CHAPTER 1

THE HUMAN RACE AND RISK

From its beginning, the human species has faced the risks of misfortune and adversity. The earliest risk included survival, not only individually, but as a species.

Our continued existence is testimony to the success of our ancestors in dealing with the risks of adversity and misfortune.

Primitive Humans Response to Risk

Some human response to risk were identical with those or other animals. Some risks were avoided instinctively.

Other risks were reduced though the unique gift of human reason.
A distinguish human feature is in the way we deal with risk.

Primitive Response to Risk

Creation of tools- serve as weapon & obtaining food. Banding together- for strength & sharing Saving- which led to private propertydomestication of animal and cultivation.

Evolution of Business Risk

It can be argued that business itself was an effort to deal with risk.

Business and commerce brought new risks, which required new techniques for dealing with them.
Innovations in particular are noteworthy: Money Legal System Other Commercial innovation

Invention of Money
Important implications for commerce, private property, and accumulating wealth. Initially the focus was on preservation and protection of self and tangible property from perils that could cause loss. With introduction of money, tangible assets that were lost or damaged could be replaced if the owner had financial assets.

MONEY- Credit
The invention of credit meant that assets could be acquired every those who did not have financial assets, if someone was willing to lend them money. This in turn, created risks for the lender, which they addressed by the interest charges they made for loans.

The Legal System

Invention of laws was a distinctly human effort to deal with risk. By defining individual rights and responsibilities, the legal system created a framework whose basic function was to protect those rights.

Other Commercial Innovations

3000BC Chinese merchants shared risk by distributing goods among each other boats. (methods of risk sharing) Code of Hammurabi (1800BC) Made provision for transfer of the risk of loss from merchants to moneylenders. Borrower was excused from repayment. Babylonian moneylenders undoubtedly loaded their interest charges to compensate for this transfer risk.

Other Commercial Innovations

Loan forgiveness Provisions Loan-forgiveness was adapted to risks of sea trade by Phoenicians and by Greeks. Loans to ship-owners with the ship pledged as security were called bottomy contracts. General Average (900BC) Developed by seafarers from the island of Rhodes as a method of sharing risk.

GROWTH OF BUSINESS RISK

Industrial revolution witnessed the application of steam to the production process, and with steam came new risks. Early steam engines were hazardous devices and explosions were common. Also caused injury to workers and eventually led to system of workers compensation.

Risk of the Modern Business Environment

Many of the risk facing business today were unknown a generation ago. Some of these new risks arise from changes in the legal environment o Environment damage o Discrimination in employment o Sexual harassment o Violence in the workplace Other risks accompanied the emergence of the age of information technology.

THE CONCEPT OF RISK

The basic problem with which risk management deals. Risk management theorist have not been able to agree on a definition of risk. Definition of risk differ from one discipline to another.
INDETERMINACY at least two possible outcomes ADVERSITY at least one of the outcomes is undesirable

Common element in definition of risk

DEFINITION OF RISK
RISK is a condition in which there is the possibility of an adverse deviation from a desired deviation from a desired outcome that is expected or hoped for.

Fact about RISK:

Risk is not subjective- a state of the real

world
Risk can exist whether or not it is perceived Risk can be imagined where possibility of

UNCERTAINTY AND ITS RELATIONSHIP TO RISK

The most widely held meaning of uncertainty refers to a state of mind characterized by doubt. It is contrasted with certainty, as in: o I am certain I will get an A in this course o I am uncertain what grade I am going to get

THE DEGREE OF RISK

The degree of risk is related to the likelihood of occurrence.

High probability of loss entitled to be riskier than those with a low probability.
The degree of risk is measured by the probability of the adverse deviation. Varies with the probability of deviation: From what is expected in case of aggregate data From what is hoped for in case of individual

RISK DISTINGUISHED FROM PERIL & HAZARD

The terms peril and hazard are often used interchangeably with each other and with risk:

HAZARD
A condition that creates or increases the chance of loss

PERIL
The cause of loss

CLASSIFICATION OF HAZARD
1) PHYSICAL HAZARD Consist of those physical properties that increase the chance of loss from the various perils.

2) MORAL HAZARD
Refers to the increase in the probability of loss which results from evil tendencies in the character of the person.

3) MORALE HAZARD
Result from the careless attitude towards the occurrence of losses.

4) LEGAL HAZARD
Refers to the increase in the frequency and severity of loss that arises from legal doctrines enacted by legislatures and create by the courts.

CLASSIFICATION OF RISK
1) Financial and Non-Financial
2) Static and Dynamic 3) Fundamental and particular

4) Pure and Speculative

CLASSIFICATION OF RISK
i. Financial and Non-financial risk Financial risk involves 3 elements which are individual/organization who exposed to loss, the asset income whose destruction and peril that can cause the loss. This adversity sometimes involves fin loss and sometimes not.

ii. Static and Dynamic Risks Static risk would exist even in the absence of economic change (from perils of nature/dishonesty) Dynamic risks result from changes in the economy (e.g: changes in price levels, consumer taste, income

iii. Fundamental and Particular Risks Fundamental risks are impersonal in origin and consequences. They are societal risks. It is held that society rather than individual should deal with them. Particular risks involve losses that arises out of individual events are felt by individuals rather than the entire group. Particular risk are considered the individuals own responsibility that are property addressed by the individual. iv. Pure and Speculative Risks Pure risks involves the possibility of loss or no loss only. Speculative risks involves the possibility of loss or gain. They are voluntarily accepted because of the possibility

CLASSIFICATION OF PURE RISK

The nature of the various pure risks can be classified as:
PERSONAL RISKS
Loss of ability to earn income

PROPERTY RISKS
Direct/indirect

LIABILITY RISKS

RISK ARISING OUT OF FAILURE OF OTHERS

THE BURDEN OF RISK

a) Some losses will occur

b) The cost of accumulated reserves

c) Deterrent effect on capital accumulation d) Higher cost of capital e) Feeling of frustration and mental unrest

TECHNIQUES FOR DEALING WITH RISK

Several methods of dealing with risks are:
Risk Avoidance refuse to accept. Risk Reduction loss prevention/control and law of large numbers. Risk Retention conscious/unconscious, voluntary/involuntary Risk Transfer to someone willing to accept. Risk Sharing transfer and retention

BUSSINESS RISK MANAGEMENT

Some people suggest that risk management is superfluous and even counterproductive to the interest of corporate owners. Although the argument focuses on insurance, insurance is an alternative to other risk management methods. The argument that businesses thought not insure is, in effect, an argument that risk management is unnecessary.

Diversification As a Solution For Pure Risk

Capital asset pricing model (CAPM) suggests that the value of a firm is equal to the discounted (present value) projected flow of income it will generate for its owners. According to the CAPM, sophisticated investors will require a higher rate of return for stocks that carry a higher degree of risk. Sophisticated investprs do not consider diversifiable risk and such risks therefore do not affect a stocks rate of return. Because investors can diversify asset holdings, they require a risk premium only for systematic risk (nondiversifiable).

Diversification and Pure Risk

Systematic or market risk are priced, but diversifiable risk is not. Therefore, reducing risk at the corporate level which are diversifiable at the portfolio level does not benefit stockholders. In theory, stockholders can deal with pure risks in the same way as speculative risks, through diversification. Purchase of insurance by a corporation reduces the return to stockholders by more than the reduction in risk.

Diversification and Pure Risk

The impact of risk on the firms projected cash flows stems from the effect of risk on the variety of constituencies with which the firm must deal. o Suppliers o Customers o Employees The higher the risks facing a firm, the less likely that suppliers will offer preferential terms. Customer become reluctant to deal with a firm when they perceive that it has excessive risk and might face distress in the future.

ORGANIZATION RISK CATEGORIES

STRATEGIC RISK BUSINESS/FINANCIAL RISK PROJECT RISK OPERATIONAL RISK TECHNOLOGICAL RISK

QUESTIONS TO PONDER