• Pre-Loss
• Post-loss

Pre-Loss objectives are addressed to limit or alleviate:

• Inefficiency
• Anxiety
• Legal consequences

Post-Loss objectives are addressed to

• Survival of the firm (resume partial operations)
• Continue regular operations (weather temporary losses)
• Stabilize earnings
• Continued Growth of the firm

• Identify Loss Exposures
• Measure and Analyze the Loss Exposures
• Select appropriate techniques to treat loss exposure
• Implement and Monitor Risk Management Program

Carefully identify all the areas of risk exposure of a particular project. This can be an exhaustive process

• Property
• Liability
• Income
• Crime
• International
• Intellectual Property and Reputation

Estimate and quantify the likelihood of a risk as well as the severity of the loss. Depending on the context, this can be challenging. Need to measure Loss Frequency and Loss Severity.

• Loss frequency Loss severity
• Economics of disasters (low likelihood high damage events) are very difficult to price
• Actuaries have developed complex methods to determine likelihoods of adverse effects (Pure Risks)
• Speculative risks: Value at Risk (VAR)
• Government Social Security Death Tables

Risk Control:

• Avoidance
• Loss Prevention
• Loss Reduction

Measures are taken to avoid certain types of risks:

• Chance of loss is reduced to zero (Move out of flood plain)
• Cost prohibitive

Measures to reduce the frequency of losses

• Training of employees
• Quality control measures (six Sigma)
• Incentives for healthy employees

Measures to reduce the severity of a loss

• Retention (Aware of potential loss but manages risk internally)
• Noninsurance Transfers (Contracts, Hold-Harmless Agreements)
• Commercial Insurance

A matrix table can be used to identify potential risky projects as well as determine which technique should be applied according to the frequency and severity of the risk.

Risk Matrix

• Cooperation with other Department
• Periodic Review and Evaluation

Sunk Costs are costs that have already been incurred and cannot be recovered. Decisions should be made according to future costs and sunk costs should not be considered.

Sunk Cost Fallacy - Sunk costs are taken into account when making decisions because of loss aversion.

• Traditionally risk management in a corporate sense referred to managing pure risks (loss or status quo)
• The last decade of the twentieth century managers started applying risk management techniques to financial risks
• Eventually risk management extends into multiple areas in business

Financial Risk Management - the identification, analysis, and treatment of speculative financial risks. - Commodity Price Risk - Interest Rate Risk - Currency Exchange Rate Risk

Companies that rely on commodities as inputs into production can face considerable risk when commodity prices change.

Examples: - General Mills needs to purchase grains in the production of cereal. Large fluctuations in price can affect the cost of production - Farmers producing agricultural goods - Oil, Electricity, Natural EX: Russian Invasion of Ukraine - Gold, Silver, other precious metals

Organization of the Petroleum Exporting Countries (OPEC) founded in 1960 by:

• Iran
• Iraqfe
• Kuwait
• Saudi Arabia
• Venezuela

OPEC has a history of trying to control production beginning in the 1970’s. Created shortages, massive price spikes, and high inflation. Oil prices fluctuate with political, international conflict, and economic factors.

Derivative Securities: - Futures Contracts are designed to transfer speculative risk from one party to another (Hedge)

• Options Contracts are designed to protect against adverse commodity price movements

In May a farmer is looking to avoid price speculation by selling corn contracts for delivery at the end of the harvest for next December at the current futures price.

• By selling contracts the farmer is able to protect against the spot price of corn declining in the future at the risk that the price will increase.

• By buying contracts the speculator absorbs the commodity price risk. If the spot price in the future increases the speculator is able to profit, while if the spot price in the future declines the speculator receives a loss. The speculator is expecting the spot price to increase relative to the futures price.

• Long Position - Expect Value of the Stock or Asset to Increase Over Time

• Short Position - Expect the Value of the Stock or Asset to Decrease Over Time

• Call Option - Right to buy an asset at some future specified date

• Put Option - Right to sell an asset at some future specified date

The buyer of the option contract pays a premium and then has the option to exercise the option at a predetermined specified date at the specified strike price.

Options as an investment:

• Consider someone who believes the value of a stock will increase. The investor can purchase a call option which gives the owner the right to buy the asset at the strike price. If the price goes up, the investor exercises the option, buys the asset at the lower strike price and immediately sells the asset at the current price. In this case, the price has to increase sufficiently to offset the premium before the option breaks even. Losses are fixed at the premium.

• Consider someone who believes the value of a stock will decline. The investor can purchase a put option which gives the owner the right to sell a stock at the strike price. If the price goes down, the investor buys the stock at the current price and exercises the option to sell those shares at the relatively higher strike price.

Options as a way to reduce speculative market risk:

• Consider an investor who owns an asset and is concerned the price might decline. The investor doesn’t necessarily want to sell the asset.

• Sell a Call Option and collect the premium (Expect the movement in price to be little)

• Purchase a put option with the right to sell the asset at the strike price. If the price declines significantly then the investor can exercise the option. If the price increases, the investor is out the premium but keeps any other gains.

• Protects against downside risk

Interest Rate Risk - Financial institutions are susceptible to adverse interest rate movements. (Similar for retirees on fixed income) Banks could possibly pay more interest on savings deposits than collecting on commercial loans that have locked in for extended time

• Bond prices are inversely related to interest rates.

• Corporate bonds lock in rates and are susceptible to interest rate movements.

• Sunk Cost Argument

Currency Exchange Risk - Changes in the exchange rate that can trigger losses in business operations or increased costs

• A business contracting with international companies can face considerable exchange rate risk
• A business selling international goods similarly faces considerable exchange rate risk
• Futures Contracts
• Options