Lecture 10: Principles of Risk Management Ref.to ch.10 THE COURSE OF FINANCE 2017 SPRING SJTU
Lecture 10: Principles of Risk Management Ref. to ch.10 THE COURSE OF FINANCE 2017 SPRING SJTU 1
D Objectives Risk and Financial Decision Making(10.1/2) Conceptual Framework for Risk Management(10.3/4/5/6) .How to measure risks(10.7/8/9) THE COURSE OF FINANCE 2017 SPRING SJTU 2
THE COURSE OF FINANCE 2017 SPRING SJTU 2 Objectives •Risk and Financial Decision Making(10.1/2) •Conceptual Framework for Risk Management (10.3/4/5/6) •How to measure risks(10.7/8/9)
Chapter 10 Contents 10.1 What is Risk? 10.2 Risk and Economic Decisions 10.3 The Risk-Management Process 10.4 The Three Dimensions of Risk Transfer 10.5 Risk Transfer and Economic Efficiency 10.6 Institutions for Risk Management 10.7 Portfolio Theory:Quantitative Analysis for Optimal Risk Management 10.8 Probability Distributions of Returns 10.9 Standard Deviation as a Measure of Risk THE COURSE OF FINANCE 2017 SPRING SJTU
Chapter 10 Contents 10.1 What is Risk? 10.2 Risk and Economic Decisions 10.3 The Risk-Management Process 10.4 The Three Dimensions of Risk Transfer 10.5 Risk Transfer and Economic Efficiency 10.6 Institutions for Risk Management 10.7 Portfolio Theory: Quantitative Analysis for Optimal Risk Management 10.8 Probability Distributions of Returns 10.9 Standard Deviation as a Measure of Risk THE COURSE OF FINANCE 2017 SPRING SJTU 3
Introduction Recall that the three pillars of finance are Time value of money Asset valuation Risk management Many financial decisions are,in essence,the determination of an asset's risk!!！ SJTU Foundations of Finance 2016
Introduction Recall that the three pillars of finance are Time value of money Asset valuation Risk management Many financial decisions are, in essence, the determination of an asset’s risk!!! SJTU Foundations of Finance 2016 4
10.1 What is Risk? Distinguish risk and uncertain Uncertainty You can not know something for sure at a given time (based on the current information) ■ Risk is uncertainty that“matters”because it affects people's welfare. THE COURSE OF FINANCE 2017 SPRING SJTU 5
10.1 What is Risk? Distinguish risk and uncertain n Uncertainty You can not know something for sure at a given time (based on the current information) n Risk is uncertainty that “matters” because it affects people’s welfare. THE COURSE OF FINANCE 2017 SPRING SJTU 5
Risk Defined Risk refers to potential variability in future cash flows. The wider the range of possible future cash flows that can occur, the greater the risk. Thus,the returns on common stock are more risky than returns from investing in a savings account in a bank
Risk Defined Risk refers to potential variability in future cash flows. n The wider the range of possible future cash flows that can occur, the greater the risk. Thus, the returns on common stock are more risky than returns from investing in a savings account in a bank
What is Risk?Both Upside and Downside Some risks are more complex.A computer mother-board manufacturer that underestimates demand will lose current sales and market share overestimates demand will own an inventory with a market price that is being eroded by rapid technological obsolescence TAnydeviation is a risk and unfavorable
What is Risk? Both Upside and Downside Some risks are more complex. A computer mother-board manufacturer that underestimates demand will lose current sales and market share overestimates demand will own an inventory with a market price that is being eroded by rapid technological obsolescence THECOURASE OnF FyINANCdE 2e017vSPRi INaG St JTi U on is a risk and unfavora7 ble
What is Risk?20/20 Hindsight The appropriateness of a risk- management decision should be determined using only the information available when the decision was made D We should avoid coloring our judgement of a earlier decision with facts know after the decision But .. THE COURSE OF FINANCE 2017 SPRING SJTU
What is Risk? 20/20 Hindsight The appropriateness of a risk- management decision should be determined using only the information available when the decision was made We should avoid coloring our judgement of a earlier decision with facts know after the decision But ... THE COURSE OF FINANCE 2017 SPRING SJTU 8
Example1 Suppose you are aware of the following investment opportunity:You could open a coffee shop around the corner from your home for $25,000.If business is strong,you could net $15,000 in after-tax cash flows each year over the next 5 years. a.If you knew for certain the business would be a success,would this be a risky investment? b.Now assume this is a risky venture and that there is a 50%chance it is a success and a 50%chance you go bankrupt within 2 years.You decide to go ahead and invest.If the business subsequently goes bankrupt,did you make the wrong decision based on the information you had at the time?Why or why not? THE COURSE OF FINANCE 2017 SPRING SJTU
Example1 Suppose you are aware of the following investment opportunity: You could open a coffee shop around the corner from your home for $25,000. If business is strong, you could net $15,000 in after-tax cash flows each year over the next 5 years. a. If you knew for certain the business would be a success, would this be a risky investment? b. Now assume this is a risky venture and that there is a 50% chance it is a success and a 50% chance you go bankrupt within 2 years. You decide to go ahead and invest. If the business subsequently goes bankrupt, did you make the wrong decision based on the information you had at the time? Why or why not? THE COURSE OF FINANCE 2017 SPRING SJTU 9
What is Risk?Preserving your Options But .. a decision that preserves the ability to make in-flight corrections (at a small cost)over one that disposes of that ability characterizes a well-made decision “Preserve your options'” THE COURSE OF FINANCE 2017 SPRING SJTU 10
What is Risk? Preserving your Options But … a decision that preserves the ability to make in-flight corrections (at a small cost) over one that disposes of that ability characterizes a well-made decision “Preserve your options” THE COURSE OF FINANCE 2017 SPRING SJTU 10