-
8/2/2019 BRM - Week 4 Full Size.pdf
1/19
Australian School of Business
Australian School of Business
Business Risk Management Week 4
Measuring Financial Risk - 1
-
8/2/2019 BRM - Week 4 Full Size.pdf
2/19
Australian School of Business
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
-
8/2/2019 BRM - Week 4 Full Size.pdf
3/19
Australian School of Business
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.
-
8/2/2019 BRM - Week 4 Full Size.pdf
4/19
Australian School of Business
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
-
8/2/2019 BRM - Week 4 Full Size.pdf
5/19
Australian School of Business
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
-
8/2/2019 BRM - Week 4 Full Size.pdf
6/19
Australian School of Business
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?
-
8/2/2019 BRM - Week 4 Full Size.pdf
7/19
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)
-
8/2/2019 BRM - Week 4 Full Size.pdf
8/19
-
8/2/2019 BRM - Week 4 Full Size.pdf
9/19
Australian School of Business
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
-
8/2/2019 BRM - Week 4 Full Size.pdf
10/19
Australian School of Business
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
-
8/2/2019 BRM - Week 4 Full Size.pdf
11/19
Australian School of Business
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
-
8/2/2019 BRM - Week 4 Full Size.pdf
12/19
Australian School of Business
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
-
8/2/2019 BRM - Week 4 Full Size.pdf
13/19
Australian School of Business
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
-
8/2/2019 BRM - Week 4 Full Size.pdf
14/19
Australian School of Business
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?
-
8/2/2019 BRM - Week 4 Full Size.pdf
15/19
Australian School of Business
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
-
8/2/2019 BRM - Week 4 Full Size.pdf
16/19
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
-
8/2/2019 BRM - Week 4 Full Size.pdf
17/19
Australian School of Business
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
-
8/2/2019 BRM - Week 4 Full Size.pdf
18/19
Australian School of Business
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:
-
8/2/2019 BRM - Week 4 Full Size.pdf
19/19
Australian School of BusinessNext Week will examine how we can
analyse
the structure of the risk distribution
$ Amount of Losses
Frequ
ency
ofLosses
