Risk Management

Instructor: Dr. Aric LaBarr

Introduction

“Only those who risk going too far can possibly find out how far they can go.” - T.S. Eliot

The entirety of risk analysis is a very extensive space. This introduction to risk management is going to focus solely on applied business risk modeling and analysis. Some examples of this would include market risk (the risk of having unknown future prices in a market), operational risk (the risk of having unknown effects impact a company’s operation like employee turnover), credit risk (the risk of having people default on loans - for more information on modeling credit risk directly check out the code notes: Credit Modeling), and liquidity risk (the risk of not being able to liquefy assets when capital is needed).

Risk is typically tied with uncertainty. Risk and uncertainty are related, however, they are different than each other. Risk is something that someone bears. Risk is a possible outcome of uncertainty. Once you have an uncertain event and you can put some distribution to it, you can measure possible risks associated with that event. Just because there is uncertainty doesn’t mean there is risk. Take the flip of a coin. The outcome of this flip of a coin is uncertain. It could be heads or tails. However, there is no risk involved in this uncertainty. Now imagine that the outcome of the flip of that coin is you getting $5 for heads and losing $5 for tails. Now there is risk to the uncertainty of the coin flip because you stand to lose something based on one of the possible outcomes.

There are three levels of uncertainty that we typically think of:

  1. Known - a guaranteed event or no uncertainty. For example, I enter in a contract where I will buy 10 bushels of corn 1 year from now.

  2. Unknown - events that carry risk that will be reduced / eliminated over time as the event gets closer. For example, I do not know the price of corn 1 year from now so our contract could be bad for me in terms of price, but as I get closer to 1 year from now I know more about my risk.

  3. Unknowable - events that carry risk that may not change over time as the event gets closer. For example, a natural disaster could prevent us from exercising the contract. The risk didn’t change up to the event because the disaster might not have been known to happen. Insurance can protect us against this kind of risk!