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Risk Management, NO, YES - Coggle Diagram
Risk Management
Corporate Risk
Definition: The exposure of a company's earnings, cash flows, or market value to uncertain external factors or events
What is Risk: Uncertainty being the difference from what was expected. Risk is often measured as a standard deviation of outcomes. Standard deviation is the square root of variance. Variance is the total risk.
Sources
Market Risk
Price movements in financial markets such as interest rates, exchange rates and commodity price risks. This usually can be handled by using financial derivatives or other financial contracts but not all types of risk cannot be managed.
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External event risks
Not firm specific risk. Stems from market events such as natural catastrophe or changes in regulation. This type of risk can be managed using insurance policies.
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Risk Management
Tries to reduce the uncertainty associated with future outcomes. Ideally, removes bad outcomes without affecting good outcomes. This is similar to options that gives us the ability to cut losses where the future payoff gets bounded at zero
The process:
- Risk Identification
- Risk Assessment
- Selection of appropriate risk management techniques
- Implementation and Monitoring
The Overall Goal is To Increase Firm Value
How do firms manage risk
Value-at-risk
Attempt to quantify the downside risk.
Its a number than says what a bad loss means.
VAR of 1 mil over the next day at probability of 0.05 means that there is a 5% chance that there will be a loss of $1 mil.
Financial institutions use this to identify how much capital is needed to handle the p% tile bad outcome. For example what's the 3% VAR means, whats the value for which there will be a loss with a probability of 3%.
Risk Management Tools
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Hedging
Buy and hold one asset and sell an offsetting amount of another asset (one is real and the other is financial).
Hedging is costly, so you do as little. Therefore we try to hedge net exposure than each individual exposure.
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