Introduction to risk management
This document provides an introduction to risk management. It discusses the different meanings of risk and types of risks facing businesses and individuals, including price, output, input price, commodity price, exchange rate, interest rate, credit, pure, legal liability, employee benefits, and personal risks. It also describes the risk management process of identifying risks, evaluating potential losses, and developing risk management methods like loss control, loss financing through retention, insurance, or hedging. The objectives of risk management are to understand the cost of risk, which includes expected losses and costs of loss control, financing, and internal risk reduction. Firms aim to maximize value by minimizing the cost of risk.
Introduction to risk management
- 2. Introduction to Risk Management • Different Meaning of Risk • Risk is costly • Direct versus Indirect Expected Losses Types of Indirect Losses Loss of Normal Profit (Net Cash Flow) Extra Operating Expenses Higher cost of funds and foregone investments Bankruptcy costs (legal expenses)
- 3. Types of Risk Facing Businesses and Individuals Price Risk Output Risk Input Price Risk Commodity Price Risk Exchange Price Risk Interest rate risk Credit Risk Pure RIsk Damage to Assets Legal Liability Employee Benefits
- 4. Personal Risk Major types of personal risk Earnings Death Disability Aging Unemploy ment Medical Expenses Liability Auto Home Physical Assets Auto Home Boats Other Watercraft Electronics Financial Assets Stocks Bonds Longevity
- 5. Risk Management • Risk Management Process • Identify All Significant Risks • Evaluate the potential frequency and severity of losses • Develop and select methods for managing risks
- 6. Risk Management Major Risk Management Methods Loss Control Reduced Level of risky activity Increased precautions Loss Financing Retention and self insurance Insurance Hedging Other Contractual risk transfers Internal Risk Reduction Diversification Investments in Information
- 7. Business Risk Management Organization •CRO •Property •Human resources •Finance Treasury
- 8. Objectives of Risk Management – understanding cost of risk Components of the cost of risk Expected Losses Direct Losses Indirect losses Cost of Loss control Increased Precautions Reduced Activity Cost of loss financing Retention and self insurance Insurance Hedging Other risk transfers Cost of Internal risk reduction Diversification Investments in Information Cost of residual uncertainty Effects on Shareholders Effects on other stakeholders
- 9. Cost Tradeoffs • For an airline, describe the most important components of the cost of risk that arise from the risk of plane crashes. • How might the risk of crashes be estimated by the airline, if at all? • Assume that you want to fly across the country and that for a price of Rs. 12000, the probability of a fatal crash is one in a million trips. To reduce this probability to one in 1.5 million trips, the price of a ticket would increase to Rs. 24000. would you be willing to pay that extra Rs. 12000?
- 10. Firm value maximization and the cost of risk • Determinants of value • Net cash flows and their variability • Maximizing value by minimizing the cost of risk • Cost of risk = value without risk – value with risk • Value with risk = value without risk – cost of risk • Measuring cost of risk • Opportunity cost? • Subsidiary Goals • Limiting cost of risk – • Objectives of non-profit firms • Effect on stake holders and not on shareholders