To Explore How Risk Affects Financial Decision Making

OBJECTIVES

·To explore how risk affects financial decision making.

·To provide a conceptual framework for the management of risk.

·To explain how the financial system facilitates the efficient allocation of riskbearing.

CONTENTS

10.1What Is Risk?

10.2 Risk and Economic Decisions

10.3 The Risk-Management Process

1O.4The Three Dimensions of Risk Transfer

10.5Risk Transfer and Economic Efficiency

10.6Institutions for Risk Management

10.7Portfolio Theory:Quantitative Analysisfor Optimal Risk Management

10.8Probability Distributions of Returns

10.9Standard Deviation as a Measure of Risk

In the preface, we said that there are three analytical “pillar” to finance as an intellectual discipline-the time value of money, valuation,and risk management. Part IV focuses on the third pillar, risk management.

We have already discussed some aspects of risk management in earlier chapters.Chapter2showed that the redistribution of risks is a fundamental function of the financial system and it described some of the institutional mechanisms that have developed for facilitating the redistribution frisk and reaping the benefits of diversification.

Part IV provides a more detailed treatment of these topics. This first of the three chapters in Part IV offers an overview of the basic principles of risk management.Section 10.1clarifies the meaning of risk and risk aversion. Section 10.2 examines the ways in which risk influences the financial decisions of each of the major types of economic organizations-households,firms, and government. Section 10.3 explores the steps in the risk-management process: identifying and assessing risks, selecting techniques to manage risk, and implementing and revising risk-manages decisions. Section 10.4analyzes the methods available to transfer risk: hedging, insuring, and diversifying. Section 10.5explores how the facility to transfer risks among people permits effective risk bearing and the efficient allocation of resource to risky projects. Section10.6considers the scope of institutional arrangements for the efficient management ofrisk and the factors that limit it. Section 10.7discusses portfolio theory, which is the quantitative analysis of the optimal trade-off between the costs and benefits of ask management, and section 10.8explains probability distributions of rates of return.

The other chapters in Part IV elaborate on the topics introduced here. Chapter 11focuses on hedging,insuring,and diversifying; chapter 12applies these concepts to personal investing.

10.1 WHAT IS RISK?

We begin by distinguishing between uncertainty and risk. Uncertainty exists whenever one does not know for sure what will occur in the future. Risk is uncertainty that“matters”because it affects people's welfare. Thus,uncertainty is a necessary but not a sufficient condition for risk. Every risky situation is uncertain, but there can be uncertainty without risk.

To illustrate, suppose that you plan to have a party, and you invite a dozen of your friends. Your best guess is that1Oof the 12invitees will come, but there is uncertainty-all 12might show up, or only8. There is,however,risk only if the uncertainty affects your plans for the party. Would having a perfect forecast of the number of guests change your actions? If not, then there is uncertainty but no risk.

For example, in providing for your guests, you have to decide how much food to prepare. If you knew for sure that 10people will show up, then you would prepare exactly enough for 10-no more and no less.If12actually show up, there will not be enough food, andyou will be displeased with that outcome because some guests will be hungry and dissatisfied.If8actually show up, there will be too much food, and you will be displeased with that too because you will have wasted some of your limited resources on surplus food. Thus,the uncertainty matters and, therefore, thereis risk in this situation.

On the other hand, suppose that you have told your guests that there will be a“pot-luck”dinner,and that each guest is to bring enough food for one person. Then it might not matter to you in planning the party whether more or fewer than 10people come. In that case, there is uncertainty but no risk.

In many risky situations, the possible outcomes can be classified either as losses or gains in a simple and direct way. For example,suppose that you invest in the stock market. If the value of your stock portfolio goes down, it is a loss, and if it goes up, it is a gain. People normally consider the “downside” possibility of losses to be the risk, not the “upside” potential for a gain.

But there are situations in which there is no obvious downside or upside. Indeed, your planned party is an example. The uncertainty regarding the number of people who will attend your party creates risk whether more or fewer than the expected number of guests show up. Thus,in some situations, deviations from the expected value can be undesirable or costly no matter in which direction.

Risk aversion is a characteristic of an individual's preferences in risk-taking situations. It is a measure of willingness to pay to reduce role’s exposure to risk. In evaluating trade-offs between the costs and benefits of reducing risk, risk-averse people prefer the lower-risk alternatives for the same cost. For example, if you are generally willing to accept a lower expected rate of return on an investment because it offers a more predictable rate of return, you are risk averse. When choosing among investment alternatives with the same expected rate of return, a risk-averse individual chooses the alternative with the lowest risk.

10.1.1Risk Management

Let us assume that your party cannot possibly be a pot-yuck affair and, therefore, the uncertainty does matter. Moreover, you prefer that there is just enough food for those guests who show up. There are several alternative courses of action open to you, each with a certain cost.

For instance, you could order enough for 12together with an option to return any surplus to the caterer for a refund.Instead,you could order enough for only 8 together with an option to order more at the last minute if needed. You almost surely will have to pay extra for these options.

Thus,there is a trade-off between the benefit of eliminating the risk of having the wrong amount of food and the cost of that risk reduction. The process of formulating the benefit-cost trade--offs of risk reduction and deciding on the course of action to take (including the decision to take no action at all)is called risk management.

People at times express regret at having taken costly measures to reduce, risk when the bad outcomes they feared do not subsequently materialize. If you sell risky stock just before it triples in price, you will surely regret that decision. It is, however, important to remember that all decisions made with respect to uncertainty must be made before that uncertainty is resolved. What matters is that your decision is the best one you could make based on the information available to you at the time you made it. Everyone has “20/20hindsight”;no one,however,has perfect foresight.

It is difficult in practice to distinguish between the skill and the luck of a decision maker. By definition, risk-management decisions are made under conditions of uncertainty and,therefore,multiple outcomes are possible. After the fact, only one of these outcomes will occur. Neither recriminations nor congratulations for a decision seem warranted when such arc based on information not available at the time the decision was made. The appropriateness of a risk-management decision should bejudged in the light of the information available at the time the decision is made.

For example, if you carry an umbrella with you to work because you think it might rain, and it does not, then you should not recriminate yourself for having made the wrong decision. On the other hand, suppose all the weather forecasters say rain is very likely, and you do not take your umbrella. If it does not rain, you should not congratulate yourself on your wisdom. You were just lucky.

10.1.2Risk Exposure

If you face a particular type of risk because of yourjob,the nature of your business, or your pattern ofconsumption,you are said to have a particular risk exposure. For example, if you are a temporary office worker, your exposure to the risk of a layoff is relativelyhigh. Ifyou are a tenured professor at a majoruniversity,your expert to the risk of a layoff is relatively low. If you are a farmer, you are exposed bothto the risk of a crop failure and to the risk of a decline in the price at which cyst sell your crops. If your business significantly involves imports or exports of goods, you are exposed to the risk of an adverse change in currency exchange rates. If you own a house, you are exposed to the risks of fire,theft,storm damage,earthquake damage, as wail as the risk of a decline in its market value.

Thus,the riskiness of anasset oratransaction cannotbeassessedin isolation or in the abstract. In one context, the purchase or sale of a particular asset may addto your risk exposure; in another, the same transaction may be risk reducing. Thus, if I buy a one-year insurance policy on my life, it is risk reducing to my family bad because the benefit paid offsets their loss in income in the event that I die. If people unrelated to me buy the policy on my life they are not reducing risk; they are betting that I will die during the year. Or if a farmer with wheat ready to be harvested ear contract to sell wheat at a fixed price in the future, the contract is risk reducing. But for someone who has no wheat to sell, entering Into that same contract is to speculate that wheat prices will fall because they profit only if the market price at the contract delivery date is below the contractually fixed price.

Speculators are defined as investors who take positions that increase posture to certain risks in the hope of increasing their wealth. In contrast, take positions to reduce their exposures. The same person can be a speculator on some exposures and a hedger on others.

10.2RISK AND ECONOMIC DECISIONS

Some financial decisions, such as how much insurance to buy against various exposures, relate exclusively to the management of risk. But many general resource allocation decisions, such as saving,investment,and financing decisive, are also significantly influenced by the presence of risk and,therefore,are partly risk-management decisions.

For example, some household saving is motivated by the desire for the increased security that comes from owning assets that can cover unanticipated expenses in the future. Economists call this precautionary saving. In chapter 5, we showed how households can use time value of money concepts to make optimal saving decisions over the life cycle. In that analysis,however,we ignored risk and precautionary saving. In the real world, households should not and do not ignore it.

In the sections to follow, we discuss the influence of risk on some of the major financial decisions of households,firms,and government. But first let us recall why we begin with households (i.e., people). The ultimate function of the financial system is to help implement optima1consumption and resource allocation of households. Economic organizations such as firms and governments exist primarily to facilitate the achievement of that ultimate function and,therefore,we can not properly understand the optimal functioning of those organizations without first understanding the financial-economic behavior of people, including their response to risk.

10.2.1Risks Facing Households

Although many possible risk classification schemes are possible, we distinguishamong five major categories frisk exposures for households:

·sickness, disability, and death: Unexpected sickness or accidental injures can impose large costs on people because of the need for treatment and care and because of the loss of income caused by the inability to work.

·Unemployment risk: This is the risk of losing role’s job.

·Consumer-durable asset risk: This is the risk of loss arising from ownership of ahouse,car,or other consumer-durable asset. Losses can occur due to hazards such as fire or theft, or due to obsolescence arising from technological change or changes in consumer tastes.

·Liability risk: This is the risk that others will have a financial claim against you because they suffer a loss for which you can be held responsible. For example, you cause a car accident through reckless driving and are required to cover the cost to others of personal injury and property damage.

·Financial-asset risk: This is the risk arising from holding different kinds of financial assets such as equities or fixed-income securities denominated in one or more currencies. The underlying sources of financial-asset risk are the uncertainties faced by the firms,governments,or other economic organizations that have issued these securities.

Ice risks faced by households influence virtually all of their economic decisions.Consider,for example, an individual's decision to invest in a graduate education.In chapter 5we analyzed this decision using time value of money techniques and ignored risk.However,an important reason to invest in more education is to increase the flexibility of one's human capital. A person with a broader education is generally better equipped to deal with the risk of unemployment.

10.2.2Risks Facing Firms

Firms are organizations whose primary economic function is to produce goods and services. Virtually every activity of the firm entails exposures to risks. Taking risks is an essential and inseparable part of business enterprise.

Business risks of the firm are borne by its stakeholders:shareholders,creditors, customers,suppliers,employees,and government. The financial system can be used to transfer risks faced by firms to other parties. Specialized financial firms, such as insurance companies, perform the service of pooling and transferring risks. Ultimately, however,all risks faced by firms are borne by people.

Consider, for example, the risks associated with producing baked goods.Bakeries are the firms that carry on this activity.Bakeries,like firms in other industries face several categories of risks:

·Production risk:This is the risk that machines (e.g.,ovens,delivery trucks) will break down, that deliveries of raw materials (e.g.,flour,eggs)will not arrive on time, that workers will not show up for work, or that a new technology will make the firm's existing equipment obsolete.

·Price risk outputs:This is the risk that the demand for the baked goods produced by the bakery will unpredictably change because of an unanticipated shift in consumer preferences(e.g., celery becomes a popular substitute for bread at restaurants)and,therefore he market price of baked goods fall. Or competition can become more intense, and the bakery might be forced to lower its prices.

·Price risk ofinputs: This is the risk that the prices of some of the inputs of the bakery will change unpredictably. Flour can become more expensive, or wage rates rise. If the bakery borrows money to finance its operations at a floatable tersest rate, it is exposed to the risk that interest rates might rise.

The bakery's owners are not the only people who bear the risks of the business. Its managers (if they are different from the owners)and its other employee bear some of them,too.If profitability is low or if the production technology changes, some of them may be forced to take a cut in pay or even lose their jobs altogether.

Expertise in managing risks is part of the skill recipe for effective management of abakery. The firm's management team can manage these risks using several techniques: It can keep extra flour in inventory to protect itself against delays in delivery; it can maintain spare parts for its machinery; and it can subscribe to services that forecast trends in the demand for its products. It can also buy insurance against some risks, such as accidental injury to its employees or theft of its equipment. It can also reduce some price risks by either engaging in fixed-price contracting withcustomers and suppliers directly or by transacting in the forward,futures,and options markets for commodities, foreign exchange, and interest rates. Making tm among the costs and benefits of these risk-reducing, measures is an essential part of managing a bakery.

The size and organizational form of the firm itself can also be affected Bakeries come in many different types and sizes. At one extreme are smallproduction and retail operations owned and operated by a single individual or family. At the other extreme are large corporations such as Continental Baking Company, with a workforce of thousands of people and an even larger number of shareholder owners. One purpose (and usually not the only one)of organizing as a large corporation is to better manage the production,demand,or price risks of the business.

10.2.3The Role of Government in Risk Management

Governments at ail levels play an important role in managing risks either by preventing them or redistributing them. People often rely on government to provide protection and financial relief from natural disasters and various human-caused hazards, including war and pollution of the environment. An argument in favor of an activist role for government in economic development is that government can readily spread the risk of an investment in infrastructure among all of the taxpayers within its jurisdiction. Government managers often use the markets and other channels of the financial system to implement their own risk-management policies in much the same way that managers offirms and other nongovernmental economic organizations do.