Risk and Uncertainity in the Decision Making

Topics: Risk, Operational risk, Credit risk Pages: 5 (1888 words) Published: December 23, 2011
1.Introduction Risk is everywhere. It is not hard to find risk. In almost every thing that we do and situations we face, there is a corresponding risk behind it. However, we cannot just run from it. All we can do to move forward is to manage this risk, or if not, at least lessen the risk involve. We can never tell what will happen unless we try to overcome it. Whether we like it or not, the world is such an unpredictable place. Moreover, as long as future uncertainties exist, which might cause adverse effects for individuals, the world remains to be a place in which risk must be managed. 2.Classifications of Risks Facing the Business Risk is defined as any source of randomness that may adversely affect a person or corporation. In connection with this, risk management is the reaction to such risk by individuals or businesses as they attempt to make sure that the risks in which they are exposed to are the risks in which they think they are actually being exposed to and want to be exposed. 3.Market Risk Market risk arises from the event of a change in some market-determined asset price, reference rate, or index. The said events define market risk further into two categories. The first event-type defines market risk based on the asset class type whose price changes impact the exposure in question. One common form of asset class-based market risk is the risk on interest rate, or risk that the balance sheet assets, liabilities, and off-balance sheet items of the firm (including its derivatives) will change in value as interest rates change. Other asset class-driven classifications of market risk include the changes in the value of an exposure attributable to exchange rates’ fluctuations, commodity prices, and values of equity.Risk factors are any market-determined price, rate, or index value that impacts the flow of cash of an exposure. The discount rate comes into play when we are talking of the asset’s present value, although convention does not classify it as a risk factor. It is also typically improper to decompose risk factors into the non-traded exposures that may underlie them. Aside from the risk factors that influence the exposure value, the market risk of an exposure is also characterized on the basis of the way these risk factors impact its value. In this case, market risk is classified by the use of fraternity row (colorful argot). Similar trade practitioners and academics tend to refer to five types of market risk using Greek or Greek-sounding letters. These are delta, gamma, theta, and rho. Delta refers to the risk that the exposure’s value will deteriorate as the price or value of some risk factor changes, all else equal. An example is a bond affected by the changes in the rates of interest. Here, the risk factor is the interest rate. As interest rates increases, the effect is opposite to the prices of bonds. Same is true with the value of a machine. This is the discounted NPV of future cash flows generated by that machine. Due to the involvement of interest rates in the said situation, an upward movement in rates results in a downward pressure on the machine’s present value. Gamma, on the other hand, is the risk that delta will change due to the value change of an underlying risk factor. Sometimes it is also termed as convexity risk or risk in change rate. Applying this to the previous example of bonds (the fall in prices of bond due to the rise of interest rates), the amount of price change here, depends on the level of interest rates. Increases in interest rates, which are large in its nature, might cause larger declines in bond-price compared to the small increases in interest rates. The risk that volatility changes in the underlying risk factor will cause a change in the exposure value that goes with many names. Among them are vega, lambda, kappa, and tau. For purchased options (longs), the thing that poses the risk is the volatility declines....
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