Chapter 2 Fundamentals of Price Risk

1. Chapter 2Fundamentals of Price Risk

2. Uncertainty versus Risk • 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. • Price Risk • Measuring price risk is a measure of uncertainty.

3. Measuring Price Risk • 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)

4. Measuring Price Risk (continued) • 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. • The mean value is the parameter of choice for most risk measurements.

5. Distribution • 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)

6. Distribution (continued) • 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.

7. Price Risk Management • This active process incorporates an action-consequence thought procedure. • Three major initial actions are involved: • acceptance • neutralizing • transference

8. 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. • 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 • Managers must have good knowledge of their markets to actively accept risks.

9. Neutralizing • 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.

10. Transference • 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.

11. Psychology of Risk Management • 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.

12. Attitudes toward Risk • 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.

13. 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. • 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?

14. A Final Word about Risk • 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.