Figure 1 What is risk?
Risk is uncertainty. An uncertain outcome requires planning to manage the downside. Risk management is the field that specializes in managing the downside of uncertain outcomes.
Just like any other business process, risk management requires a combination of intuition and common sense mixed with the right processes and controls.
Why do you need it? Even if you are not a large bank or hedge fund manager, you still need to think about risk? In fact you are tuned to think about risk at an intuitive level, it is only when we extend that intuition that we land in trouble.
What is risk? Why should I care
Do you really need risk management as an individual, as a professional or a business owner? Think about an important desired outcome. Like making a business appointment on time. To ensure you are not late (negative outcome ), you will look up directions (preparation ) and leave a little early (prevention ) so that you can reach the meeting on time (desired outcome ) or a little early (preferred outcome ).
If you are stuck in traffic (uncertainty ), you will look at alternate routes (management ) or call ahead (hedging ) to let your client know (managing expectations ). The next time you head in the same direction you will adjust your behavior (learning and adaptability ) based on how long it took you to finally get to your destination. If you make the same trip on a daily basis, your behavioral adjustments will fine tune themselves using average, likely and unlikely conditions (data set and probabilities) .
What if you are manufacture, trader and supplier of good. Apply the same principles to locking in costs before input prices rise. If you run the sales function how do you ensure revenues meet the year end quota even if average unit sale prices fall? These are all applications of risk management at an intuitive level. The science is just one step ahead.
What is risk? Price volatility
Risk Management is not just about banks, financial services and hedge funds. Prices go up and down. It’s a fact of life. Once upon a time they used to move in reasonable ranges. Ranges that were factored in when you drew your budget. Today prices move abruptly and without notice without caring for budgets, quota, reasonable historical behavior or economic impact.
Price changes are measured
through volatility, a fancy term for standard deviation. Are markets today more volatile? It certainly feels that way. Probably because the speed with which markets are beginning to move and the reaction time of traders to news. However if you are a non-trader married to price volatility as a buyer, seller, inventory holder your reaction time when it comes to managing price risk is simply not fast enough. But it is not just price risk that suffers from volatility; volatility has many facets:
- Oil price volatility
- Exchange rate volatility
- Fuel price volatility
- Production input price volatility
- Payroll cost inflation
- Transaction costs
- delivery times
- production lags
Unfortunately volatility doesn’t work in isolation. Which makes it difficult to work with and manage. Here is a simple example that works through the impact of change in crude oil prices and your PnL
Figure 2 What is risk? The cascading waterfall impact of one risk factor on PnL
What is Risk? Understanding Risk & Risk management.
Figure 3 What is risk? Risk management planning
The right time to manage risk is not when a full blown risk related crisis is brewing. It is when there is still time to think through your reaction and pick the most suitable options available to you. A good risk management plan takes into consideration possible scenarios and appropriate reactions and then get a mandate from the board to execute on those reactions if ever such a need arises. A great risk management plan goes one step further and validates and tests all assumptions and fall backs if assumptions break down during the crisis.
What is risk? Risk assessment checklist
There is a simple risk assessment checklist for businesses based on risk common sense index. The common sense index quickly walks through the most common risk faced by non financial businesses.
Figure 4 Risk assessment checklist
Of the above, price risk is only aspect. The rest (concentration, liquidity, counterparty, strategy & execution risks) are associated with business decisions made by managers and owners that should be evaluated on a regular basis using
What is Risk? A collection of class notes & lectures on risk management
To begin working with risk we first need to better understand the following risk management themes.
What is Risk? Commodity Price Forecasting Applications