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RISK MANAGEMENT

RISK MANAGEMENT

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RISK MANAGEMENT

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  1. RISK MANAGEMENT • DIVERSIFICATION • MARKETING ALTERNATIVES • FLEXIBILITY • CREDIT RESERVES • INSURANCE

  2. DIVERSIFICATION • IT MAY BE POSSIBLE TO REDUCE THE TOTAL VARIABILITY OF RETURNS BY COMBINING SEVERAL ASSETS, ENTERPRISES, OR INCOME-GENERATING ACTIVITIES WITHOUT UNDULY SACRIFICING EXPECTED RETURNS.

  3. HOLDING A COMBINATION OF INVESTMENTS IS CALLED DIVERSIFICATION • A PORTFOLIO REFERS TO A MIX OR COMBINATION OF ASSETS, ENTERPRISES, OR INVESTMENTS

  4. LETS LOOK AT AN EXAMPLE OF DIVERSIFICATION AN INVESTOR IS EVALUATING TWO FARM UNITS, ONE LOCATED IN THE CORN BELT AND THE OTHER LOCATED IN THE GREAT PLAINS. EACH FARM HAS AN EXPECTED RETURN ON ASSETS OF 20% AND A STANDARD DEVIATION OF RETURNS OF 10%

  5. THEREFORE, THE INVESTOR WOULD BE INDIFFERENT BETWEEN THE TWO FARMS. HOWEVER, SINCE THE TWO FARMS ARE LOCATED IN DIFFERENT REGIONS AND HAVE A DIFFERENT MIX OF ENTERPRISES A COMBINATION OF INVESTMENT IN THE TWO FARMS MIGHT PROVIDE AN ADVANTAGE IN RISK

  6. THE PORTFOLIO MODEL • A PORTFOLIO'S EXPECTED RETURN IS THE WEIGHTED AVERAGE OF THE INDIVIDUAL EXPECTED RETURNS WEIGHTED BY THE PERCENT OF INVESTMENT IN EACH RT = r1 P1 + r2 P1

  7. A PORTFOLIO'S TOTAL VARIANCE IS THE SUM OF THE INDIVIDUAL PROPORTIONAL VARIANCES PLUS (OR MINUS) THE COVARIANCE σT2 = σ12P1 2 + σ22P2 2 + 2P1 P2 c σ1σ2 σ1

  8. WHERE: RT IS THE PORTFOLIO EXPECTED RETURN ri IS THE EXPECTED RETURN FOR EACH INVESTMENT Pi IS THE PROPORTION OF INVESTED IN EACH INVESTMENT σT2 IS THE PORTFOLIO VARIANCE σi IS THE STANDARD DEVIATION FOR EACH INVESTMENT c IS THE CORRELATION COEFFICIENT BETWEEN RETURNS FOR EACH INVESTMENT.

  9. IF WE ASSUME THAT THE PROPORTION INVESTED IN EACH FARM IS 50% AND THE CORRELATION BETWEEN RETURNS IS 0.5 WHAT WOULD BE THE PORTFOLIO EXPECTED RETURN AND STANDARD DEVIATION?

  10. THE EXPECTED PORTFOLIO RETURN WOULD BE: RT = (0.20)(0.5) + (0.20)(0.5) = 0.20

  11. THE EXPECTED PORTFOLIO VARIANCE WOULD BE: σT2 = (0.10)2(0.50)2 + (0.10)2(0.50)2 + 2 (0.50) (0.50) (0.50) (0.10) (0.10) = (0.0025) + (0.0025) + (0.0025) = 0.0075 σT= 0.0866 or 8.66%

  12. THE KEY COMPONENT WITH REGARD TO CONSTRUCTING A PORTFOLIO THAT REDUCES RISK WHILE MAINTAINING RETURN IS THE CORRELATION COEFFICIENT BETWEEN RETURNS FOR THE INVESTMENTS

  13. CORRELATION OF RETURNS THE VALUE OF THE CORRELATION COEFFICIENT BETWEEN THE RETURNS OF INVESTMENTS “c” CAN TAKE ON A VALUE BETWEEN -1 ≤ c ≤ 1

  14. PORTFOLIO VARIANCE FOR DIFFERENT VALUES OF “c” c = -1 σT2 = σ12P1 2 + σ22P2 2 - 2P1 P2σ1σ2 c = 0 σT2 = σ12P1 2 + σ22P2 2 c = 1 σT2 = σ12P1 2 + σ22P2 2 + 2P1 P2 σ1σ2

  15. USING THE PREVIOUS EXAMPLE IF c = -1: σT2 = (0.10)2(0.50)2 + (0.10)2(0.50)2 + 2 (0.50) (0.50) (-1.0) (0.10) (0.10) = (0.0025) + (0.0025) - (0.005) = 0.0 σT= 0.0%

  16. USING THE PREVIOUS EXAMPLE IF c = 0: σT2 = (0.10)2(0.50)2 + (0.10)2(0.50)2 + 2 (0.50) (0.50) (0.0) (0.10) (0.10) = (0.0025) + (0.0025) = 0.005 σT= 7.07%

  17. USING THE PREVIOUS EXAMPLE IF c = 1: σT2 = (0.10)2(0.50)2 + (0.10)2(0.50)2 + 2 (0.50) (0.50) (1.0) (0.10) (0.10) = (0.0025) + (0.0025) + 0.005 = 0.01 σT= 10.00%

  18. RISK – RETURN TRADE 0FF Profits G H D E F A B C Risk

  19. WHAT IS TERMED A RISK EFFICIENT SET OF PORTFOLIOS IS COMPOSED OF PORTFOLIOS OF ASSETS THAT MINIMIZE VARIANCE FOR DIFFERENT LEVELS OF EXPECTED RETURNS THE PORTFOLIOS IN THE PRECEDING GRAPH OF THE RISK-RETURN TRADE OFF ILLUSTRATES THE CONCEPT OF RISK EFFICIENCY

  20. PORTFOLIO “A” DOMINATES PORTFOLIO “C” FOR RETURN AND PORTFOLIO “B” FOR RISK PORTFOLIOS “A” “D” “G” AND “H” REPRESENT PORTFOLIOS THAT LIE ON THE RISK EFFICIENT FRONTIER WHICH GIVES THE HIGHEST RETURN FOR A GIVEN LEVEL OF RISK

  21. ENTERPRISE DIVERSIFICATION IN AGRICULTURE DIVERSIFYING AMONG SEVERAL FARM ENTERPRISES AND EVEN BETWEEN FARM AND NON-FARM ACTIVITIES IS A TRADITIONAL APPROACH TO RISK MANAGEMENT IN AGRICULTURE

  22. THIS TYPE OF DIVERSIFICATION IS BASED ON THE PREMISE THAT THERE IS A LOW OR NEGATIVE CORRELATION OF RETURNS AMONG SOME ENTERPRISES THAT WILL STABILIZE TOTAL RETURNS OVER TIME.

  23. A CONSIDERATION WITH ENTERPRISE DIVERSIFICATION IS THE LOSS OF EFFICIENCIES AND RETURNS THAT MAY BE DERIVED FROM SPECIALIZATION.

  24. MARKETING ALTERNATIVES THE USE OF HEDGING, OPTIONS, AND FORWARD CONTRACTING ARE TOOLS THAT CAN BE USED TO MANAGE RISK FOR BOTH OUTPUT PRICES AND INPUT PRICES. MARKETING POOLS, SUCH AS THE PCCA COTTON MARKETING POOL, CAN ALSO PROVIDE A USEFUL MARKETING ALTERNATIVE.

  25. FLEXIBILITY FLEXIBILITY IN A BUSINESS ORGANIZATION ENABLES THE MANAGER TO RESPOND MORE QUICKLY AS NEW INFORMATION BECOMES AVAILABLE TO THE FIRM.

  26. FLEXIBILITY DOES NOT DIRECTLY REDUCE RISK, BUT PROVIDES A MEANS OF COPING WITH RISK. EXAMPLES OF FLEXIBILITY ARE: • REDUCING FIXED COSTS RELATIVE TO VARIABLE COSTS. • CHOOSING NONSPECIFIC RESOURCES IN PLACE OF SPECIFIC RESOURCES. • MANAGERS THAT ARE WILLING TO MAKE CHANGES WHEN NEEDED OR AS CONDITIONS WARRANT

  27. FLEXIBILITY HAS SOME OF THE SAME PROBLEMS AS WITH DIVERSIFICATION IN THAT BEING FLEXIBLE MAY ENTAIL LESS SPECIALIZATION AND THE GAINS IN EFFICIENCIES.

  28. CREDIT RESERVES • A CREDIT RESERVE IS A SOURCE OF LIQUIDITY. • A FIRM’S CREDIT RESERVE IS REPRESENTED BY ITS UNUSED BORROWING CAPACITY. • THE DIFFERENCE BETWEEN THE MAXIMUM AMOUNT OF POTENTIAL BORROWING AND THE AMOUNT ALREADY BORROWED IS THE CREDIT RESERVE.

  29. IN GENERAL, CREDIT IS CONSIDERED A HIGHLY EFFICIENT WAY TO PROVIDE LIQUIDITY. • USING CREDIT DOES NOT DISTURB A FIRM’S BASIC ASSET STRUCTURE AND PRODUCTION ORGANIZATION. • TRANSACTIONS COSTS OF CREDIT ARE RELATIVELY LOW. • CREDIT IS GENERALLY AVAILABLE.

  30. INSURANCE • INSURANCE PROVIDES A SPECIALIZED FORM OF LIQUIDITY, INSTEAD OF RESERVING CASH, SAVINGS OR CREDIT TO COUNTER LOSSES DUE TO EVENTS SUCH AS HAIL OR CAUSALITY LOSS • INSURANCE PROTECTS AN ASSET OR FLOW OF INCOME AGAINST THE OCCURRENCE OF SPECIFIED EVENTS.

  31. INSURANCE PROTECTS AN ASSET OR FLOW OF INCOME AGAINST THE OCCURRENCE OF SPECIFIED EVENTS.