RISK MANAGEMENT MODELS

Risk Theory and Risk Management Models

Risk Theory and Risk Management Models

Task 1

Risk Theory

Risk is part of life for most people, although it comes to the forefront in certain situations, such as financial decisions and business management decisions. Risk may be unavoidable, but the decision between various options, each of which offers a different level of risk and a different potential reward, can have a significant impact on the outcome, especially if someone uses the same selection methods over an extended time (Whaley, 2006, 44-55).

Risk theory is the body of psychology and economics that studies why people avoid certain risks and instead choose low-risk options that have smaller possible rewards. Economists study behavioral trends to determine when and why people make risk-averse choices. Psychologists engage in studies in which they subject participants to decision-making scenarios and gauge the results over large groups. In each case, simple mathematics reveal the statistical value of each risk or option, which may or may not reflect real-world and test results (Jarrow, 2009, 1- 32).

Example

A classic example of risk theory is a conventional double-or-nothing proposition. Testers will tell participants each has won $100. However, each person may choose to keep the $100 or enter into a wager where a coin flip decides between doubling the $100 to $200 or losing everything. Because of the 50 percent odds for each outcome, the expected result of the risk is $100, (half of all participants will lose everything, half will double their money, for an average of no change), which is the same as the guaranteed result of not taking the wager. Risk-averse individuals are those who choose not to take the wager (Whaley, 2006, 44-55).

Applications

Risk theory applies to many types of decisions. One is investing, where individuals and businesses must choose between various levels of risk and potential rewards. A risk-averse decision would be to buy bonds or place money in fixed-income securities with a low, but guaranteed, payout. A less risk-averse strategy involves buying stock, with a high potential upside but the risk of losing a great deal of value should the share price fall. Business leaders also face decisions that risk theory could analyze when they select a business plan or negotiate with another business (Roco, 2006, 123-129).

It does suggest that investors, business leaders and anyone else who faces decisions about risk should carefully weigh the true likelihood of risks and the values of potential outcomes before making a decision. Risk-averse individuals may make consistently conservative choices without realizing they are operating in a risk-averse way. At the same time, investors who are aware of risk aversion and go out of their way to avoid it may take unnecessary or unreasonable risks.

Risk Management Models

The 2007 credit crisis was a wake-up call with respect to model usage. It has been alleged that the misuse of risk management models helped to generate the crisis.

In numerous cases, models used wrongly by the financial industry prior to the 2007 credit crisis, and some are still being misused ...