© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Chapter 2 Fundamentals of Price Risk

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Uncertainty versus Risk Uncertainty can be managed when identified as a risk. Uncertainty can be managed when identified as a risk. The difference lies in the impact of the outcomes. The difference lies in the impact of the outcomes. –Uncertainty is an unknown outcome. –Risk is when the unknown outcome has an impact on the person or business. Price Risk Price Risk –Measuring price risk is a measure of uncertainty.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Measuring Price Risk Probability and Random Variables Probability and Random Variables –Probability is the quantitative measure of uncertainty. Objective probabilities are generated from events that have known values. Subjective probabilities are less certain. –A random variable is a numeric value that occurs by chance—for example, a price. –Probability distribution of the random variable is the result of assigning a probability to each outcome. (continued)

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Measuring Price Risk (continued) Expected value is the sum of the probability of each price occurring times the price. Expected value is the sum of the probability of each price occurring times the price. An outlier is an unusually high or low price. An outlier is an unusually high or low price. –An outlier price impacts the mean. –An outlier price does not impact the median. The mean value is the parameter of choice for most risk measurements. The mean value is the parameter of choice for most risk measurements.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Distribution Variance is the other major parameter of the distribution. Variance is the other major parameter of the distribution. Standard deviation is the square root of the variance. Standard deviation is the square root of the variance. Discrete random variables (e.g., $1.70 to $2.90 at 10-cent intervals). Discrete random variables (e.g., $1.70 to $2.90 at 10-cent intervals). Continuous random variables (e.g., $1.71¾ or $2.31¼ can be price values). Continuous random variables (e.g., $1.71¾ or $2.31¼ can be price values). Normal distribution results from a continuous random variable coupled with a large number of observations over a sufficiently long enough time period. Normal distribution results from a continuous random variable coupled with a large number of observations over a sufficiently long enough time period. –based on having a large amount of data –based on the Central Limit Theorem or the Law of Large Numbers –also called a bell curve (continued)

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Distribution (continued) A continuous distribution will asymptotically approach the axis. A continuous distribution will asymptotically approach the axis. Figure 2-6 shows two normal distributions with the same variance but different means; Figure 2-7 shows the same mean but with two different variances. Figure 2-6 shows two normal distributions with the same variance but different means; Figure 2-7 shows the same mean but with two different variances. Figure 2-6 has identical variability between the two mean values; Figure 2-7 has identical mean values with different variability. Figure 2-6 has identical variability between the two mean values; Figure 2-7 has identical mean values with different variability. –This variability becomes the standard measure of risk— the higher the variance, the higher the degree of risk, and vice versa.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Price Risk Management This active process incorporates an action- consequence thought procedure. This active process incorporates an action- consequence thought procedure. Three major initial actions are involved: Three major initial actions are involved: –acceptance –neutralizing –transference

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Acceptance Acceptance of a price risk is to absorb the full consequence of the uncertainty of the action—which is the most common form of price risk management. Acceptance of a price risk is to absorb the full consequence of the uncertainty of the action—which is the most common form of price risk management. Managers actively accept risk with the full knowledge of the uncertainty of the action. Managers actively accept risk with the full knowledge of the uncertainty of the action. Two categories of acceptance exist: Two categories of acceptance exist: –naïve—no management, no knowledge of outcome –active—full knowledge of the uncertainty of the outcomes Managers must have good knowledge of their markets to actively accept risks. Managers must have good knowledge of their markets to actively accept risks.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Neutralizing To neutralize a price risk is to remove it completely. To neutralize a price risk is to remove it completely. Businesses neutralize risk in three major ways: Businesses neutralize risk in three major ways: –Forward contracts neutralize price risk; uncertainty is replaced by a single price. –Passing the risk to another party. –Tandem actions are taken to mitigate the effect— for example, variable priced loans and the interest rate on deposits.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Transference This is done by transferring or shifting the risk of price change in one market to another— commonly called hedging. This is done by transferring or shifting the risk of price change in one market to another— commonly called hedging. Futures and options contracts are the most common tools used to transfer the risk of cash prices changing. Futures and options contracts are the most common tools used to transfer the risk of cash prices changing.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Psychology of Risk Management Managers attitudes about price risk influence the way the way they handle risk. Managers attitudes about price risk influence the way the way they handle risk. Behavioral finance or behavioral economics— the idea that a dollar is not always a dollar— puts a greater emphasis on opportunity costs. Behavioral finance or behavioral economics— the idea that a dollar is not always a dollar— puts a greater emphasis on opportunity costs. The human mind dose not view all events the same or always rationally; it is very important that price risk managers know how they feel about price risk. The human mind dose not view all events the same or always rationally; it is very important that price risk managers know how they feel about price risk.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Attitudes toward Risk Three attitudes: averse, neutral, or enthusiast. Three attitudes: averse, neutral, or enthusiast. A price risk averse person will attempt to manage risk; opts for financial gain that has the highest probability of occurring. A price risk averse person will attempt to manage risk; opts for financial gain that has the highest probability of occurring. A risk neutral person will be indifferent, no matter the combination of probabilities and returns. A risk neutral person will be indifferent, no matter the combination of probabilities and returns. A risk lover (enthusiast) embraces the risk; opts for higher return with a lower probability. A risk lover (enthusiast) embraces the risk; opts for higher return with a lower probability. –Individuals may have all three attitudes, but at different times and for different events. –It is difficult to quantify an individual’s attitude.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Developing a Risk and Mitigation Profile Determine what risks exist in a business, and determine whether or not those risks can be mitigated and how. Determine what risks exist in a business, and determine whether or not those risks can be mitigated and how. Elements to a Risk and Mitigation Profile: Elements to a Risk and Mitigation Profile: –What are the risks? –Can the risks be mitigated? –How can the risks be mitigated? –What are the costs and benefits? –Do I want to mitigate the risks?

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation A Final Word about Risk It is difficult to define what risk is in general and almost impossible for each individual situation. It is difficult to define what risk is in general and almost impossible for each individual situation. Risk can be recognized and defined by individuals for their own situations or business situations. Risk can be recognized and defined by individuals for their own situations or business situations. The process of trying to understand risk more fully is worth the effort. The process of trying to understand risk more fully is worth the effort.