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Chapter 2
Fundamentals of
Price Risk
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Uncertainty versus Risk
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Uncertainty can be managed when identified
as a risk.
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.
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Price Risk
– Measuring price risk is a measure of uncertainty.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Measuring Price Risk
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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)
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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 price impacts the mean.
– An outlier price does not impact the median.
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The mean value is the parameter of choice for
most risk measurements.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Distribution
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Variance is the other major parameter of the distribution.
Standard deviation is the square root of the variance.
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).
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)
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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 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
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This active process incorporates an actionconsequence thought procedure.
Three major initial actions are involved:
– acceptance
– neutralizing
– transference
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Acceptance
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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.
Two categories of acceptance exist:
– naïve—no management, no knowledge of outcome
– active—full knowledge of the uncertainty of the outcomes
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Managers must have good knowledge of their
markets to actively accept risks.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Neutralizing
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To neutralize a price risk is to remove it
completely.
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
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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.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Psychology of Risk Management
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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.
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
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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 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.
– 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
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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:
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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
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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.
The process of trying to understand risk more
fully is worth the effort.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation