The Human Race and Risk

• From its beginning, the human species has

faced the risks of misfortune and adversity.
• The earliest risks included survival, not only
individually, but as a species.
• Our continued existence is testimony to the
success of our ancestors in dealing with the
risks of adversity and misfortune.

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 Primitive Human’s Responses to Risk

• Some human responses to risk were identical

with those of other animals.
• Some risks were avoided instinctively.
• Other risks were reduced through the unique
gift of human reason.
• A distinguishing human feature is in the way
we deal with risk

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 Primitive Responses to Risk

• Creation of tools

• Banding together - for strength & sharing

• Saving - which led to private property

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 Evolution of Business Risks

• It can be argued that business itself was an

effort to deal with risk.

• Business and commerce brought new risks,

which required new techniques for dealing
with them.

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 Evolution of Business Risks

Two innovations in particular are noteworthy

• Money

• Legal System

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 Invention of Money

• Important implications for commerce, private

property, and accumulating wealth
• Initially, the focus was on preservation and
protection of self and tangible property from
perils that could cause loss.
• With introduction of money, tangible assets
that were lost or damaged could be replaced
if the owner had financial assets.

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 Money - Credit

• The invention of credit meant that assets

could be acquired every by those who did not
have financial assets, if someone was willing
to to lend them money.

• This, in turn, created risks for the lender,

which they addressed by the interest charges
they made for loans.

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 The Legal System

• Invention of laws was a distinctly human

effort to deal with risk.

• By defining individual rights and

responsibilities, the legal system created a
framework whose basic function was to
protect those rights.

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 OTHER COMMERCIAL INNOVATIONS

3000 BC

Chinese merchants shared risk by

distributing goods among each other’s boats

Basically a method of risk sharing

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 1800 BC - CODE OF HAMMURABI

• Code of Hammurabi made provision for

transfer of the risk of loss from merchants to
moneylenders.
• Borrower was excused from repayment of
loan if property was taken by bandits
• Babylonian moneylenders undoubtedly
loaded their interest charges to compensate
for this transfer of risk.

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 Loan Forgiveness Provisions

• Loan-forgiveness was adapted to risks of sea

trade by Phoenicians and by Greeks

• Loans to shipowners with the ship pledged

as security were called bottomry contracts.

• Loans to merchants where cargo was

pledged as collateral were called
respondentia contracts.

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 900 BC: General Average

Developed by seafarers from the Island of

Rhodes as a method of sharing risk

• a maritime convention for sharing losses

among participants in a venture

• participants share in loss of property

intentionally sacrificed in proportion to their
interest in the total venture.

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 GROWTH OF BUSINESS RISKS

• Industrial revolution witnessed the

application of steam to the production
process, and with steam came new risks.

• Early steam engines were hazardous devices

and explosions were common.

• Also caused injury to workers and eventually

led to system of workers compensation

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 GROWTH OF BUSINESS RISKS

• Electric power followed steam and was in

turn followed by nuclear power.
• With each new era, new risks arose.
• Because old risks remain, the inventory of
risks increased geometrically.
• Modern business corporations and not-for-
profit entities face a profusion of risks.

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 RISKS OF THE MODERN BUSINESS
ENVIRONMENT

• Many of the risks facing business today were

unknown a generation ago.
• Some of these new risks arise from changes
in the legal environment
• environmental damage,
• discrimination in employment,
• sexual harassment, and
• violence in the workplace.

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 MODERN BUSINESS RISKS

Other risks accompanied the emergence of the

age of information technology;

• interruptions of business resulting from

computer failures,

• privacy issues, and

• computer fraud

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 Nuclear Hazards

• incident at the Three Mile Island nuclear

facility in Pennsylvania in 1979

• Accident at the Soviet Union's Chernobyl

plant in April 1987

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 Terrorism

Bombing

• World Trade Center in 1993

• Oklahoma Federal Building in 1995

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 Perils of Nature

• Hurricane Andrew’s $22 billion plus in

damages

• 1993 floods that ravaged the Midwest United

States in 1993

• Earthquakes in California and Kobi, Japan in

1993 and 1994.

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 Increasing Dollar Amount of Loss

• Increase in amount of losses not solely a

function of increasing number of losses

• Even those losses that arise from perils of

nature--windstorms, earthquakes, floods--
have exhibited increasing values.

• There is simply more wealth, investment, and

more assets exposed to loss.

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 Increasing Dollar Amount of Loss

As business has become more capital

intensive, as technology of production
becomes more costly, capital investment
increased.

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 The Concept of Risk

1. The basic problem with which risk

management deals.

2. Risk management theorists have not been

able to agree on a definition of risk.

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 Common Elements in Definitions of Risk

1. Indeterminancy - at least two possible

outcomes

2. Adversity - at least one of the outcomes is

undesirable

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 The Text’s Definition of Risk

Risk is a condition in which there is the possibility

of an adverse deviation from a desired outcome
that is expected or hoped for.
1. Risk is not subjective - a state of the real world
2. Risk can exist whether or not it is perceived
3. Risk can be imagined where possibility of loss
does not exist

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 Uncertainty and its Relationship to Risk

1. The most widely held meaning of

uncertainty refers to a state of mind
characterized by doubt.
2. It is contrasted with certainty, as in
• “I am certain I will get an A in this
course”
• “I am uncertain what grade I am going to
get.”

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 The Degree of Risk

1. What is more risk or less risk?

2. Varies with the probability of deviation

• from what is expected in case of

aggregate data

• from what is hoped for (no loss) in case

of individual

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 Risk Distinguished From Peril and Hazard

Peril: the cause of loss

Hazard: a condition that creates or increases

the chance of loss

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 Classifications of Hazards

Physical

Moral

Morale

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 Classifications of Risk

1. Financial and non-financial

2. Static and dynamic

3. Fundamental and particular

4. Pure and speculative

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 Static and Dynamic Risks

1. Dynamic risks result from changes in the

economy (e.g., changes in price levels,
consumer taste, income, and output).
• benefit society in the long run, by
adjusting misallocations of resources

2. Static risks would exist even in the absence

of economic change (from perils of nature or
human dishonesty).
• not a source of gain to society
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 Fundamental and Particular Risks

1. Fundamental risks are impersonal in origin

and consequences. They are societal risks.
• It is held that society (rather than the
individual) should deal with them.
2. Particular risks involve losses that arise out
of individual events and are felt by
individuals rather than the entire group.
• Particular risks are considered the
individual’s own responsibility that are
properly addressed by the individual.
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 Pure and Speculative Risks

1. Speculative risks involve the possibility of

loss or gain. They are voluntarily accepted
because of the possibility of gain.

2. Pure risks involve the possibility of loss or

no loss only.

3. In general, insurance deals with pure risks

only.

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 Classifications of Pure Risk

1. Personal risks

2. Property risks

3. Liability risks

4. Risks arising out of failure of others

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 The Burden of Risk

1. Some losses will occur

2. The cost of accumulated reserves

3. Deterrent effect on capital accumulation

4. Higher cost of capital

5. Feeling of frustration and mental unrest

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 Methods of Dealing With Risk

1. Avoidance

2. Reduction

3. Retention

4. Transfer

5. Sharing

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 BUSINESS RISK MANAGEMENT

• Some people suggest that risk management

is superfluous and even counterproductive to
the interest of corporate owners.
• Although the argument focuses on insurance,
insurance is an alternative to other risk
management methods
• The argument that businesses ought not
insure is, in effect, an argument that risk
management is unnecessary.

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 Diversification as a Solution for Pure Risks

• Capital asset pricing model (CAPM) suggests

that the value of a firm is equal to the
discounted (present value) projected flow of
income it will generate for its owners.

• According to the CAPM, sophisticated

investors will require a higher rate of return
for stocks that carry a higher degree of risk.

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 Diversification and Pure Risk

• Sophisticated investors do not consider

diversifiable risk and such risks therefore do
not affect a stock’s rate of return.

• Because investors can diversify asset

holdings, they require a risk premium only for
systematic (nondiversifiable) risk.

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 Diversification and Pure Risk

• Systematic or market risks are priced, but

diversifiable risk is not.

• Therefore, reducing risks at the corporate

level which are diversifiable at the portfolio
level does not benefit stockholders.

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 Diversificaiton and Pure Risk

• Following from this premise, it has been

argued that corporations should never
purchase insurance.
• In theory, stockholders can deal with pure
risks in the same way asspeculative risks,
through diversification.
• Purchase of insurance by a corporation
reduces the return to stockholders by more
than the reduction in risk.

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 Diversification and Pure Risk

• Insurance always costs more than the

amount paid in losses
• The return on investment will be higher in a
diversified portfolio of stocks that do not
insure than for the same stocks if insurance
is purchased.
• Some corporations will suffer catastrophic
loss and fail, but the overall return to
investors will be higher without insurance
than with it.
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 Diversification and Pure Risk

• Although total risk may not affect the

required rate of return on stocks, a large
amount of diversifiable risk, if unmanaged,
can reduce the value of the firm.

• While diversifiable risks may not affect the

investor’s discount rate (the denominator in
the discounted cash flow model), it can
significantly reduce the expected cash flows
(the numerator).

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 Diversification and Pure Risk

The impact of risk on the firm’s projected cash

flows stems from the effect of risk on the
variety of constituencies with which the firm
must deal.

• Suppliers

• Customers

• Employees

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 Diversification and Pure Risk

• The higher the risks facing a firm, the less

likely that suppliers will offer preferential
terms.
• Customers become reluctant to deal with a
firm when they perceive that it has excessive
risk and might face distress in the future.
• Riskier firms will have to pay employees more
than other firms to induce them to commit
their services to the organization

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