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TitleFinancial Risk Management
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Table of Contents
                            About the Author
Contents
Introduction
	Arrangement of the Course
	Approach and Key Concepts
	Assessment
PART 1:
Introduction
	Module 1:
Introduction
		Contents
		Learning Objectives
		1.1 Introduction
			1.1.1 Historical Background
			1.1.2 Increased Volatility in Foreign Exchange Rates
			1.1.3 Increased Volatility in Interest Rates
			1.1.4 Increased Volatility in Commodity Prices
			1.1.5 Increased Availability of Financial Risk Management Products
			1.1.6 New Developments in Technology
		1.2 What Is Risk?
			1.2.1 Definitions of Risk and Risk Management
			1.2.2 The Risk Landscape
			1.2.3 Risk Management
		1.3 What Is Financial Risk?
			1.3.1 The Nature of Cash Flows
			1.3.2 Accounting Definition
			1.3.3 Contingent Exposures
			1.3.4 Economic or Competitive Exposure
		1.4 Steps to Risk Identification
			1.4.1 Risk Awareness
			1.4.2 Risk Measurement
			1.4.3 Risk Adjustment
		1.5 Top-Down and Building-Block Approaches to Risk Management
			1.5.1 Equity Value
			1.5.2 Asset–Liability Management
			1.5.3 Transactions and the Cash Flow Approach
		Learning Summary
		Appendix to Module 1: What Risks Are We Taking?
		Review Questions
			Multiple Choice Questions
			Case Study 1.1: Attitudes to Risk
		References
                        
Document Text Contents
Page 1

FK-A3-engb 1/2013 (1011)



Financial Risk
Management

Sources of Financial Risk and Risk
Assessment

Peter Moles

Page 2

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1.2 What Is Risk?

1.2.1 Definitions of Risk and Risk Management

A single definition of risk will not serve all risk management purposes. Risk manage-
ment is carried out in such diverse areas as transport, health and safety, finance, and
insurance. In mathematics, there is no single definition for the idea of a number; a
similar situation arises in risk management when it comes to defining risk and risk
management. Each of the disciplines above makes use of the idea of risk in the
context of its particular objectives. So, for transport, risk is taken to be an accident or
damage; for health, it is taken to be illness, injury or loss of life.

The term risk originates from the Italian riskare, which means ‘to dare’. The dic-
tionary lists risk as both a noun and a verb. When used as a noun it has the
connotation of danger, hazard, the chance of loss, an enterprise that can lead to
profit or loss, the amount of a loss (hence the ‘sum at risk’), a gamble or a bet.
When used as a verb, risk means to expose oneself to the potential for loss, to make
a bet or a wager, to gamble, to undertake an uncertain enterprise or venture. Both
uses imply that there is the possibility of gains as well as losses.

There is also a psychological meaning to risk: it is that state of uncertainty or
doubt in the face of a situation with beneficial and adverse consequences (gains and
losses).*

A simple definition of risk that includes the meanings above is:


The chance (or probability) of a deviation from an anticipated outcome.


The implications of this definition are given below.

 We can attach probabilities to risk. Therefore, it can be measured, estimated or
calculated in some way. Risk can therefore be quantified and expressed as a pa-
rameter, number or value.

 Risk is concerned not just with the extent or probabilities of potential losses but
with deviations from the expected outcome. It is the extent to which the
actual result may deviate from the expected result that makes a situation risky.

 Risk is a function of objectives. It is the consequences of the actual result
deviating from the expected result that leads to risk. Without an objective or
intended outcome, there is only uncertainty. A rider to this is that risk arises only
where the deviation from the objective matters; that is, if it affects individuals or
firms financially, or entails some other adverse consequence. It can also provide
an opportunity.


* For a review of the behavioural aspects of risk, see Fischhoff (2012).

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Within the discipline of risk management, of which financial risk management
forms a sub-element, the following additional concepts for risk are in use:


Possibility of a gain or loss
Where there is a possibility of a gain or loss, this is often referred to as a

risk. Note that this usage does not necessarily attempt to quantify the degree
of loss.

Probability of a gain or loss
This defines risk as the chance or probability of a gain or loss. In terms of

risk theory, the probability of an event occurring takes a value that can range
from zero to one. An event is impossible if it has a probability of zero; an
event is certain if it has a probability of one. Risk will be greatest if the gain-
or loss-making event has a probability of one; that is, it is certain to occur.
In practice, the probability of loss ( ) will lie above zero and be less than
one, i.e. 0 < < 1.0. Often people will talk of the odds of gains and losses.
This is the ratio of unfavourable to favourable outcomes. So, if the probabil-
ity of gain is 0.25, the odds are 0.75:0.25, which are more often expressed as
3 to 1. Hence we would say that the odds are 3 to 1 against success.

Cause of loss or peril
Peril is a term used in the insurance industry for the source of a risk. It is the

cause of a loss. For instance, fires, floods, explosions, accidents, death and
so on are all perils. In finance, the more common term is risk factor.

Hazard
Another term common in insurance. It is a condition or action of the

insured party that increases the likelihood or likely magnitude of a loss.
There are three common types of hazard:

 Physical hazard: the condition of the insured property, person or operations
that has the effect of increasing the likelihood and/or severity of the loss.

 Moral hazard: a condition where the insured intentionally seeks to take
advantage of insurance cover either by deliberately causing an accident or
by inflating the value of a loss.

 Morale hazard: actions taken by the insured party that increase the likeli-
hood and/or severity of a loss. Morale hazard arises because the
consequences of the action are borne by the insurer rather than the in-
sured. For instance, car owners with fully comprehensive theft insurance
are less likely to lock their cars when they leave them. Such persons are
likely to own more expensive vehicles and experience higher theft rates
than individuals who are not similarly insured.

(Note that these last two concepts bring in the behavioural aspect of risk.)

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Financial Risk Management Edinburgh Business School 1/49

1.26 Firms seek to manage their risks by looking at the risks in the firm’s:
I. assets.
II. liabilities.
III. balance sheet.
IV. income statement.
V. cash flows.
Which of the following is correct?
A. I and II.
B. III and IV.
C. IV and V.
D. All of I, II, III, IV and V.

1.27 The risk management task follows a series of logical steps that are undertaken to carry
out the process. These involve initially identifying the risks facing the firm. Which of the
following represents the major difficulty that arises in this identification process?
A. There are insufficient data for the analysis.
B. Risks are ignored because they are seen as unimportant.
C. There is no consensus over which risks are to be included.
D. Some factors are included that are not risks.

1.28 There are many dimensions to risk. A firm will seek to manage some or all of these, and
the most appropriate combination of methods will be to:
I. manage each risk separately.
II. manage the sum of all the risks.
III. manage those risks that are considered important.
IV. manage those risks that exceed a given exposure.
Which of the following is correct?
A. I and III.
B. I and IV.
C. II and III.
D. II and IV.

Case Study 1.1: Attitudes to Risk

A family reunion has brought together three generations of a family. At this gathering
are the grandparents, the parents and their children. It is a cold winter’s day and, after
lunch, they decide to go for a walk. As they progress along they find that the route they
wish to take is thickly covered over a considerable area by ice from a broken water
pipe.

1 Consider the attitudes that the different members of this family might have towards the
idea of crossing the ice.

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References
Bauman, J., Saratore, S. and Liddle, W. (1994) ‘A Practical Framework for Corporate

Exposure Management’, Journal of Applied Corporate Finance, 7 (3), 66–72.
Bernstein, P.L. (1996) Against the Gods: The Remarkable Story of Risk. New York: John Wiley &

Sons.
Black, F. and Scholes, M. (1972) ‘The Valuation of Option Contracts and a Test of Market

Efficiency’, Journal of Finance, 27 (May), 399–418.
Black, F. and Scholes, M. (1973) ‘The Pricing of Options and Corporate Liabilities’, Journal of

Political Economy, 81 (May–June), 637–54.
Casserley, D. (1993) Facing up to the Risks. New York: John Wiley & Sons.
Fischhoff, B. (2012) Risk Analysis and Human Behaviour. New York: Routledge.
Lintner, J. (1965) ‘The Valuation of Risky Assets and the Selection of Risky Investments in

Stock Portfolios and Capital Budgets’, Review of Economics and Statistics, 47 (February), 13–37.
MacCrimmon, K.R. and Wehrung, D.A. (1986) Taking Risks: The Management of Uncertainty.

London: Collier Macmillan.
Miller, M. (1991) Financial Innovation and Market Volatility. Oxford: Blackwell.
Rawls, S.W. III and Smithson, C. (1990) ‘Strategic Risk Management’, Journal of Applied

Corporate Finance, 2 (4), 6–18.
Ross, S. (1976) ‘The Arbitrage Theory of Capital Asset Pricing’, Journal of Economic Theory, 13

(December), 341–60.
Sharpe, W. (1964) ‘Capital Asset Prices: A Theory of Market Equilibrium Under Conditions

of Risk’, Journal of Finance, 19 (September), 425–42.
Smith, C. Jr, Smithson, C. and Wilford, D.S. (1995) Managing Financial Risk: A Guide to

Derivative Products, Financial Engineering and Value Maximization. Chicago: Irwin Profession-
al Publishing.

Wynne, B. (1992) ‘Science and Social Responsibility’, in Ansell, J. and Wharton, F. (eds) Risk:
Analysis, Assessment and Management. Chichester: John Wiley & Sons.

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