Risk Management:

First Principles

Introduction
O Risk underlies and affects every decision

that a business makes. O Risk management is not just risk hedging. O 10 principles that govern risk assessment and risk management

1.
O O

Risk is Everywhere
They reject the fact that risk exists and it goes away. In idealized world, actions and consequences are logical. Allow the existence of risk to determine every aspect of behavior. To avoid worst manifestations we cover behind insurance and derivatives.
Accept the existence of risk and be realistic and map out the best way to deal with it.

O Individuals and businesses have 3 choices: O Denial

O O O

Fear
O O
O

Choice

Final thought about handling risk would be to make it an ally rather than an adversary. O 3 broad trends in studying the nature of Risk
O O O

Risk is Global Risk Cuts across businesses Risk comes increasingly from financial markets.

Contd..
O

Risk have become more international, spread across sectors and have encompassed both financial and product markets. O 20 years ago in US large sections of the economy were insulated from risk. O In Europe, protection of foreign competition allowed domestic companies in each country to preserve market share and profits. O In past decade, the balance of power between businesses and consumers has shifted decisively in the consumers favor, lowering profits and increasing risk of businesses.

Risk Management Principle 1: The essence of good risk management is to able to roll with the punches when confronted with the unexpected.

2.
O O O O O O

Risk is Threat and Opportunity

O O

Chinese symbol for risk is the combination of danger and opportunity. Market volatility can ruin us or make us wealthy. Business failures and large losses come from exposures to large risks, but so do large profits and lasting successes. Bad side of risk- avoided or pushed for protection. People with different perspectives on risk will lead to either groups of almost every debate, with side tarred as either stuck in the mud or imprudent. Risk requires a more nuanced approach, if we accept the proposition that we cannot have one (upside) without the other (downside) and hence our approach to risk becomes more realistic. Which risks to seek? ( Upside exceeds the downside) Which risks are imprudent? ( the downside exceeds the upside)

Risk management Principle 2 Risk is a mix of upside and downside. Good risk management is not about seeking out or avoiding risk but about maintaining the right balance between the two.

3. Ambivalent about risks and not always rational about the way we assess or deal with risk
O As we know from Chinese symbol of risk, risk being a

combination of danger and opportunity and humans have mixed feelings about its existence. O One hand, we fear it and its consequences, other hand we seek it out and hope to share in profits. O Traditional theory of risk is built on the premise of the riskaverse rational investor with a well-behaved preference function. O Risk aversion varies widely across the population or with same individual depending on the way choices are framed and the circumstances of the choice. Risk Management Principle 3: Managing risk is a human endeavor, and a risk management system is only as good as the people manning it.

4.
O O

Not all Risk is created equal

Risk comes from different sources, takes different forms and has different consequences, but all risks are not created equal. Conventional risk and return models draw a line between risks that affect one or a few firms and are thus diversifiable and risk that affect many or all firms and are not diversifiable.

Categorization of risk based on few dimensions: O Small versus large risks O Symmetric versus asymmetric risks O Short term versus long term O Continuous versus discontinuous

Contd
O

Risk inventory-listing all potential risk faced by the firm is a good beginning to the risk management process. Breaking down risk based on above categorization will make risk inventory more useful tool.

Principle 4 To manage risk in the right way, we have to pick the right perspective on risk and stay consistent through the process to that perspective.

5.
O O

Risk can be measured

Risks are too qualitative to be assessed. Debate surrounds on what tools to use to assess risks rather than whether they can be assessed. 2 keys to good risk assessment:
O

Better quality and more timely information of risks is necessary to reduce the element of surprise. Tools such as risk-adjusted discount rates, simulations, scenario analysis, and VaR are use to convert raw data into risk measures.

Contd
O

Advances in risk assessment should not lead to false complacency or the conclusion that risk management has become easier due to 3 reasons:
O

Interesting question is improvements in information and assessment are keeping up with evolution of risks. Risk management is still a relative game. Both the data and the tools have become more plentiful, picking the right tool to assess a risk has become more critical component of success at risk management.

O O

Principle 5 To pick the right tool to assess risk, we have to understand what the tools share in common, what they do differently, and how to use the output from each tool.

6. Good risk measurement/ Assessment leads to better decisions

O Risk assessment tools are often not tailored to the O

O
O O

needs of decision makers. Assessing risk is equivalent to eliminating it and feel more secure with an analysis. Risk assessment is used as cover, if things do not work out as anticipated. Risk assessment makes aware of risk, but does not eliminate it and not an excuse for poor decisions. More information often leads to uncertainty rather than less.

Contd
O

For better decision making risk assessments needs 3 things: O Risk is assessed and decisions are made by different entities, each has to be aware of the others requirements and preferences. O Risk assessment tools have to be built around the risks that matter rather than all risks. O Risk assessment should not become an exercise in testing only the downside or bad side of risk, thought it worries decision makers most.
Principle 6

The tools to assess risk and the output from risk assessment should be tailored to the decision-making process, rather than the other way round.

7.
O

Key to good risk management

For good risk management, some risk should be passed to investors, some should be hedged and insured, some should be actively sought out and used as a source of competitive advantage. O Which risk to exploit to have an advantage in: O Better information O Speedier response O More flexibility or better resources. O Should weigh the costs of protecting ourselves against potential benefits O Publicly traded firms are better off passing through a significant portion of their firm risk Principle 7 Hedging risks is but a small part of risk management. Determining which risks should be hedged, which should not, and which should be taken advantage of is the key to successful risk management.

8.

Payoff to better risk management Is higher value

O Risk managers are measured and judged based on how

decisions matters business. O Good risk management- increases value. O Bad risk management destroys value. O Problems with stock-price focus. O Decisions relating to risk often alter the balance between debt and equity and makes stockholders better off at the expense of lenders. O How to link risk management to value? Principle 8 To manage risk right, we have to understand the levers that determine the value of business.

9. Risk management Is part of Everyones Job

O Risk management over decades has been

viewed as finance function. O Risk management risk assessment and risk hedging. O Every decision made by a firm in any functional area has a risk management component. Principle 9
Managing risk well is the essence of good business practice and is everyones responsibility

10. Successful risk taking organizations do not get there by accident.

O

Lot of moving pieces work together consistently for risk management to succeed. O Firms that succeed at risk never plan for risk management and are organized to deliver success. O Some ingredients of successful risk-taking organisations: O Alignment of interests O Good and timely information O Solid analysis O Flexibility O People

Principle 10 To succeed at risk management, we have to embed it in the organization through its structure and culture.

Conclusion
O Interconnections between economies and

sectors have increased and become more complex, managing risk has increased concurrently. O Exposure of firms to risk has opened new frontiers to exploit profit. O Risk management as a discipline has evolved unevenly across different functional areas.