T H E N AT U R E O F R I S K

Presented by:
Cempaka Paramita
cempaka.feb@unej.ac.id
CONTENT
• DEFINITION OF RISK
• CHANCE OF LOSS
• ATTITUDE TOWARD RISK
• PERIL AND HAZARD
• TYPES OF RISK
• BURDEN OF RISK ON SOCIETY

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 What does a businessperson mean when he
or she says,

“This project should be rejected

since it is too risky”?

Does it mean that the amount

of loss is too high or that the
expected value of the loss is
high?
Is the expected profit on the
project too small to justify the
consequent risk exposure and the
potential losses that might ensue?
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 DEFINITION OF RISK
What is risk?
 An uncertainty concerning the occurance of
loss (Redja, 2005)
E.g., the risk of being killed in auto accident.

 Risk has also been defined as

(1) variability in future outcomes
(2) chance of loss

 Certainty refers to lack of doubt, knowing

something will happen or won’t happen.

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“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
(New York City: John Wiley & Sons, 1996)

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 Risk as a Consequence of Uncertainty

 Risk has to do with consequences (both positive and

negative). It involves having more than two possible
outcomes (uncertainty). The consequences can be
behavioral, pyschological, or financial.

 Uncertainty causes us to take precautions. It also

creates opportunities for gain and the potential for loss.

 Nevertheless, if no possibility of a negative outcome

arises at all, even remotely, then we usually do not refer
to the situation as having risk.

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Examples of Consequences That Represent Risks

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Level of Uncertainty
Level of Characteristics Example
Uncertainty
No uncertainty The outcomes can be Natural law
(certain) certainly predict
Objective uncertainty The outcomes can be Card games,
identified with known Rolling dice
probability
Subjective uncertainty The outcomes can be Fire, car accident,
identified with unknown investment
probability
Very uncertain The outcomes cannot Space
be identified with exploration
unknown probability
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P = 1/240.000 P = 1/14 million
P = 1/15.000 Page 9
 CHANCE OF LOSS
What is chance of loss?
 The probability than an event that causes a loss will occur.
 Like risk, “probability” has both objective and subjective
aspects.

Objective probability
 The long-run relative frequency of an event based on the
assumptions of an infinite number of observations and of no
change in the underlying conditions.

Subjective probability
 The individual’s personal estimate of the chance of loss.
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 ATTITUDE TOWARD RISK
 Risk Averse: people are risk averse when they shy away from risks and
prefer to have as much security and certainty as is reasonably
affordable in order to lower their discomfort level.
 Risk Seeker: a risk seeker is someone who will enter into an endeavor
as long as a positive long run return on the money is possible ,
however unlikely.
 Risk Neutral: when its risk preference lies in between these two
extremes. Risk neutral individuals will not pay extra to have the risk
transferred to someone else, nor will they pay to engage in a risky
endeavor.

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 PERIL AND HAZARD
PERIL is defined as the cause of loss.
E.g., if your house burns because of a fire, the
peril (or cause of loss) is the fire.

HAZARD is a condition that creates or

increases the chance of loss.
4 major types of hazard:
 Physical hazard
 Moral hazard
 Morale hazard
 Legal hazard
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Types of Perils by Ability to Insure

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Physical hazard Moral hazard
 A physical condition that  Dishonesty or character defects in an
increases the chance of loss. individual that increase the frequency
 E.g., icy roads that increases the of severity of loss.
chance of an auto accident  E.g., faking an accident collect from an
insurer

Morale hazard Legal hazard

 Carelessness or indifference to a  Characteristics of the legal system or
loss because of the existence of regulatory environment that increase
insurance (careless acts that the frequency or severity of losses.
increase the chance of loss).  E.g., statutes that require insurer to
 E.g., leaving car keys in an include coverage for certain benefits
unlocked car, which increases the in health insurance plans, such as
chance of theft. coverage for alcoholism.

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 TYPES OF RISK
 Basic categories of risk
 Pure risk
 Speculative risk
 Fundamental risk
 Particular risk
 Enterprise or business risk

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PURE RISK
• A situation in which there are only the
possibilities of loss or no loss (personal risks,
property risks, liability risks)
• E.g., job-related accidents, premature death,
damage to property from disaster.

SPECULATIVE RISK
• A situation in which either profit or loss is
possible.
• E.g., betting on a horse race, investing in real
estate or stocks.
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Examples of Pure vs Speculative Risk Exposures

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FUNDAMENTAL RISK
• A risk that affects the entire economy or large
numbers of persons or groups within the economy.
• E.g., rapid inflation, cyclical unemployment, war, and
terrorist attack.

PARTICULAR RISK
• A risk that affects only individuals and not the
entire community.
• E.g., car thefts, bank robberies, and dwelling
fires.
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 ENTERPRISE OR BUSINESS RISK
• All major risks faced by a business firm, including pure risk,
speculative risk, strategic risk, operational risk, and financial risk,
marketing risk.
• Strategic risk refers to uncertainty regarding the firm’s financial
goals and objectives. E.g., if a firm enters a new business line, the
line may be unprofitable.
• Operational risk results from the firm’s business operation. E.g., a
bank that offers an online banking service may incur losses if
“hackers” break into the bank’s computer.
• Financial risk refers to the uncertainty of loss because of adverse
changes in commodity prices, interest rates, foreign exchange
rates, and the value of money. E.g., an American corporation doing
business in Japan may lose money when Japanese yen is exchanged
for American dollars.
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Categorization of Operational Risks
- The Basel Committee of Banking Supervision, 2002 -

 Internal fraud: employee theft

 External fraud: robbery
 Employment practices and workplace safety: worker
compensation claims, general liability due to work accident
 Clients, products, and business practices: misuse of
confidential customer information, money laundering
 Damage to physical assets: due to natural disasters,
terrorism
 Business disruption and system faillures:
hardware/software failures,
 Execution, delivery, and process management: data
entry error Page 21
Complete Picture of the Holistic Risk Puzzle

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 BURDENS OF RISK ON SOCIETY
The present of risk results in certain undesirable
social and economic effects.
 The size of an emergency fund must be increased
E.g., in the absence of insurance, individuals or business
firms would have to increase the size of their emergency
fund to pay for unexpected loss.
 Society is deprived of certain goods and services
E.g., because of the risk of a liability lawsuit, many
corporations have discontinued manufacturing products.
 Worry and fear are present
E.g., some passengers in a commercial jet may become
extremely nervous and fearful if the jet encounters
severe turbulence during the flight. Page 23
HIGH RISK,
HIGH RETURN??

Every opportunity involves both risk and return

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REFERENCES
• Baranof, E., Patrick, B. & Yehuda, K. 2009. Risk
Management for Enterprises and Individual.
USA: Saylor Foundation.
• Hull, J. C. 2012. Risk Management and Financial
Institutions + Website, 3rd edition. New Jersey:
John Wiley & Sons, Inc.
• Hanafi, M. M. 2014. Manajemen Risiko, Edisi
Kedua. Yogyakarta: UPP STIM YKPN.
• Redja, G. E. 2005. Principles of Risk
Management and Insurance. USA: Pearson
Education, Inc.

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