Subject: Risk Management

COURSE 2 RISK IN BUSINESS. INTRODUCTORY NOTIONS Main Objective: to operate with a system of knowledge, rules, methods, techniques and procedures so as to help the manager and the managerial team deal with risky situations in order to maintain the normal conditions within the structures they manage. At the end of this course, you will be able to: operate with notions such as: risk, uncertainty, chance, gain, loss, maximum turnover, minimum turnover, profitableness threshold, physical production, exploitation risk, safety interval, lever effect coefficient, total variable costs, probability, risky situation, safety situation, uncertainty situation, risk management; determine the risk of a business, to understand, explain and correctly apply mathematical relations and to formulate a managerial decision, in risky conditions; elaborate the most adequate responding strategies by using the methods by which managerial decisions are substantiated in such situations.

CONTENTS OF THE COURSE 1.1. Introduction 1.2. The concepts of risk and uncertainty in business 1.3. Risk typology

1.4. Risk Management

1.1. INTRODUCTION Peoples efforts to quantify risk and advisedly take decisions have lead to the improvement of some theories on risk. Some scientists who were preoccupied with the field of risk theory and improved it are: Bernoulli (1738 decreasing marginal utility); Knight (1921 uncertainty versus risk); J.M. Keynes (1937 knowledge and uncertainty). Risks are present in all human activities; they are inevitable and may have severe consequences. The contents of this course and the scientific research instruments are at your disposal to build those professional and human abilities that you could need in a future world full of uncertain events.

1.2. THE CONCEPTS OF RISK AND UNCERTAINTY IN BUSINESS

In a common language, risk means the uncertainty associated to whatever result. Uncertainty can be expressed by the probability of an event to happen or by its impact upon the situation where it is produced.

Other definitions given to risk: the chance to lose; the possibility to lose; the uncertainty affecting the result; the current dispersion of the expected results.

profit loss

Fig. 1. Profit and loss

Using the logics of these definitions, one can easily notice that the risk noted VA(a), also designated the expected value of the probability of an event occurring (a), tends to be measured according to the probability of an event occurring P(a) and the impact ampleness or the effect of the event (Ea) occurring upon the results of the organizations business. Thus, the relation below expresses the above-stated idea, as follows: VA(a) = P(a) x E(a) where: VA(a) = expected value of the event (a); P(a) = probability of the event occurring (a); E(a) = effect of the phenomenon occurring (a).

Case Study no.1 The managerial team of the TRONSONSRL company specialized in utility works (water, sewerage) is taking part in the auction organised for a water supply work to an industrial plant. In order to take part in the offering, it elaborated the required documentation and it remarked that there was the risk to meet a concrete foundation on the way . The team chose to include in the quotation the additional costs resulted from the digging through the foundation as follows: the additional costs estimated at 4,000 Euros, and the probability to meet the concrete foundation 60%. In these circumstances, the expected value of the risk will be: VA(risk) = 0.60 x 4,000 = 2,400 Euros. Normally, the contractor should include in the offer value the sum of 2,400 Euros for such risk prevention. This method of risk calculation presents a high subjectivity degree; for this reason, the method of the expected value of the risk is used only for a preliminary orientation (as entry data for further studies).

VA (Risk) = P(a) x E(a)= 0.60 x 4,000 = 2,400 Euros Risk Perception

Risk comes from the limited possibilities of the human being to anticipate the future, and it becomes conscious of such risk through the results of some actions presenting a rather significant degree of uncertainty. Organizational risk perception can be assimilated to a strategic game between two opponents, the manager (the decident) and the future. The decident elaborates the business plan under the form of some action variants (concepts) presenting the main factors of the business, while its opponent, the future, offers him/her the states it manifests: the business favourable conditions (BFC) and the business adverse conditions (BAC).

Case Study no. 2 a. The ELECTRON S.A. company elaborated the Business Plan for (year) in three variants - V1, V2, V3 and it expects to reach the profitableness threshold in time units as follows: a. For the favourable condition (BFC): V1 = 10 months; V2 = 8 months; V3 = 6 months; b. For the adverse condition (BAC): V1 = 11 months; V2 = 12 months; V3 = 13 months; The probability of event occurring (reaching the profitableness threshold) is of 0.6 for BFC and of 0.4 for BAC. It is necessary to decrease the business risk by choosing the optimum variant. Solution: The mathematical expectation to achieve the profitableness threshold for each variant is calculated, considering the two conditions (the mathematical expectation to achieve the respective variant), as follows: MV1 = 10 x 0.6 + 11 x 0.4 = 6.80 months MV2 = 8 x 0.6 + 12 x 0.4 = 6.72 months MV3 = 6 x 0.6 + 13 x 0.4 = 6.64 months Conclusion: the third variant presents the lowest degree of risk.

V1 6.80

V2 6.72

V3 6.64

Fig. 2. Variant with the lowest degree of risk

The Concept of Uncertainty While loss is associated to risk having quantifiable indices, uncertainty expresses a condition of uncertainty. The uncertainty degree of a situation, process or phenomenon depends both on the number of factors influencing their evolution and on the frequency and amplitude of their change as well. Therefore, uncertainty is used to describe such situations, phenomena and processes to which a probability of occurring cannot be associated. Risk and uncertainty are components existing in various proportion in each situation, phenomenon or process. Risk and uncertainty have an important impact upon companies, materialized as the risk cost. The most obvious cost is the loss cost which appears when a company is on the verge of bankruptcy or when work accidents or natural catastrophes occur.

Event division based on risk severity Probability is the index showing to what extent an event occurrence is possible in well-determined conditions. Based on the probability of an event occurring, the contemporary theories present the following three situations: a. CERTAINTY CONDITION when the probability of an event occurring is equal to 1; b. RISK CONDITION when the probability of an event occurring is lower than 1; c. UNCERTAINTY CONDITION when the probability of an event occurring is unknown. In most of the speciality works, event division based on risk severity is: a. High risk events when the event occurring probability is very high (above 0.50); b. Medium risk events when the event occurring probability is moderate (between 0.20 and 0.50); c. Low risk events when the event occurring probability is very low (below 0.20).

1.3. THE TYPOLOGY OF RISK In the speciality works, there are a lot of criteria and typologies as regards risk grouping. You are invited to approach risk typology considering their proportions, the grouping being as follows: microrisks, macro-risks, regional and global risks.

MICRO-RISKS RISK TYPOLOGY MACRO-RISKS REGIONAL AND GLOBAL RISKS

A. Micro-risks (at the micro-economic level the organization) Pure Risk is of an accidental and unintentional nature; it occurs without warning signs, independent of the parties will; it refers only to the bussiness entities possibility to lose, without deciding on the loss size. It is also named insurable risk. Examples: Physical risks: technical disturbances, accident occurrence degree, effort increase above the actual capacity of the system, delays, etc.; Financial risks: computation mistakes, loss of documents, image- and database deterioration, etc; Subversive risks: the fraudulent use of the companys resources, document forgering, falsification of statistical data and reports; embezzlement of financial funds, etc. Speculative Risk is known, evaluated and assumed by managers, in general. This type of risk offers the bussiness entities both the possibility of gaining an additional profit and the possibility of losing, as well. Examples: launching a new product on the market; setting a merchandise new point of sale; implementation of a new manufacturing technology; penetrating new markets.

B. Macro-risks (at macro-economic and macro-social level) They arise at the national economy level and are generated by the incoherence of the economic policies and strategies correlated to an unfavourable international environment. Social Risk is the one provoked by major social events, with a great impact on peoples life. Examples: violent social movements (mineriads); strikes and unauthorized demonstrations; fiscal evasion. Economic Risk is expressed by its two forms: inflation and unemployment. Information Technology (IT) Risk appears more and more frequent in activities developed within the national economy by the aid of the IT system. Examples: the error occurring probability within the IT flows and programmes; inopportune and unqualified intervention in the administration of IT networks, failing to update the data bases and magnetic files; perils related to errors occurred in telecommunication systems. Country Risk measures a country ability to provide the private resident or non-resident companies and governmental entities with the currency necessary in order to carry out their activity. Example: This type of risk is determined not only by the economic results but also by the political events of major significance such as: wars, crises of political authority, corruption at the central administrative level, etc.

C. Regional and global risks They are specific to the international geopolitical environment and have a decisive impact upon international business. Risks generated by globalitary institutions. Examples: Religious risks and threats; Risks generated by territorial disputes; Risks generated by hegemony disputes of the Great Powers in order to get the supremacy in different areas and to get access to energetic resources; Risks generated by terrorist actions; Risks generated by poverty and under-development; Ecological risks; Risks generated by the contradiction between the unique economic thought and the political fragmentation of our Planet;

1.4. Risk Management

Defining Risk Management In a broad meaning, Risk Management is defined as that component of the scientific management comprising all the principles, methods, techniques, pieces of information and models used in the managerial process for the purpose of counteracting the actions of the disturbing risk factors and of maintaining the functional stability of the organization within the limits of the planned parameters. In a narrow meaning, Risk Management comprises all the operations aiming at preventing and limiting the organizational losses. Within big companies, the responsibilities regarding the reaction to risk factors action fall on an expert employed especially for this purpose and called the risk manager; in the other companies, such responsibilities fall on the financial manager and the managerial team.
Risk Analysis and Evaluation Risk Identification Formulating a strategy to respond to risks

RISK MANAGEMENT

Risk Control

Fig M.1.1.12. Risk Management

Identifying Organizational Risks Virtually, in this phase, there are identified all the elements meeting the following condition: 0 < P(a) < 1 In this phase, the potential risk sources are concretely identified in the following fields: natural, political, social, juridical and legal, technical, operational, economic and cognitive. Risk Analysis and Evaluation The main purpose of the risk analysis is that of processing the objective pieces of information answering the following questions: What are the risk factors with critical action that can compromise the objectives achievement by the company? What is their occurring probability and frequency? What are the consequences of their actions upon the results (analysis of consequences)? Developing a responding strategy under risky conditions The following strategies are used in Risk Management: A. Avoiding risky situations (e.g. daily depositing of money in the bank account in order to avoid risks related to the utilization of cash money). B. Risk prevention. When risks cannot be eliminated, the entrepreneur must try to reduce the occurring probability of such situation. C. Risk transfer to other organization. D. Risk assumption, when all the other methods cannot be applied.

Risk Control In the specialty literature, 5 distinct categories of risk control are known and applied: risk acceptance, risk avoidance, risk monitoring and preparation of unpredictable situations plan, risk transfer, risk systematic reduction.

A small dictionary for your attention!

Risk Management = managementul riscului risky situation = situaie de risc safety situation = situaie de siguran uncertainty situation = situaie de incertitudine risk = risc uncertainty = incertitudine chance = ans gain = ctig loss = pierdere turnover = cifr de afaceri profitableness threshold = prag de rentabilitate physical production = producie fizic exploitation risk _ risc de exploatare safety interval = interval de siguran lever effect coefficient = coeficient al efectului de levier decreasing marginal utility = utilitate marginal descresctoare the expected value of the probability = valoarea ateptat a probabilitii the probability of an event occurring = probabilitatea de apariie a unui eveniment quotation = licitaie additional costs = costuri adiionale risk prevention = prevenirea riscului risk calculation = calcularea riscului risk perception = percepia riscului degree of uncertainty = grad de incertitudine business favourable conditions = starea favorabil afacerii the business adverse conditions = starea nefavorabil afacerii quantifiable indices = indicatori cuantificabili the risk cost = costul de risc the loss cost = costul pierderii bankruptcy = faliment risk severity = gravitatea riscurilor micro-risks = macroriscuri macro-risks = microriscuri regional and global risks = riscuri regionale i globale pure risk = risc pur insurable risk = risc asigurabil physical risk = risc fizic financial risk = risc financiar subversive risk = risc subversiv speculative risk = risc speculativ social risk = risc social economic risk = risc economic IT risk = risc informatic country risk = risc de ar risk manager risk transfer = transferul riscului risk control = controlul riscului

Quiz
1. Based on risk severity, events can be: a certainty condition, an uncertainty condition and a .. 2. Which of the following risks are pure risks: a. Speculative risks b. Financial risks c. Country risk

3.

State the 4 steps of Risk Management