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    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


    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

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    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.

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    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

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    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

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    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


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

    terms of Frequency and Loss Consequences




    $ Amount of Losses (increasing losses)

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


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


    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

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    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

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    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

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    Australian School of Business

    Regret& Risk Measurement (cont)

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


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

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    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

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    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?

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    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

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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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    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:



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    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


    Australian School of BusinessNext Week will examine how we can analyse

    the structure of the risk distribution

    $ Amount of Losses