (payoffs) of specific decisions when certain states of nature occur. 14 TYPES OF DECISION-MAKING ENVIRONMENTS The types of decisions people make depend on how much knowledge or information they have about the situation. There are three decision- making environments: Decision making under certainty Decision making under uncertainty Decision making under risk 15 DECISION Decision makers know with For example, let’s say that MAKING certainty the consequence of every alternative or decision you have $1,000 to invest for a 1-year period. One alternative is to open a UNDER choice. savings account paying 4% interest, and another CERTAINTY Naturally, they will choose the alternative that will is to invest in a government Treasury bond maximize their well-being or paying 6% interest. will result in the best If both investments are outcome. secure and guaranteed, there is a certainty that When an event is certain, the Treasury bond will pay there is a 100% chance of a higher return. The return occurrence, hence the after 1 year will be $60 in probability is 1.0. interest. 16 DECISION MAKING There are several possible outcomes for each alternative, and the decision maker does not know UNDER the probabilities of the various outcomes. UNCERTAINTY As an example, the probability that a Democrat will be president of the United States 25 years from now is not known. Sometimes it is impossible to assess the probability of success of a new undertaking or product. 17 DECISION there are several possible outcomes for each MAKING alternative, and the decision maker knows the UNDER RISK probability of occurrence of each outcome. In decision making under risk, the decision maker usually attempts to maximize his or her expected well-being. For example, that when playing cards using a standard deck, the probability of being dealt a club is 0.25. The probability of rolling a 5 on a die is 1/6. 18 PROBABILITY Probability provides a method for mathematically expressing doubt or assurance about the occurrence of a chance event. Assigning Probabilities. Decision makers must assign probabilities to the various outcomes that represent the likelihood of their occurrence. A probability distribution describes the chance or likelihood of each of the collectively exhaustive and mutually exclusive set of events. The probability of an event varies from 0 to 1. a) A probability of 0 means the event cannot occur, whereas a probability of 1 means the event is certain to occur. b) A probability between 0 to 1 indicates the likelihood of the event’s occurrence. 19 In the Thompson Lumber example, John Thompson is faced with decision making under uncertainty. If either a large plant or a small plant is constructed, the actual payoff depends on the state of nature, and probabilities are not known. If probabilities for a favorable market and for an unfavorable market were known, the environment would change from uncertainty to risk. For the third alternative, do nothing, the payoff does not depend on the state of nature and is known with certainty. 20 DECISION MAKING UNDER UNCERTAINTY The presentation in this section of the criteria for decision making under uncertainty (and also for decision making under risk) is based on the assumption that the payoff is something in which larger values are better and high values are desirable. For payoffs such as profit, total sales, total return on investment, and interest earned, the best decision would be one that resulted in some type of maximum payoff. However, there are situations in which lower payoff values (e.g., cost) are better, and these payoffs would be minimized rather than maximized. The statement of the decision criteria would be modified slightly for such minimization problems. 21  Several criteria exist for making decisions under conditions of uncertainty: 1. Optimistic 2. Pessimistic 3. Criterion of realism (Hurwicz) 4. Equally likely (Laplace) 5. Minimax regret 22 OPTIMISTIC In using the optimistic criterion, the best (maximum) payoff for each alternative is considered, and the alternative with the best (maximum) of these is selected. Hence, the optimistic criterion is sometimes called the maximax criterion. In using the optimistic criterion for minimization problems in which lower payoffs (e.g., cost) are better, you would look at the best (minimum) payoff for each alternative and choose the alternative with the best (minimum) of these. 23 DECISION MAKING UNDER UNCERTAINTY- OPTIMISTIC 24 DECISION MAKING UNDER RISK Decision making under risk is a decision situation in which several possible states of nature may occur and the probabilities of these states of nature are known. We consider one of the most popular methods of making decisions under risk: selecting the alternative with the highest expected monetary value (or simply expected value). 25 EXPECTED MONETARY VALUE EMV is the weighted sum of possible payoffs for each alternative. Given a decision table with conditional values (payoffs) that are monetary values and probability assessments for all states of nature, it is possible to determine the expected monetary value (EMV) for each alternative. The expected value, or the mean value, is the long-run average value of that decision. The EMV for an alternative is just the sum of possible payoffs of the alternative, each weighted by the probability of that payoff occurring. 26 EXPECTED MONETARY VALUE FORMULA: WHERE: If this were expanded, it would become 27 EXPECTED MONETARY VALUE 28 EXPECTED VALUE OF PERFECT INFORMATION Perfect Information is the knowledge that a future state of nature will occur with certainty, i.e., being sure of what will occur in the future. The uncertainty about the future outcome from taking a decision can sometimes be reduced by obtaining more information first about what is likely to happen. Information can be obtained from various sources, such as the following: 1. Market research surveys 2. Other surveys or questionnaire 3. Conducting a pilot test; and 4. Building a prototype model 29 EXPECTED VALUE OF PERFECT INFORMATION The expected value with perfect information (EVw/PI) is the expected or average return, in the long run, if we have perfect information before a decision has to be made. To calculate this value, we choose the best alternative for each state of nature and multiply its payoff times the probability of occurrence of that state of nature. 30 EXPECTED VALUE OF PERFECT INFORMATION EVPI places an upper bound on what to pay for information. The EVPI is the expected value with perfect information minus the expected value without perfect information (i.e., the best or maximum EMV). Thus, the EVPI is the improvement in EMV that results from having perfect information. 31  John Thompson has been approached by Scientific Marketing, Inc., a firm that proposes to help John make the decision about whether to build the plant to produce storage sheds. Scientific Marketing claims that its technical analysis will tell John with certainty whether the market is favorable for his proposed product. In other words, it will change his environment from one of decision making under risk to one of decision making under certainty. This information could prevent John from making a very expensive mistake. Scientific Marketing would charge Thompson $65,000 for the information. 1. What would you recommend to John? Should he hire the firm to make the marketing study? 2. Even if the information from the study is perfectly accurate, is it worth $65,000? 32 Decision Table with Perfect Information Best EMV 33 Thus, the most Thompson would be willing to pay for perfect information is $60,000. 34