MUSAVIR UL HABIB

AREA OF INTEREST: RISK (ECONOMIC)

RISK ECONOMICS A SHORT SUMMARY

INTRODUCTION
Economic risk is a nebulous term with a variety of definitions. In a nutshell, economic risk is the risk that an endeavor will be economically unsustainable, for a variety of reasons ranging from a change in economic trends to fraudulent activities which ruin the outcome of the project. Before starting projects, economic risk has to be considered to determine whether or not the potential risks are outweighed by the benefits. There are a variety of ways to look at economic risk, with an assortment of modeling systems. In a simple example of economic risk, imagine a planned housing development. The economic risk in this case is that the profits from the development will not cover the costs of the development, leaving the developer in debt. This can occur because of downturns in the real estate market, unexpected cost overruns, lack of interest in the housing, and a variety of other factors. eople can try to predict economic risk, but they are not always successful. Economies are notoriously fickle, and they do not necessarily follow patterns which can be followed or mapped out ahead of time. The risks that a project will not repay itself increase with the si!e of the project, and they also get larger the longer it takes for a project to be completed. "osts of production, for example, tend to go up, which means that every year a project runs over schedule, the more costly it becomes. Economists who act as consultants can command a hefty fee for their services when they are asked to map out economic risk. In addition to predicting risks, economists can also come up with suggestions which may reduce risk. In the housing development example above, for example, an economist might recommend preselling a set percentage of units before breaking ground to make sure that the project will have enough funds to take it through to completion. Investors also look at economic risks when considering things like making loans, doing business with another country, or even sending aid supplies to other nations. #isk on a national level can be an important consideration for potential investing partners and lenders who are reluctant to work with countries which appear to be economically unstable. Balanced with this risk is the very real problem that a nation which is economically unstable may have trouble getting assistance, which in turn increases economic risk for other investors, because the country lacks support.

BASIC DEFINITIONS
$. The probability of something happening multiplied by the resulting cost or benefit if it does. %This concept is more properly known as the &Expectation 'alue& and is used to compare levels of risk( ). The probability or threat of *uantifiable damage, injury, liability, loss, or any other negative occurrence that is caused by external or internal vulnerabilities, and that may be avoided through preemptive action.

+. ,inance- The probability that an actual return on an investment will be lower than the expected return. ,inancial risk can be divided into the following categoriesBasic risk, "apital risk, "ountry risk, .efault risk, .elivery risk, Economic risk, Exchange rate risk, Interest rate risk,/i*uidity risk, 0perations risk, ayment system risk, olitical risk, #efinancing risk, #einvestment risk, 1ettlement risk, 1overeign risk, and 2nderwriting risk. 3. ,ood industry- The possibility that due to a certain ha!ard in food there will be a negative effect to a certain magnitude. 4. Insurance- 5 situation where the probability of a variable %such as burning down of a building( is known but when a mode of occurrence or the actual value of the occurrence %whether the fire will occur at a particular property( is not. 5 risk is not an uncertainty %where neither the probability nor the mode of occurrence is known(, a peril %cause of loss(, or a ha!ard %something that makes the occurrence of a peril more likely or more severe(. 6. 1ecurities trading- The probability of a loss or drop in value. Trading risk is divided into two general categories- %$( 1ystematic risk affects all securities in the same class and is linked to the overall capital7market system and therefore cannot be eliminated by diversification. 5lso called market risk. %)( 8onsystematic risk is any risk that isn&t market7related or is not systemic. 5lso called nonmarket risk, extra7market risk, diversifiable risk, or unsystemic risk.

LITERATURE REVIEW
The 0xford English .ictionary cites the earliest use of the word in English %in the spelling of risque( as from $6)$, and the spelling as risk from $644. It defines risk as%Exposure to( the possibility of loss, injury, or other adverse or unwelcome circumstance9 a chance or situation involving such a possibility. 1cenario analysis matured during "old :ar confrontations between major powers, notably the 2nited 1tates and the 1oviet 2nion. It became widespread in insurance circles in the $;<=s when major oil tanker disasters forced a more comprehensive foresight. The scientific approach to risk entered finance in the $;6=s with the advent of the capital asset pricing model and became increasingly important in the $;>=s when financial derivatives proliferated. It reached general professions in the $;;=s when the power of personal computing allowed for widespread data collection and numbers crunching. ?overnments are using it, for example, to set standards for environmental regulation, e.g. @pathway analysis@ as practiced by the 2nited 1tates Environmental rotection 5gency. #isk is ubi*uitous in all areas of life and risk management is something that we all must do, whether we are managing a major organi!ation or simply crossing the road. :hen describing risk however, it is convenient to consider that risk practitioners operate in some specific practice areas. ,or the sociologist 8iklas /uhmann the term &risk& is a neologism that appeared with the transition from traditional to modern society. @In the Aiddle 5ges the term risicum was used in highly specific contexts,above all sea trade and its ensuing legal problems of loss and damage.@ In the vernacular languages of the $6th century the words rischio and rie!go were used. This was introduced to continental Europe, through interaction with Aiddle Eastern and 8orth 5frican 5rab traders. In the English language the term risk appeared only in the $<th century, and @seems to be imported from continental Europe.@ :hen the terminology of risk took ground, it

replaced the older notion that thought @in terms of good and bad fortune.@ 8iklas /uhmann %$;;6( seeks to explain this transition- @ erhaps, this was simply a loss of plausibility of the old rhetorics of ,ortuna as an allegorical figure of religious content and of prudentia as a %noble( virtue in the emerging commercial society.@ In other words, #isk is when you take a chance at something which can either turn out better for you or could result in a negative outcome.

ECONOMIC RISK
Economic risks can be manifested in lower incomes or higher expenditures than expected. The causes can be many, for instance, the hike in the price for raw materials, the lapsing of deadlines for construction of a new operating facility, disruptions in a production process, emergence of a serious competitor on the market, the loss of key personnel, the change of a political regime, or natural disasters. 5dditionally, it is worth noting that from a societal standpoint, losses are much more lucrative than gains, as governmental bodies will do anything it takes, according to recent research, to avoid losing or resorting to an inferior position.

BUSINESS AND MANAGEMENT

Aeans of assessing risk vary widely between professions. Indeed, they may define these professions9 for example, a doctor manages medical risk, while a civil engineer manages risk of structural failure. 5 professional code of ethics is usually focused on risk assessment and mitigation %by the professional on behalf of client, public, society or life in general(. In the workplace, incidental and inherent risks exist. Incidental risks are those that occur naturally in the business but are not part of the core of the business. Inherent risks have a negative effect on the operating profit of the business.

HIGH RELIABILITY ORGANIZATIONS (HROs)

5 Bigh reliability organi!ation %B#0( is an organi!ation that has succeeded in avoiding catastrophes in an environment where normal accidents can be expected due to risk factors and complexity. Aost studies of B#0s involve areas such as nuclear aircraft carriers, air traffic control, aerospace and nuclear power stations. 0rgani!ations such as these share in common the ability to consistently operate safely in complex, interconnected environments where a single failure in one component could lead to catastrophe. Essentially, they are organi!ations which appear to operate &in spite& of an enormous range of risks. 1ome of these industries manage risk in a highly *uantified and enumerated way. These include the nuclear power and aircraft industries, where the possible failure of a complex series of engineered systems could result in highly undesirable outcomes. The usual measure of risk for a class of events is then- R C probability of the event D the severity of the conse*uence. In the nuclear industry, conse*uence is often measured in terms of off7site radiological release, and this is often banded into five or six decade7wide bands.

The risks are evaluated using fault treeEevent tree techni*ues. :here these risks are low, they are normally considered to be @Broadly 5cceptable@. 5 higher level of risk %typically up to $= to $== times what is considered Broadly 5cceptable( has to be justified against the costs of reducing it further and the possible benefits that make it tolerableFthese risks are described as @Tolerable if 5/5# @. #isks beyond this level are classified as @Intolerable@. The level of risk deemed Broadly 5cceptable has been considered by regulatory bodies in various countriesFan early attempt by 2G government regulator and academic ,. #. ,armer used the example of hill7walking and similar activities, which have definable risks that people appear to find acceptable. This resulted in the so7called ,armer "urve of acceptable probability of an event versus its conse*uence.

HUMAN FACTORS Decision theory and Prospect theory

0ne of the growing areas of focus in risk management is the field of human factors where behavioral and organi!ational psychology underpins our understanding of risk based decision making. This field considers *uestions such as @how do we make risk based decisionsH@, @why are we irrationally more scared of sharks and terrorists than we are of motor vehicles and medicationsH@ In decision theory, regret %and anticipation of regret( can play a significant part in decision7making, distinct from risk aversion %preferring the status *uo in case one becomes worse off(. ,raming is a fundamental problem with all forms of risk assessment. In particular, because of bounded rationality %our brains get overloaded, so we take mental shortcuts(, the risk of extreme events is discounted because the probability is too low to evaluate intuitively. 5s an example, one of the leading causes of death is road accidents caused by drunk driving I partly because any given driver frames the problem by largely or totally ignoring the risk of a serious or fatal accident. ,or instance, an extremely disturbing event %an attack by hijacking, or moral ha!ards( may be ignored in analysis despite the fact it has occurred and has a non!ero probability. 0r, an event that everyone agrees is inevitable may be ruled out of analysis due to greed or an unwillingness to admit that it is believed to be inevitable. These human tendencies for error and wishful thinking often affect even the most rigorous applications of the scientific method and are a major concern of the philosophy of science. 5ll decision7making under uncertainty must consider cognitive bias, cultural bias, and notational bias- 8o group of people assessing risk is immune to @groupthink@- acceptance of obviously wrong answers simply because it is socially painful to disagree, where there are conflicts of interest. ,raming involves other information that affects the outcome of a risky decision. The right prefrontal cortex has been shown to take a more global perspective while greater left prefrontal activity relates to local or focal processing. ,rom the Theory of /eaky Aodules AcElroy and 1eta proposed that they could predictably alter the framing effect by the selective manipulation of regional prefrontal activity with finger tapping or monaural listening. The result was as expected. #ightward tapping or listening had the effect of narrowing attention such that the frame was ignored. This is a practical way of manipulating regional cortical activation to affect risky decisions, especially because directed tapping or listening is easily done.

QUANTITATIVE ANALYSIS
5s risk carries so many different meanings there are many formal methods used to assess or to @measure@ risk. 1ome of the *uantitative definitions of risk are well7grounded in statistics theory and lead naturally to statistical estimates, but some are more subjective. ,or example in many cases a critical factor is human decision making. Even when statistical estimates are available, in many cases risk is associated with rare failures of some kind, and data may be sparse. 0ften, the probability of a negative event is estimated by using the fre*uency of past similar events or by event tree methods, but probabilities for rare failures may be difficult to estimate if an event tree cannot be formulated. This makes risk assessment difficult in ha!ardous industries, for example nuclear energy, where the fre*uency of failures is rare and harmful conse*uences of failure are numerous and severe. 1tatistical methods may also re*uire the use of a cost function, which in turn may re*uire the calculation of the cost of loss of a human life. This is a difficult problem. 0ne approach is to ask what people are willing to pay to insure against death or radiological release %e.g. ?B* of radio7iodine(, but as the answers depend very strongly on the circumstances it is not clear that this approach is effective. In statistics, the notion of risk is often modeled as the expected value of an undesirable outcome. This combines the probabilities of various possible events and some assessment of the corresponding harm into a single value. The simplest case is a binary possibility of Accident or No accident. The associated formula for calculating risk is then,or example, if performing activity X has a probability of =.=$ of suffering an accident of A, with a loss of $===, and then total risk is a loss of $=, the product of =.=$ and $===. 1ituations are sometimes more complex than the simple binary possibility case. In a situation with several possible accidents, total risk is the sum of the risks for each different accident, provided that the outcomes are comparable,or example, if performing activity X has a probability of =.=$ of suffering an accident of A, with a loss of $===, and a probability of =.=====$ of suffering an accident of type B, with a loss of ),===,===, then total loss expectancy is $), which is e*ual to a loss of $= from an accident of type A and ) from an accident of type B. 0ne of the first major uses of this concept was for the planning of the .elta :orks in $;4+, a flood protection program in the 8etherlands, with the aid of the mathematician .avid van .ant!ig. The kind of risk analysis pioneered there has become common today in fields like nuclear power, aerospace and the chemical industry. In statistical decision theory, the risk function is defined as the expected value of a given loss function as a function of the decision rule used to make decisions in the face of uncertainty.

FEAR AS INTUITIVE RISK ASSESMENT

,or the time being, people rely on their fear and hesitation to keep them out of the most profoundly unknown circumstances. In The Gift of Fear, ?avin de Becker argues that JTrue fear is a gift. It is a survival signal that sounds only in the presence of danger. Ket unwarranted fear has assumed a power over us that it holds over no other creature on Earth. It need not be this way. #isk could be said to be the way we collectively measure and share this @true fear@Fa fusion of rational doubt, irrational fear, and a set of un*uantified biases from our own experience. The field of behavioral finance focuses on human risk7aversion, asymmetric regret, and other ways that human financial behavior varies from what analysts call @rational@. #isk in that case is the degree of uncertainty associated with a return on an asset. #ecogni!ing and respecting the irrational influences on human decision making may do much to reduce disasters caused by naive risk assessments that presume to rationality but in fact merely fuse many shared biases.

MEASUREMENT OF RISK
5 set of possibilities each with *uantified probabilities and *uantified losses. Example@There is a 3=L chance the proposed oil well will be dry with a loss of M$) million in exploratory drilling costs@. In this sense, Bubbard uses the terms so that one may have uncertainty without risk but not risk without uncertainty. :e can be uncertain about the winner of a contest, but unless we have some personal stake in it, we have no risk. If we bet money on the outcome of the contest, then we have a risk. In both cases there is more than one outcome. The measure of uncertainty refers only to the probabilities assigned to outcomes, while the measure of risk re*uires both probabilities for outcomes and losses *uantified for outcomes.

RISK ATTITUDE, APPETITE AND TOLERANCE

The terms attitude, appetite and tolerance are often used similarly to describe an organi!ation&s or individual&s attitude towards risk taking. #isk averse, risk neutral and risk seeking are examples of the terms that may be used to describe a risk attitude. #isk tolerance looks at acceptableEunacceptable deviations from what is expected. #isk appetite looks at how much risk one is willing to accept. There can still be deviations that are within a risk appetite. ,or example, recent research finds that insured individuals are significantly likely to divest from risky asset holdings in response to a decline in health, controlling for variables such as income, age, and out7of7pocket medical expenses. ?ambling is a risk7increasing investment, wherein money on hand is risked for a possible large return, but with the possibility of losing it all. urchasing a lottery ticket is a very risky investment with a high chance of no return and a small chance of a very high return. In contrast, putting money in a bank at a defined rate of interest is a risk7averse action that gives a guaranteed return of a small gain and precludes other investments with possibly higher gain. The possibility of getting no return on an investment is also known as the #ate of #uin.

RISK AS A VECTOR QUANTITY

Bubbard also argues that defining risk as the product of impact and probability presumes %probably incorrectly( that the decision makers are risk neutral. 0nly for a risk neutral person is the @certain monetary e*uivalent@ exactly e*ual to the probability of the loss times the amount of the loss. ,or example, a risk neutral person would consider )=L chance of winning M$ million exactly e*ual to M)==,=== %or a )=L chance of losing M$ million to be exactly e*ual to losing M)==,===(. Bowever, most decision makers are not actually risk neutral and would not consider these e*uivalent choices. This gave rise to rospect theory and "umulative prospect theory. Bubbard proposes instead that risk is a kind of @vector *uantity@ that does not collapse the probability and magnitude of a risk by presuming anything about the risk tolerance of the decision maker. #isks are simply described as a set or function of possible loss amounts each associated with specific probabilities. Bow this array is collapsed into a single value cannot be done until the risk tolerance of the decision maker is *uantified. #isk can be both negative and positive, but it tends to be the negative side that people focus on. This is because some things can be dangerous, such as putting their own or someone elseNs life at risk. #isks concern people as they think that they will have a negative effect on their future.

REFERENCES & BIBLIOGRAPHY

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