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Risk Management

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You are on page 1of 57

Professor Jeremy Tobacman

January 16, 2014

Goals

Individuals and firms face risks in nearly all

decisions that they make.

Provide an introduction to decision making in a

world with uncertainty.

How should individuals, and managers of firms, make

decisions involving risk?

What are the typical mistakes made in decisions

involving risk?

2

Why study risk management?

As an individual, you face risks in many aspects

of your life.

Managers of firms make many decisions that

involve risks, and the consequences can be large.

A lesson from the recent financial crisis: the

failure to properly manage risk can result in

disaster.

3

Lessons from the financial crisis

The crisis spurred a remarkable degree of

reflection and activity throughout the community.

The unifying theme is a focus on risk

management: the risks of a particular product or

financial service, the risks to a firm, and the

systemic risks to society as a whole.

- Retiring HBS Dean Jay Light on the recent

developments in the curriculum

4

I believe that a CEO must not delegate risk

control. Its simply too important

Warren Buffet

5

"Named must your fear be before banish it you

can.

Yoda

6

Structure of the course

1. Optimal decision making under risk (Tobacman)

2. Barriers to risk management (Wang)

3. Corporate risk management (Nini)

7

Module I in one slide

Why is it important to account for risks?

How is risk measured in practice?

What is the optimal way to make decisions

under risk?

8

Module II in one slide

Barriers to risk management

Market impediments

Information and incentive problems

Psychological impediments

People dont always behave optimally

9

Module III in one slide

Corporate risk management

When firms SHOULD NOT manage risk

When firms SHOULD manage risk

Strategies for corporate RM

Managing liability risk

10

Overview of the syllabus

Course structure and requirements

Prerequisites

Course grading

Policies for dropping/withdrawing

Expectations

Policies for exams

11

Grading

Three exams, one for each module.

Problem sets, posted on Canvas

Work in teams but write your own solutions

Graded on a complete/incomplete system

You can skip turning in one problem set with no penalty

Module I due dates: 1/24, 1/31, 2/7 at 5:00pm

Survey questions will also be posted on Canvas

Problem sets and survey answers are worth 10% of your

grade

12

Slides and notes

Slides will be posted on Canvas

Notes summarizing certain aspects of the course

material will be posted on Canvas periodically,

generally after the material is covered in class

13

One slide study guide

Primary resources:

Lectures

Notes posted to Canvas

Problem sets

Readings are intended to be references

14

About me

Assistant Professor in BEPP since 2008

Ph.D. in Economics from Harvard

Research on household finance for the poor

Consumer credit in the US

Microinsurance against rainfall risk in India

Behavioral economics

15

My info

Office: 1409 SH-DH

Email: tobacman@wharton.upenn.edu

Office hours: Tuesdays 4:30-5:30pm or by appt

16

TAs for the course

Banruo (Rock) Zhou

banruo@wharton.upenn.edu

Ella Zhang

zhq@sas.upenn.edu

Neil Iyer

neiliyer@wharton.upenn.edu

17

Practice Sessions

Neil (1/21 & 2/4) - 4:30pm

Rock (1/21 & 2/4) - 7:30pm

Ella (1/22 & 2/5) - 4:30pm

Attend the most convenient one

Optional but awesome

Rooms TBA

18

Probability Theory

Rest of the lecture

1. Define what we mean by risk

2. Build up concepts of probability theory

3. Some methods for measuring risk

a. Variance as a measure of risk

b. Value at Risk

c. Mean-variance criterion

20

An example

A person retires at age 70, with a total of $1

million

She expects to live for another 25 years

How much can this person consume per year?

21

An example

A person retires at age 70, with a total of $1

million

She expects to live for another 25 years

How much can this person consume per year?

Assume a real interest rate of 2% per year:

Approximately $50.22k per year

22

Dollars remaining (in thousands)

23

But, there is uncertainty!

What if the person lives longer than 25 years?

What if the interest rate falls?

Calculations based on averages can be

misleading

Need to account for risk

24

Another example

A manager wants to estimate inventory costs for

the business, based on inventory amount.

If demand is lower than inventory: Unsold units

spoil, entailing a $50 cost per unit.

If demand exceeds inventory: Extra units must be

air-freighted in, at a cost of $150 per unit.

Monthly demand is, on average, 5,000 units per

month.

25

Understanding probabilities is crucial

Given average monthly sales of 5,000, what are

expected inventory costs if the manager decides

to have monthly inventory of 5,000?

Zero?

More than Zero?

Cannot be determined?

Source of this example: Harvard Business Review

26

Understanding probabilities is crucial

Expected inventory costs are greater than zero, if

there is any variation in demand from month to

month.

Using averages can be very misleading!

The appropriate method is to consider the whole

probability distribution for demand, not just the

average of the distribution.

27

The flaw of averages

28

One of many other examples

In 1997, the U.S. Weather Service forecast that

North Dakotas rising Red River would crest at

49 feet.

Official in Grand Forks made flood management

plans using this single number, an average.

29

One of many other examples

In 1997, the U.S. Weather Service forecast that

North Dakotas rising Red River would crest at

49 feet.

Official in Grand Forks made flood management

plans using this single number, an average.

The river crested above 50 feet, breaching the

dikes.

50,000 people were forced from their homes,

and there was $2 billion in property damage.

30

What is risk?

Very broadly, risk involves uncertainty

Many possible outcomes

Most decisions involve some degree of

uncertainty

31

Examples of risk

Individuals

Labor income, mortality, injuries, asset returns

Firms

Input costs, borrowing costs, demand, regulation

Governments

Unemployment, social security costs, business

cycles, wars, commodity prices

32

How can we model risk?

Answer: Probability theory

Provides us a way to think about what the most

likely outcome is

and gives us a way to model the range of

possible outcomes

33

Some concepts

Sample space

Set of all possible things that can happen

Probability distribution

Relative chance that each state can occur

Random variable

Function that assigns outcomes to each state

34

A simple example: a coin flip

Sample space

{H,T}

Probability distribution

{, }

Random variable, some examples

X = Number of heads

X(H)=1. X(T) = 0

Y = Number of tails

Y(H)=0, Y(T) = 1

35

Another example: two coin flips

Sample space

{HH, HT, TH, TT}

Probability distribution

{, , , }

Random variables

X = number of heads

X(HH) =2, X(HT) = 1, X(TH) = 1, X(TT) = 0

Y = proportion of heads

Y(HH) = 1, Y(HT)= , Y(TH) = , Y(TT) = 0

36

Probability distribution

Outcomes x

1

x

2

x

3

x

4

x

5

x

6

P

r

o

b

a

b

i

l

i

t

y

p

1

p

2

p

3

p

4

p

5

p

6

37

Properties of random variables

Expected value

Measure of the central tendency

Variance and standard deviation

Measures of dispersion

38

Expected value (mean)

Weighted average of outcomes

E X | | = p

1

x

1

+ p

2

x

2

+...+ p

n

x

n

=

=

n

i

i

x

i

p

1

39

Variance

Expected squared deviation from the mean

( ) ( ) | | ( ) | | ( ) | |

( ) | | { }

2

2 2 2

...

2 2 1 1

X E X E

X E

n

x

n

p X E x p X E x p X Var

=

+ + + =

40

Standard deviation

Square root of the variance

Same units as X

SD X ( ) = Var X ( )

41

Variance and SD as measures of risk

Var and SD measure the expected dispersion

between outcomes and the average outcome

Higher when

Outcomes can deviate a lot from expected value

Probability of extreme deviations is high

Lets think about whether these are good

measures of risk

42

Example

Investment A

$0 with probability 2/3

$9M with probability 1/3

Investment B

$-5M with probability 0.2

$5M with probability 0.8

Which is the riskier investment?

43

Example

Profit from Investment A

$0 with probability 2/3

$9M with probability 1/3

Profit from Investment B

$-5M with probability 0.2

$5M with probability 0.8

Mean = 3M

Variance = 18

2

Mean = 3M

Variance = 16

2

44

Asymmetry

Var and SD potentially measure risk, but they

miss something:

Large losses are more risky than large gains

Extreme example

Worst case scenario

45

Another way to quantify risk

Value at Risk (VaR)

Question:

What is the minimum loss under

exceptionally bad outcomes?

46

Value at Risk (VaR)

Minimum loss in the bottom p% of outcomes

Focus on the left tail of the distribution

Usually 1% or 5% for a given time interval

P

r

o

b

a

b

i

l

i

t

y

1%

2%

3%

5%

VaR at 10% is -4

7.5%

VaR at 1% is -10

VaR at 5% is -6

Profit -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18 20

47

Example

Profit from Investment A:

-$1M with probability 0.1%

$0 with probability 49.9%

$2 with probability 50%

Profit from Investment B:

-$1 with probability 20%

$1 with probability 80%

Which investment is riskier?

48

Example

Profit from Investment A:

-$1M with probability 0.1%

$0 with probability 49.9%

$2 with probability 50%

Profit from Investment B:

-$1 with probability 20%

$1 with probability 80%

Which investment is riskier?

VaR at 1% = $0

VaR at 5% = $0

VaR at 10%= $0

VaR at 1% = -$1

VaR at 5% = -$1

VaR at 10%= -$1

49

Mean-Variance Criterion

Balancing expected tendency and variance

aE(X)-bVar(X)

a>0, b>0

An investment in X might be preferred to Y if:

a[E(X)]-b[Var(X)] > a[E(Y)]-b[Var(Y)]

What does this say?

50

Mean-Variance Criterion

Basis of Markowitzs (1950) portfolio theory

1990 Nobel Prize

Often used in practical applications

Prior to Markowitz, portfolios were chosen on

the basis of E(X) alone, without regard for

Var(X)!

We will study the properties of the mean-

variance criterion later in the course

51

Review of concepts: An example

Random variable: damages from an automobile

accident

Possible Outcomes for Damages Probability

$0 0.50

$200 0.30

$1,000 0.10

$5,000 0.06

$10,000 0.04

52

Expected value

Possible Outcomes for Damages Probability

$0 0.50

$200 0.30

$1,000 0.10

$5,000 0.06

$10,000 0.04

EV = .5(0) + .3(200) + .1(1,000)

+ .06(5,000) + .04(10,000)

= $860

53

Variance

Possible Outcomes for Damages Probability

$0 0.50

$200 0.30

$1,000 0.10

$5,000 0.06

$10,000 0.04

Variance = .5(0-860)

2

+ .3(200-860)

2

+ .1(1,000-860)

2

+ .06(5,000-860)

2

+ .04(10,000-860)

2

= 4,872,400 ($

2

)

54

Standard deviation

Possible Outcomes for Damages Probability

$0 0.50

$200 0.30

$1,000 0.10

$5,000 0.06

$10,000 0.04

SD = (Variance)

1/2

= (4,872,400)

1/2

= 2,207 ($)

55

Practical concerns

Where do these probabilities come from?

We need a way to translate past observations

into probabilities

Statistics

56

Summary of todays class

Inference based on samples averages can be

quite misleading

Need to account for risk

Probability theory allows us to model risks

A measure of a typical observation (mean)

Measures of expected dispersion (variance and SD)

(Imperfect) measures of risk

57

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