22-2) Suppose that company A and company B are identical in all respects
except that company A is twice the size of company B, which firm would you
expect to buy insurance? Briefly explain.
Company B would be likely to purchase more insurance for several

Value at Risk (VaR)
Basic idea: Measure the magnitude of the possible loss on
a portfolio over the some given time period
Popularized by JP Morgan in early 1990s
Riskmetrics
Example: Suppose a portfolio worth $200 million has a
0.01 probability of los

Tax Effects of Risk Reduction
Main tax benefits from risk reduction arise for four
reasons:
Progressivity in tax rates
Different tax treatment of insurers and noninsurance firms
Tax treatment of depreciated property
Risk reduction allows for greater

Objective of Corporate Risk Management
Objective:
Maximize Value to Shareholders
Question:
Does reducing risk increase
equity value?
Two notions of risk
Probability or severity of a bad outcome (expected
loss)
Ch. 20
Uncertainty (variability) about

Converting Monthly Returns to Annual Returns
Let
Rt = uncertain annual return in year t
rt = uncertain monthly return in month t
If you invest $1 at beginning of year 2015, at the end of the year
you will have
(1 + R2015 ) = (1+r1)(1+r2)(1+r3) (1+r12)
Mat

Determinants of Insurance Premiums
In a competitive market, the premium charged by insurers
would equal their expected costs, including a fair return to
capital
The premium that covers expected costs is known as the Fair
Premium
4 Determinants of Fair

What is meaning of term Risk?
When is a situation risky?
Uncertainty
Our approach:
When the outcome is not certain, we will say there
is risk
Ch. 1&2
Two Useful Notions of Risk
2 Common & Useful Ways that People think of Risk
A situation is riskier

What is Enterprise Risk
Management?
Focus:
On the overall risk of the enterprise &
On the main sources of risk that threaten the value of the
enterprise
Requires identifying and assessing all the enterprise's major risks
Requires communication across

Characteristics of Probability Distributions
Instead of comparing entire distributions,
managers often work with characteristics of
probability distributions:
Expected value
Standard deviation or variance
Skewness
Percentile values
Then ask: How doe

Outline of Concepts you need to Know
Random variable
Probability distributions
Discrete vs. continuous random variables
Objective vs. subjective
Where do probability distributions come from?
Characteristics of probability distributions
Expected val

Outline of Concepts you need to Know
Random variable
Probability distributions
Discrete vs. continuous random variables
Objective vs. subjective
Where do probability distributions come from?
Characteristics of probability distributions
Expected val

Common Characteristics of ART
Products
Alternative risk transfer (ART) refers to non-traditional
insurance products
ART products often contain one or more of the following:
High level of retention
Spans multiple years
Involves multiple sources of risk
C

Hedging Using Derivatives
Important part of modern risk management
Examples of the types of risk that are hedged
commodity prices
interest rates
exchange rates
A derivative is a contract that has a payoff that is
derived from some underlying index o

Credit Risk (Counterparty Risk)
What is credit risk?
Probability of one party defaulting
Uncertainty associated with the payments (actual
payments can differ from expected payments)
What happens to the value of a bond as credit risk
increases?
Credit

Cost of Carry Model
Model that identifies the factors that affect the
forward (futures) price on a forward (futures) contract
Assumptions:
No taxes, no transactions costs
One-year forward contract exists
Physical settlement
Forward price = F (this is wh

Reducing the Risk of Supply Chain
Disruptions
Examples of Disruptions
AEP Case - coal
Thailand floods in 2011 hard drives
Japanese tsunami in 2011 auto parts
Focus in supply chains has been on efficiency
Getting inputs just in time
Utilizing low co

Rational RM Decision Making
Process
(1) Identification of risks
What are the variables that can affect objectives (firm value)?
(2) Assess the risk
(3) Evaluate impact of alternative RM treatments
Insurance , hedging , mitigation, contingency plans
(4)

Rational RM Decision Making
Process
(1) Identification of risks
What are the variables that can affect objectives (firm value)?
(2) Assess the risk
(3) Evaluate impact of alternative RM treatments
Insurance , hedging , mitigation , CONTINGENCY PLANS
(4

ERM at Hydro One
Risk workshops with many employee groups to
develop a collective understanding of the
companys key objectives and risks that threaten
achieving those objectives
CRO interviewed senior managers to review risk
profile
Allocated resources

Name: _Solutions_
Section: 2:20 or 3:55
Finance 444
Midterm 1 Spring 2014
You have 75 minutes to complete the exam. Good luck.
1.
(20 points)
EDN Corp currently has $200 million of assets; 40% is invested in Fund A and 60% is invested in
Fund B. You have

Contract RM: Surety, Guarantees,
Indemnities
Contract Risk Mgmt.
Two Parties agree to a contract (e.g., supply a product,
build a building):
Promissor, principal
Promisee, creditor, beneficiary
A Surety bears responsibility for the fulfillment of the

Leadership and Risk Culture
The ability to manage risk is the crucible of a
leaders effectiveness.
Effective Leaders create
What is culture?
Shared assumptions, values, beliefs, behavioral norms
How things are done
What behaviors is rewarded and san

Name: _
Section: 2:20 or 3:55
Finance 444
Midterm 1 Spring 2014
You have 75 minutes to complete the exam. Good luck.
1.
(20 points)
EDN Corp currently has $200 million of assets; 40% is invested in Fund A and 60% is invested in
Fund B. You have been hired

Variance Minimizing Hedge
Assume
Revenue is fixed (e.g., $30 million)
Quantity of input, Q, is fixed (e.g., 0.5 million barrels of oil)
Price of input, P, is uncertain
Forward contract with underlying = Pc
Forward price = F (e.g., $50)
Size of the hedge

Exposure Diagrams Revisited
The Relation between Oil Prices and NeedOils Cash Flows
Cash Flow = 30 - 0.5 Poil
Cash
Flow
$10
$5
$0
$40
Derivatives
$50
$60
Possible oil prices in six
months in New Orleans
for the grade of oil
NeedOil uses ($/barrel)
Hedgin

Quiz
1. Yes or No:
Would you accept a gamble that offers
a 10% probability to win $95
a 90% probability to lose $5
2. Yes or No:
Would you pay $5 to play a game that offers
a 10% probability to $100
a 90% probability to win nothing
Biases in Decision

Relationships between Random Variables
In many situations (models), there are
multiple random variables
Therefore, we need to understand how
random variables are related to one another
Covariance
Correlation coefficients
Review Prob Distributions
Cova

Cost of Carry Model
Model that identifies the factors that affect the forward
(futures) price on a forward (futures) contract
Assumptions:
No taxes, no transactions costs
One-year forward contract exists t think of everything
as a one year time period

Variance Minimizing Hedge
Assume
Revenue is fixed (e.g., $30 million)
Quantity of input, Q, is fixed (e.g., 0.5 million barrels of oil)
Price of input, P, is uncertain
Forward contract with underlying = Pc
Forward price = F (e.g., $50)
Size of the hedge