1:19 am - Tuesday May 30, 2017

A treatise on risk basics

What is risk?

Risk are of three types: Known—a risk that is recognized by all, Unknown—a risk that is known by at least one person but is not known to many and Unknowable—a risk that is totally unexpected and impossible to foresee

Examples

Known— Alligators live in the swamp, It might rain during monsoon season.  Unknown— Alligator breeding cycle – Times to avoid – During mating and after birth when defensive mothers are around – Your driver’s license expired and you can’t rent a car. Unknowable— Swamps that freeze as a result of 100 year temperature swings, The electricity is going to go out in a few minutes

Traditionally risk has been defined in terms of uncertainty – the occurrence of a loss / gain. However, there is no single definition of risk. Everyone has his / her own concept of risk.

Risk is a concept that denotes a potential negative impact to an asset or some characteristic of value that may arise from some present process or future event. In everyday usage, “risk” is often used synonymously with the probability of a loss. In professional risk assessments, risk combines the probability of an event occurring with the impact that event would have and with its different circumstances (Wikipedia)

A definition of risk that is suitable for the economist or statistician may be worthless as an analytic tool for the insurance theorist. The fact that each group treats a different body of subject matter requires the use of different concepts. Although the statistician, the decision theorist, and the insurance theorist all use the term risk, they may each mean something entirely different

“The threat or possibility that an action or event will adversely or beneficially effect an organization’s ability to achieve its objectives.”

A risk is an uncertain event or condition, that if it occurs, has a positive or negative effect on at least one project objective (Ch 11) A Guide to the Program Management Body of Knowledge, (PMBOK® Guide, Third Edition)

Characteristics of Risk

Uncertainty and risk

As uncertainty and risk are co-related, one may be need to look at them closely.  According to by Frank Knight (in his popular work, Risk, Uncertainty and Profit may be useful (in his popular work, Risk, Uncertainty and Profit may be useful)

–      Risk can be measured in some cases quantitatively

–      At other times, it is something un-measurable

–      There are far reaching and crucial differences on which of the two is really present and operating

–      A measurable uncertainty (or risk proper)  is no uncertainty at all

Hence can we call risk is inherent? No uncertainty on this?

For ease of use, it is assumed that risk and uncertainty refer to the same thing. But it is not so. When speaking of risk we refer to events for which the chance of occurrence is known in advance. Uncertainty refers to the events for which the chances are not know in advance

Uncertainty and irreversibility

It is important to bear in mind that scientific certainty has boundaries. The failure to prove scientifically a product is unsafe does not mean and amount to having proved that it is safe. This is very relevant because some decisions once made are irreversible resulting in beneficial or harmful effects

Risks and Probability

The ranges of consequences are known (for example, low prices/high prices, low yields/high yields, etc) and Each consequence can be assigned to specific numerical probability of occurrence, both the specific consequence and outcome Is unknown. Risk thus is defined as uncertainty based on a well grounded (quantitative) probability Formally Risk = (The probability that some event will occur) X (the consequences if it does occur). Uncertainty on the other hand cannot b e assigned such a (well grounded) probability. Further, genuine uncertainty can not often be reduced significantly by attempting to gain more information about the phenomena in question and their causes (well grounded) probability.

Time and risk

Time is a dominant factor. Risk is about future. Time is more relevant when decisions are irreversible

Components of Risk

In other words, a risk is:

–      A possible event  that might make your life much better or worse,

–      A possible event that keeps you or one of your team members awake at night (working, worrying, filling out a resume)

Risk events consist of three elements:

–      The event itself

–      The consequence of the event occurring

–      The likelihood of the event occurring

Risk in finance.

A risk can be defined as an unplanned event with financial consequences resulting in loss or reduced earnings. Risks basically stem from uncertainty or unpredictability of the future

Therefore a risky proposition is one with potential profit or looming loss.

In commercial and business angle risk generates profit or loss depending upon the way in which it is managed Risk can be defined as the volatility of the potential outcome.

Thus a financial risk is a chance that an investment’s actual return will be different than original expected. Or all of the original investment.

Ron S Dembo (a financial engineer, entrepreneur and founder of Algorithmic Incorporated, Toronto) uses general methods to assess risk as an expected after the fact level of regret. Such methods have been popular in limiting interest rate risk in financial markets. Financial markets are considered to be a proving ground for general methods of risk assessment.

In mathematics, computing, linguistics, and related disciplines, an algorithm is a procedure (a finite set of well-defined instructions.) for accomplishing some task which, given an initial state, will terminate in a defined end-state

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return.

The reason for this is that investors need to be compensated to taking on additional risk.

For example, bonds issued by government are assumed to be risk less and they carry lower coupon rates (interest rates) whereas bonds issued by corporates carry higher risk and therefore they offer high coupon rates.

Risk is anything, event, practice, process, activity, etc which has an uncertain outcome. of our organisational objectives An uncertainty about a future event that threatens achievement of organizational mission/goals We may generally define risk as the uncertainty of meeting objectives over a specified time horizon

It is any threat to the achievement of our organisational objectives. An uncertainty about a future event that threatens achievement of organizational mission/goals

A bond is a fixed interest financial asset issued by governments, companies, banks, public utilities and other large entities. Bonds pay the bearer a fixed amount a specified end date. A discount bond pays the bearer only at the ending date, while a coupon bond pays the bearer a fixed amount over a specified interval (month, year, etc.) as well as paying a fixed amount at the end date.

Coupon rates.

The interest rate stated on a bond, note or other fixed income security, expressed as a percentage of the principal (face value). Also called coupon yield.

For example, bonds issued by government are assumed to be risk less and they carry lower coupon rates (interest rates) whereas bonds issued by corporates carry higher risk and therefore they offer high coupon rates.

A fundamental idea in finance is the relationship between risk and return.

The greater the amount of risk that an investor is willing to take on, the greater the potential return.

Types of risk

Financial institutions provide important benefits through their various functions and they are: borrowing and lending, price determination, information aggregation and coordination, liquidity and efficiency Due to these multifarious functions, financial institutions encounter many risks in their operations and they can be categorized as under

–      Credit risk

–      Liquidity risk

–      Interest rate risk

–      Market risk

–      Off balance sheet risk

–      Foreign exchange risk

–      Country risk

–      Sovereign risk

–      Technology risk

–      Operational risk

–      Insolvency risk

A brief on risks

Credit risk

The risk that promised cash flows from loans and securities held by financial institutions may not be paid in full

Liquidity risk

The risk that a sudden and unexpected increase in liability withdrawals may require a financial institution to liquidate assets in a very short period of time and at low prices

Interest rate risk

The risk incurred by a financial institution when the maturities of its assets and liabilities are mismatched and interest rates are volatile

Market risk

The risk incurred in trading assets and liabilities due to changes in interest rates, exchange rates and other asset prices

Off balance sheet risk

The risk incurred by a financial institution as the result of its activities related to contingent assets and liabilities

Foreign exchange risk

The risk that exchange rate changes can affect the value of a financial institution’s assets and liabilities denominated in foreign currencies

Country risk

The risk that a foreign entity, private or sovereign, may be unwilling or unable to fulfill obligations for reasons beyond its control

Sovereign risk

The risk arising due to immunity enjoyed by the sovereign entity from legal and other recovery processes in which the lender has no legal recourse against the sovereign entity which fails to fulfill its obligations

Technology risk

The risk incurred by a financial institution when its technological investments do not produce anticipated cost savings

Operational risk

The risk that existing technology or support systems may malfunction; that fraud may occur that impacts the financial institution’s activities; and / or external shocks such as hurricanes and floods occur

Insolvency risk

The risk that a financial institution may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities

A short cut to remember…

How to recall various risks faced by financial institutions?

Just remember COOL TIMES

C – Credit Risk, Country risk (2)

O – Operational risk

O – Off balance sheet risk

L – Liquidity risk

 

T – Technology risk

I – Interest rate risk, insolvency risk (2)

M – Market risk

E – Exchange (foreign exchange) risk

S – Sovereign risk

Quotable quotes on risk

When we take a risk, we are betting on an outcome that will result from a decision we have made, though we do not know for certain what the outcome will be

Peter L Bernstein, Against the Gods, The Remarkable Story of Risk

Take calculated risks. That is quite different from being rash.

George S. Patton, 1944

Risk is not always apparent but its invisibility is no longer an excuse for ignoring it.

Bankers Trust, “RAROC and Risk Management,” 1995

A lot of people approach risk as if it’s the enemy when it’s really fortune’s accomplice.

Sting, A Man’s Journey to Simple Abundance, Sarah Ban Breathnach & Michael Segell Scribner

We view risk as an asset.

Noel Donohoe, Goldman Sachs, Risk, July 2004

Far better it is to dare mighty things, to win glorious triumphs, even though chequered with failures, than to take rank with those poor spirits who neither enjoy much nor suffer much, because they live in the gray twilight that knows not victory nor defeat

Theodore Roosevelt, Speech before the Hamilton Club, Chicago, April 10, 1899

You take risks in whatever you do. But if you understand, measure and account for them, that should keep you out of trouble.

Dennis Weatherstone, Chairman and CEO JP Morgan, Business Week, October 31, 1994

. . . the anticipation of what might happen is almost as important as what actually happens.

Bob Costas, Fair Ball 2000

“Risk is like love:  we all know what it is but we don’t know how to define it”

Dr. Joseph Stiglitz, Nobel Laureate and economist

Do you Know?

  • When the Greeks threw the dice in ancient times, they believed the outcome to be predetermined by the gods rather than ruled by the laws of probability.
  • The first major breakthrough in risk management, however, came with the invention of probability theory during the Renaissance. The application of this theory drastically improved our ability to live with uncertainty because it gave us a rational framework for making decisions. We can quantify risk and make informed decisions about how much and what type of risk we are willing take

Do you Know?

Various risks faced in international trade

–      Buyer risk

  • Non acceptance risk
  • Non payment risk
  • Quality claim risk
  • Credit risk or counter party risk

–      Seller risk

  • Non shipment risk
  • Quality risk
  • Late shipment risk

–      Shipping risk

  • Goods mishandled
  • Goods abandoned
  • Goods siphoned
  • Goods wrongly delivered
  • Goods delivered at another destination
  • Goods appropriated for freight payment
  • Trans-shipment risk

–      Other risks

  • Bank failure risk
  • Settlement risk
  • Competition
  • Genuineness of documents
  • Price risk
  • Legal risk
  • Market risk

Well. Now I believe we will not abhor risk; rather we will embrace risk knowing fully well what it can and it cannot.

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