Basic Concepts of

Risk
What is Risk?
Potential variation in outcomes
Exposure to a potential loss
Dispersion of unexpected outcomes due to movements
in financial variables (Jorion)
Volatility of unexpected outcomes, generally the value of
assets or liabilities of interest (Jorion)
Volatility of returns leading to unexpected losses
(CGM)
Risk for a profit-making organization is defined as the
unexpected financial loss due to the existence of
downside probability of firms business related activities.
(Louis Cheng)
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Risk Concepts
Uncertainty
Possibility of undesirable outcomes
Probability How likely is it that some risky event will
actually occur?
Volatility Variability of potential outcomes
Exposure
Created whenever an act or circumstance gives rise to possible
gain or loss that cannot be predicted with certainty
Maximum amount of damage that will be suffered if some event
occurs
Horizon
The time period relating to the risk being considered
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Risk Concepts (contd)
Risk Factors
Variables causing volatility in returns
Loss Frequency / Loss Severity
Expected loss
Expected vs. Unexpected Loss (or Cost)

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Outcomes of $1 & $100 Coin
Tosses
$1 Coin Toss $100 Coin Toss
Outcome Probability Outcome Probability

Head +$1 0.5 +$100 0.5

Tail -$1 0.5 -$100 0.5
Probability of loss 0.5 0.5
Expected value $0 $0

Which bet is more risky?

Attitude toward risk will influence reactions of
people.

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Definition of Risk Management
A set of tools and process that deal with defining risks,
measurement of the risks, and managing over the risks.

Organization Risk Management (ORM) A general

management function that seeks to identify, assess and
address the causes and effects of uncertainty and risk
on an organization
The purpose is to enable an organization to progress toward its
goals and objectives in the most direct, efficient and effective
path.

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Definition of Risk Management
(contd)
A general management function, for a profit-making
organization, which helps to preserve firms feasibility in
pursuing profit and market value maximizations by
measuring & controlling risks, and by minimizing the
negative impacts due to the necessary speculative and
pure risks undertaken by the organization (L. Cheng)

Really about how firms actively select the type and level
of risk that it is appropriate for them to assume (CGM)

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Risk Management Process