Version: January 3, 2011 FIN 7400: Financial Risk Management Unit IA Notes Page 1 of 17 D. M. Chance, LSU I. CONCEPTS OF RISK MANAGEMENTThis is a course on risk management, primarily financial risk management. It is designed for MBAs’, MS students, and students of accounting, math, statistics, engineering, and economics who want to know more about measuring and managing risk. The course is not designed to make you a risk manager. To do that, you have to study risk at a fairly advanced level and learn a great deal about finance and probability. Banks and major investment firms, which offer risk management products and services, have these types of people on their staffs. Corporations, pension funds, and government agencies typically cannot afford this type of expertise. But increasingly we find that these organizations are being hurt by not managing risk and realizing that they have to start doing it. We know risk management is important and has reached the mainstream when it starts being mentioned in sit-coms. In a Seinfeldepisode called “The Fatigues,” which first aired on October 31, 1996, George Costanza’s boss, New York Yankees Owner George Steinbrenner, asks George C. to give a lecture to the Yankees’ staff on risk management. George C. is no expert but gets a book on risk management and reads a little. He records himself saying some things about risk management into a tape recorder and plays it back: “In order to understand risk, we must first define risk.” So, taking the advice of George Constanza, let’s begin. A. What is Risk?As a general and very simplistic definition: Risk is the potential that an event will have an outcome different from the outcome that is expected to occur.For example, we might expect that •the stock market will go up 10% in a year •we will make a B in this course Each of these outcomes is the result of an event. The actual outcome may differ from what we expect. Risk deals with unexpected outcomes, defined obviously as those that occur that were not expected. Ironically, if we know there is risk, we know that an unexpected outcome is the most likely result. That is, we expect an unexpected outcome. We simply do not know what specific outcome to expect. Some events have outcomes that are both desirable and undesirable. Each of the events above has unexpected outcomes that are both desirable and undesirable. Sometimes this phenomenon is called good riskand bad risk. But some events have only bad outcomes and a few have only
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