Intoduction to Risk

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LESSON 1: INTRODUCTION TO RISK
Chapter Objectives
• Discuss different meanings of the term risk. • Describe major types of business risk and personal risk. • Explain and compare pure risk to other types of risk. • Outline the risk management process and describe major risk Expected loss

UNIT I CHAPTER 1 RISK & ITS MANAGEMENT

Expected loss Uncertainty (vaiability around the expected loss) One situation is riskier than other if it has greater

RISK MANAGEMENTFOR GLOBAL FINANCIAL SERVICES

management methods.
• Discuss organization of the risk management function within

Uncertainty (variability around the expected loss)

business. Risk Different Meanings Of Risk The term risk has a variety of meanings in business and everyday life. At its most general leve1, risk is used to describe any situation where there is uncertainty about what outcome will occur. Life is obviously very risky. Even the short-term future is often highly uncer-tain. In probability and statistics, financial management, and investment management, risk is often used in a more specific sense to indicate possible variability in outcomes around some expected value. We will develop the ideas of expected value and risk as reflecting variability around the expected value in the next few chapters. For now it is sufficient for you to think of the expected value as the outcome that would occur on average if a person or business were repeatedly exposed to the same type of risk. If you have not yet encountered these concepts in statistics or fi-nance classes, the following example from the sports world might help. Allen Iverson has averaged about 30 points per game in his career in the National Basketball Association. As we write this, he shows little sign of slowing down. It is therefore reasonable to assume that the expected value of his total points in any given game is about 30 points. Risk, in the sense of variability around the expected value, is clearly present. He might score 50 points or even higher in a particular game, or he might score as few as 10 points. In other situations, the term risk may refer to the expected losses associated with a situ-ation. In insurance markets, for example, it is common to refer to high-risk policyholders. The meaning of risk in this context is that the expected value of losses to be paid by the in-surer (the expected loss) is high. As another example, California often is described as hav-ing a high risk of earthquake. While this statement might encompass the notion of variability around the expected value, it usually simply means that California’s expected loss from earthquakes is high relative to other states. In summary, (see Figure 1.1) risk is sometimes used in a specific sense to describe vari-ability around the expected value and other times to describe the expected losses. We em-ploy each of these meanings in this book because it is customary to do so in certain types of risk management and in the insurance business. The particular meaning usually will be obvious from the context. One situation is riskier than other if it has greater

Risk Is Costly Regardless of the specific meaning of risk being used, greater risk usually implies greater cost. To illustrate the cost of risk we use a simple example: Suppose that two identical homes are in different but equally attractive locations. The structures have the same value, say $100,000, and initially there is no risk of damage to either house. Then scientists announce that a meteor might hit the earth in the coming week and that one house is in the potential impact area. We would naturally say that one house now has greater risk than the other. Let’s assume that everyone agrees that the probability of one house being hit by the me-teor is 0.1 and that the probability of the other house being hit is zero. Also assume that the house woul9- be completely destroyed if it were hit (all $100,000 would be lost). Then the expected property loss at one house is...
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