January 3, 2011
Financial Risk Management
Unit IA Notes
Page 1 of 17
D. M. Chance, LSU
CONCEPTS OF RISK MANAGEMENT
This 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.
pension funds, and government agencies typically cannot afford this type of expertise.
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.
episode 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.
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
Risk deals with unexpected outcomes, defined obviously as those that occur that were
Ironically, if we know there is risk, we know that an unexpected outcome is the
most likely result.
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
But some events have only bad outcomes and a few have only