Risk Management

FME 321
What is Risk
 Risk is an uncertain even that may transpire in the
future that may either come up with a
constructive (positive) or destructive (negative)
effect on an undertaking.
A risk may foil or interrupt the realization of an
individual or group’s purpose or target.
a risk definitely not guaranteed –its chances can
only be projected.
Risk and Individual Behavior

Risk, and how it is managed,

are critical aspects of decision
making at all levels.
Why?
AllRISK is uncertain but not all
uncertainties are risk
 Risk denotes the uncertainty
concerning the possible occurrence
of loss.
Thus in evaluating solution to the
problem either personal or
business we must based it on on a
risk-cost, cost-benefit basis rather
than on an absolute basis.
What Is the Difference Between
Objective Risk and Subjective Risk?

Objective risk is anything that is

measurable directly or indirectly
and quantified. Most of the risks could
become objective, once the number of
such incidences become significant to
statistically estimate its probability
What Is the Difference Between
Objective Risk and Subjective Risk?
 (E.g:Cigarette smokers have 60% more
probability of dying early than non-smokers
- % may be off the mark, but it is based on
extensive data collected).This means that
depending on who made the research and
the time period, location, number of
samples.
What Is the Difference Between Objective Risk
and Subjective Risk?
 Subjective risk refers to an individual’s
mental perception or condition. It is less
quantifiable, because the parameters
affecting are less well known (E.g:
likelihood of losing income due to
depression - one starts missing work due to
depression and is very unlikely to even
recognize that he/she is doing it due to
depression…).
What Is the Difference Between
Objective Risk and Subjective Risk?
 In the example above, it feels the
statement is partly true or false at the
outset, but our judgment is largely based
on gut feel and not data. Subjective risk
assessment is useful for personal and quick
decision making in scenarios where severity
as well as likelihood of the risk is low.
 
Business Risk
 Business Risk refers to the expectation
that the company may make less than
anticipated profits or even incur losses due
to risks inherent in the business, such as
pricing, changes in consumer expectations
and attitudes, product prices, changes in
government policy, and so on. This could
impede the ability of the company to
provide returns on the investment.
Causes of Business Risk:

1.2.1 Natural Causes

Nature is an independent phenomenon and
man has no control. Natural disasters such as
earthquake, flood, drought, famine etc.
Affect a business which can result in heavy
losses. Natural causes are such unpredictable
factors that human beings can not make any
plans against them.
Causes of Business Risk:
 1.2.2 Human Causes related to increased risk of loss due
to human being or employees of the organization. A,
Dishonesty of employees can lead to heavy losses for the
company e.g.,
 A. the employees may leak a business information to a
rival business
 B. may commit corruption, leading misuse of resources.
 C. delay of the production due to strikes, riots etc.
 D. Price fluctuations in the market, change in fashion,
taste, preferences, and demands of customers are also
considered as human causes.
Causes of Business Risk:
 1.2.3 Economic Causes are linked to the
chance of loss due to market shift.
 change in the level of competition.
 have a direct impact on the business
earnings. ( Forever 21, Rolex, Chanel ,
Starbucks, Nike etc.)
 Even the change in Government policy has
a great impact on business.
Causes of Business Risk:
1.2.4 Physical Causes
All causes which result in damage to as
sets are considered to be a Physical
cause.
technology change may result in
machinery being out of date.
Different Type of Risk That a Business May Face:

 Political risk is the risk of investing funds in

another country whereby a major change in the
political or economic environment could occur.
 could devalue your investment and reduce its
overall return.
 usually restricted to emerging or developing
countries that do not have stable economic or
political arenas.
Different Type of Risk That a Business May Face:
 Inflation risk - The risk of a loss in your
purchasing power because the value of your
investments does not keep up with inflation.
 Inflation erodes the purchasing power of money
over time – the same amount of money will buy
fewer goods and services.
  Inflation risk is particularly relevant if you own
cash or debt investments like bonds, shares of
stock or real estate .
Different Type of Risk That a Business May Face:
 Exchange Rate risk –uncertainty of returns for
investors that acquire foreign investments and wish to
convert them back to their home currency.
 Ifexchange rate risk is high – even though a substantial
profit may have been made overseas, the value of the
home currency may be less than the overseas currency
and may.erode a significant amount of the investments
earnings
 More volatile exchange rate between the home and
investment currency, the greater the risk of differing
currency value eroding the investments value.
Different Type of Risk That a Business May Face:
 Currency Risk - applies when you own
foreign investments. It is the risk of losing
money because of a movement in
the exchange rate.
 For example, if the U.S. dollar becomes
less valuable relative to the Canadian
dollar, your U.S. stocks will be worth less in
Canadian dollars.
Different Type of Risk That a Business May Face:
 Liquidity Risk - The risk of being unable to
sell your investment at a fair price and get
your money out when you want to. To sell
the investment, you may need to accept a
lower price. In some cases, such as 
exempt market investments, it may not be
possible to sell the investment at all.
 
Different Type of Risk That a Business May
Face:
Interest Rate Risk -  applies
to debt investments such as bonds.  
the risk of losing money because of a
change in the interest rate. Since this
is fixed rate at the time of the
borrowing.
Different Type of Risk That a Business May Face:

 Credit Risk - The risk that the government entity

or company that issued the bond will run into
financial difficulties and won’t be able to pay the
interest or repay the principal at maturity. 
 applies to debt investments such as bonds. You
can evaluate credit risk by looking at the credit
rating of the bond.
 For example, long-term Canadian government
bonds have a credit rating of AAA, which indicates
the lowest possible credit risk.
Sub- Categories of Business Risks:

 Market Risk - refers to price fluctuations

or volatility increases and decreases in the
day-to-day market.
 mainly applies to both stocks and options
and tends to perform well in a bull
(increasing) market and poorly in a market
bear (decreasing).
Sub- Categories of Business Risks:
 Strategic Risk- risk related to a particular
strategy.
 Sales Risk- the potential of sales failure
 Management Risk- losing management support
that may be attributable to change in focus or
change in manpower.
 Budget Risk - the likelihood for the approximation
or estimations built into a budget to end up to be
insufficient in numbers.
Classification of Risk:

 Pure Risk:
 Also known as absolute risk.
 facing risk with no chance of gain
 two possibilities: something bad happening or
nothing happening (ex. the house will enjoy a
year with nothing bad occurring or there will be
damage caused by a covered cause of loss due to
fire, wind, etc.).
 is insurable
Classification of Risk:

 Speculative Risk:
 three possible outcomes: something good (gain),
something bad (loss) or nothing (staying even).
 Basic Example: Gambling and investing in the
stock market are two examples of speculative
risks. Each offers a chance to make money, lose
money or walk away even.
 not insurable in the traditional insurance market
There are other means to hedge speculative risk
such as: diversification and derivatives.
 Diversifiable risks
 Also called as non-systematic or particular
risk.
A risk that affects only individuals,
businesses or small groups. Example: Car
theft.
 Diversifiable risk is associated primarily with
factors specific to a particular firm. For e.g., if a
business produces high profits, it will sustain a
higher stock price. Conversely, if a corporation
produces poor earnings, the stock price is
projected to fall.
 To reduce or remove this risk, investors diversify
their holdings by purchasing securities from
various markets, businesses and geographic
regions. The higher the diversification, the lower
the residual risk in the overall position.
There are other means to hedge speculative risk
such as: diversification and derivatives.

 Nondiversifiable Risks
 Also called Systemic risks or fundamental risk.
 Are shared by all, on the other hand, such as
global warming, or movements of the entire
economy such as that precipitated by the credit
crisis of fall 2008, are considered
Nondiversifiable. Every asset or exposure in the
portfolio is affected. The negative effect does not
go away by having more elements in the portfolio.
Risk Exposure
 is a measure of possible future loss (or
losses) which may result from an activity or
occurrence. In business, risk exposure is
often used to rank the probability of
different types of losses and to determine
which losses are acceptable or
unacceptable.
e and
Risk Exposure
Diversifiable Risk-
Idiosyncratic Risk
• Reputational risk
• Brand risk
•   Credit risk
•   Product risk
•   Legal risk
•   Physical damage risk:
- Operational Risk
- Strategic Risk
 
 
Nondiversifiable Risks-
Systemic Risk
• Market risk
• Regulatory risk
• Environmental risk
• Political risk
• Inflation and recession risk
• Accounting risk
• Mortality and morbidity risk at the
societal and global level
(pandemics, social security
program exposure, nationalize
health care systems, etc.)
Frequency and Severity

 Frequency is the number of times losses have

happened in a given time period often 12 months.

 Severitydenotes how bad the loss has been in

both human and monetary terms

 Total cost of loss for a particular loss exposure=

(average severity) x (the frequency of loss)
Peril and Hazard

A peril is something that can cause a financial

loss. Examples include falling, crashing your car,
fire, wind, hail, lightning, water, volcanic
eruptions, falling objects, illness, and death.
A hazard is any condition or situation that makes
it more likely that a peril will occur. Types of
hazards include:
 - Physical hazards such as ice on the
sidewalks, smoking, or skydiving
- Moral hazards such as carelessness