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INTRODUCTION TO RISK MANAGEMENT

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Title: INTRODUCTION TO RISK MANAGEMENT


1
INTRODUCTIONTORISK MANAGEMENT
2
WHAT IS RISK?
3
DEFINITIONS I
  • Arabic - Fortuitous and favorable.
  • Greek - Fortuitous and neither favorable nor
    unfavorable.
  • Latin (risicum) - the challenge that a barrier
    reef presents to a sailor.
  • French (risque) - mainly negative connotation,
    but sometimes positive.
  • Oxford Dictionary - ... the chance of hazard,
    bad consequences, loss, etc....

4
DEFINITIONS II
  • Economic risk - the chance of loss due to .
  • Business risk - the chance of loss
    associated with
  • Market risk - the chance that a portfolio
    of investments can lose
    money because..
  • Inflation risk - the danger that a general
    increase in prices ...
  • Interest-rate risk - market risk due to interest
    rate fluctuations
  • Credit risk - the chance that of a
    default on a loan ...
  • Liquidity risk - the difficulty in selling
    a fixed asset ...
  • Derivative risk - the chance of financial loss
    due to increased volatility .
  • Cultural risk - the chance of loss because
    of product market ..

CHANCE Random Occurrence
BAD CONSEQUENCE Sense of Loss
Hirschey Pappas, Fundamentals of Managerial
Economics Dryden Press, 1998
5
A LITTLE BIT OF PROBABILITY
6
PROBABILITY
  • Its a number its JUST A NUMBER!
  • Its a number between 0 and 1 ( 0 P 1)
  • It quantifies the likelihood of an event
  • Its a function of experience, judgment,
    subjective assessment, available data
  • Its uses all information you think is relevant
    to the determination of the likelihood of
    occurrence of an event

7
Probability Rules
  • Probability 0 if never/impossible
  • Probability 1 if always/certain
  • If we are collectively exhaustive and
  • mutually exclusive then
  • the probabilities over the outocmes
  • SUM to 1.

8
Probability Rules
  • If mutually exclusive then
  • P(A or B) P(A) P(B)
  • If independent
  • P(A and B) P(A) x P(B)

9
Probability from Data
  • Given data we can always derive approximate
    probabilities using relative frequency.
  • Relative frequency can be used as an estimate of
    the probability of the observed value
  • Taken all together, these can represent the
    underlying PROBABILITY DISTRUBUTION FUNCTION

10
Earthquakes
11
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12
Frequency Table
How Big?
How Many?
Richter Scale Number of Earthquakes
1.5 R lt 2.5 474
2.5 R lt 3.5 240
3.5 R lt 4.5 158
4.5 R lt 5.5 65
5.5 R lt 6.5 38
6.5 R lt 7.5 20
7.5 R lt 8.5 4
8.5 R lt 9.5 1
13
Relative Frequency Table
How Big?
How Many?
Richter Scale Number of Earthquakes
1.5 R lt 2.5 0.474
2.5 R lt 3.5 0.240
3.5 R lt 4.5 0.158
4.5 R lt 5.5 0.065
5.5 R lt 6.5 0.038
6.5 R lt 7.5 0.020
7.5 R lt 8.5 0.004
8.5 R lt 9.5 0.001
14
Relative Frequency Histogram
0.50
0.474
0.45
0.40
0.35
0.30
0.240
0.25
0.20
0.158
0.15
0.10
0.065
0.05
0.038
0.020
0.004
0.001
0.00
1.5 - 2.5)
2.5 - 3.5)
3.5 - 4.5)
4.5 - 5.5)
5.5 - 6.5)
6.5 - 7.5)
7.5 - 8.5)
8.5 - 9.5)
15
Prob. of an event proportion of observations
that corresponds to the event
percent of observations that corresponds
to the event
portion of area of histogram that
corresponds to the event
16
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17
AN INVESTMENT DECISION
  • Planning for retirement
  • Two options for investment
  • Each has a track record, the historical
    rates-of-return over a specified time period
  • Each can be used to compute various statistics
    e.g., average rate-of-return, etc.

18
AN INVESTMENT DECISION
Expected Value
Std. Dev.
Variance
A1
5.00
1.25
1.5625
A2
5.70
2.75
7.5625
19
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20
Whats the likelihood of ?
r lt 0
I dont want a rate of return lt 0!
I want a rate of return gt 0!
Whats the likelihood of ?
r lt 0
21
THE FREQUENCY HISTOGRAM( The KEY to it ALL )
  • The relative frequency histogram over the
    outcomes contains all relevant information.
  • This information allows us to quantify risk.
  • This is provides our most powerful tool for risk
    management.

22
A QUANTITATIVE DEFINITION OF RISK
23
A QUANTITATIVE DEFINITION OF RISK
Risk is a COMBINATION of the answers to three
questions (1) What can go wrong? (2) How
likely is it to go wrong? (3) If it does go
wrong, what are the consequences?
Adapted from S. Kaplan and B. John Garrick, On
the Quantitative Definition of Risk, Risk
Analysis, Vol.1, no.1, 1981
24
EXAMPLE Hinterland Illegal Immigration
recession depression economic collapse
What can go wrong?
chances are 1 in a 10 a 10 chance PF .10
How likely is it to go wrong?
large numbers of illegal immigrants increasing
crime failing social services social unrest
If it does go wrong, what happens to Drmecia?
25
A QUANTITATIVE DEFINITION OF RISK
What can go wrong?
How likely is it to go wrong?
If it does go wrong, what are the consequences?
26
THE ANSWER TO THE FIRST QUESTION
1. It all starts with the future scenario, F.
2. The F is uncertain so we need probability, PF.
3. F causes a result, an outcome of concern, Y.
4. Y is a function of F. We need to know this
relation! The relation between Y and F is
uncertain!!!
27
BEGINNING MIDDLE END
F ? X ? Y
THE SYSTEM
F1, F2, ? X1 then X2 then ? Y1, Y2,
28
EXAMPLE Hinterland Illegal Immigration
Illegal immigration is proportional to the ratio
of per capita GDP.
GDPD/popD GDPH/popH
Y
illegal immigration
G. H. Hanson (2009), The Economics and Policy of
Illegal Immigration in the U.S., Washington,
D.C. Migration Policy Institute
29
THE ANSWER TO THE SECOND QUESTION
THE SYSTEM
SIMULATION MODELING
30
THE ANSWER TO THE SECOND QUESTIONPY
31
THE ANSWER TO THE THIRD QUESTION
What number of illegal immigrants do you most
want to avoid? 10000 100000 1000000 10000000
20000000.
HOW YOU FEEL (about the possible Y)
PREFERENCE
What outcome do you most prefer to avoid minor
economic strain substantial strain or collapse
of government social/educational services?
32
THE ANSWER TO THE THIRD QUESTION
1. It all starts with the future scenario, F.
2. The F is uncertain so we need probability, PF.
3. F causes a result, an outcome of concern, Y.
4. Y is a function of F. Given PF we can derive
PY
5. How do you feel about the probable outcomes?
Do you prefer to avoid some Y more than other
Y?
33
THE ANSWER TO THE THIRD QUESTION
  • Preferences lt gt value function lt gt v(Y)
  • (1) v(Y) gt 0 if Y is good
  • (2) v(Y) lt 0 if Y is bad
  • Value Function Charcteristics
  • reference point defining GAINS from LOSSES
  • (2) loss aversion losses MORE IMPORTANT than
    GAINS
  • (3) decreasing marginal values

34
v(Y)
Illegal Immigration
35
A QUANTITATIVE DEFINITION OF RISK
1. It all starts with the future scenario, F.
2. The F is uncertain so we need probability, PF.
3. F causes a result, an outcome of concern, Y.
4. Y is a function of F. Given PF we can derive
PY
5. Your preference info, v(Y), is the LAST PIECE!
defines the consequences!
36
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37
Hinterland Economy Collapse
Prob. of Economic Collapse
Prob. Dist. Illegal Immigrants
Number of Illegal Immigrants
How does Drmecia feel about the Y?
38
SPECIAL CASE OF PREFERENCE
v(Y)
Y
39
SPECIAL CASE OF PREFERENCE
v(Y)
Y
I cant bear the thought of experiencing loss!
In the limit the weight we assign to all outcomes
ltgt a loss tends to - 8. In this case risk is
very simple to quantify risk.
Experiencing loss would be a catastrophe!
40
ASSESSING THE RISK
PY
-

v(Y)
41
ASSESSING THE RISK
PY
v(Y)
42
ASSESSING THE RISK
PY
v(Y)
43
ASSESSING THE RISK (SPECIAL CASE)
RISK P Y correspond to loss
RISK P Y reference point
RISK P unacceptable Y
RISK P Y you prefer to avoid
44
Who uses this stuff?.......
OVERALL C-RATING System for Readiness C-1 MAE
gt 89 Pnot capable 0.11 C-2
MAE 80-89 0.11 Pnot capable 0.20 C-3
MAE 70-79 0.21 Pnot capable 0.30 C-4
MAE 50-69 0.31 Pnot capable 0.50 C-5
MAE lt 50 0.50 Pnot capable
Senate Armed Services Committee, terminology used
in arguments before the committee, Feb. 1997
AR 220 1 (2010), AFI 10-201 (2006), SORTS (US
Department of Defense)
45
A QUANTITATIVE APPROACH TO RISK MANAGEMENT
46
The History of Risk Management
  • 1950 B.C. Code of Hamurabi formalization of
    bottomry contracts containing a risk premium for
    chance of loss of ships and cargo.
  • 750 B.C. Greece the use of bottomry
    contracts.
  • 1285 A.D. King Edward - forbids use of soft
    coal in kilns to manage air pollution in
    London.
  • 1583 A.D. 1st life insurance policy issued in
    England.
  • 19th and 20th century water and garbage
    sanitation, building codes, fire codes, boiler
    inspections, railroads, steamboats, autos.
  • 1959 A.D. H. Markowitz, stock portfolio
    diversification.

47
RISK MANAGEMENT PROCESS
What can go wrong F? What is F and PF?
Identify Risks
Assess Risks
What are the outcomes Y, and PY? What are the
consequences, v(Y)? What is the risk
quantified?
Prevent Mitigate Negotiate
Implement Monitor
Management Action
48
Tools of Risk Management
  • Prevention.
  • Mitigation.
  • Hedging.
  • Diversification.

49
ASSESSING THE RISK
Definition depends on a reference point.
National policy often specifies a reference point.
Not everyone has the same reference point.
THE RISK CURVE
Why not plot P Y y versus y, for any y ?
50
Determining the Outcome Distribution
  • theoretical derivation
  • direct assessment
  • simulation

Generating your own data
51
EARTHQUAKES
52
P Total Cost y
1.00
0.652
0.11
0.012
0.002
0.00
53
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54
A1 Do Nothing
A2 New Building Codes
A3 Retro-Fit New Codes
55
P Total Cost x
The RISK CURVES compared
56
A1 (red)
A2 (blue)
A3 (green)
57
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58
ACCEPTABLE RISK
The perennial question free people ask with
regard to defense is How much is enough? To
this there can be no precise answer. A countrys
security is a function of the DEGREE OF RISK
A COUNTRY IS WILLING TO ACCEPT.
Hitch McKean, The Economics of Defense in the
Nuclear Age, Atheneum, 1986
59
ACCEPTABLE RISK
Risk
Too Risky
Acceptable Risk
Proposed Budget
Required Budget
Cost
60
Who uses this stuff?.......
Ultimately, policy makers must decide how much
the United States is willing to pay to lower the
risks associated with de-ploying forces abroad.
But some might argue that defense planners
occasionally focus on absolute requirements the
minimum number of forces that they believe will
meet DoDs military needs without fully
weighing the relative risks and costs of
alternative levels.
Moving U.S. Forces Options for Strategic
Mobility Congressional Budget Office, Feb. 1997
61
Who uses this stuff?.......
Our armed forces remain capable, within an
acceptable level of risk, of meeting the demands
of our strategy.
Maj. Gen. John J. Maher, Vice Director for
Operations, Joint Staff testimony before House
National Security readiness subcommittee, Feb.
1997
62
Who uses this stuff?.......
Computer security is basically risk management.
. Managers have to decide what they are trying
to protect and how much they are willing to
spend, both in cost and convenience, to defend
it.
Stephen H. Wildstrom, review of the book Secrets
and Lies by Bruce Schneier, Businessweek Sept.
2000
63
Who uses this stuff?.......
we continue to believe the federal government
can benefit from risk management.
. An effective risk management approach
includes a threat assessment, a vulnerability
assessment and a criticality assessment ...
Raymond J. Decker, Director, Defense Capabilities
and Management, GAO, Testimony before the Senate
Committee on Governmental Affairs Oct. 2001
64
RISK MANAGEMENT
Risk
old
Cost
65
RISK MANAGEMENT
Risk
Proposed Budget
Cost
66
RISK MANAGEMENT
Risk
Acceptable Risk
Cost
67
APPLICATION I ENTERPRISE BUSINESS RISK
68
P .02
Error
P(uncorrected) 0.1
Reconciliation Check
P(corrected) 0.9
P .18
P(error) 0.2
Correct
Data Entry
P(correct) 0.8
P .80
Correct
SECNAV M-5200.35 March 2007
69
DIR.
Define Needs, prepare Purchase Requisition Form
Forward to ASA
End User
INDIR.
Forward to SPFA
NO
YES
ASA reviews PR, confirms funds, obtains approval
Admin. Support
YES
SPFA assigns PR number and form to PA
Sponsored Program
SPFA Reviews PR
NO
Purchase Agent
70
Clarify requirements with end user
End User
ASA /OA will Assign req., number and task
Purchaser
Admin. Support
Sponsored Program
NO
Screen request for mandatory sources of supply,
prohibited or special items, and authority to buy
YES
Purchaser reviews for completeness of
documentation
Purchase Agent
71
Receive ordered items and sign acknowledging
STOP
End User
Admin. Support
Sponsored Program
YES
Place order with source, direct delivery point,
and provide estimated delivery date
NO
Receive order (if delivery point)
Reconcile with vendor
Purchase Agent
72
P .6561
What can go wrong?
NO ERROR
0.9
How likely is it to go wrong?
Receipt Review
ERROR
P .1
0.1
0.9
0.1
P .0729
ERROR
ASA
Screen Request
0.9
0.9
0.1
P .081
Reimburse Or Direct Funds
ERROR
Purchaser
0.9
0.1
P .09
ERROR
SPFA
P .3439
P .1
0.1
ERROR
73
P .69255
NO ERROR
0.9
Receipt Review
ERROR
P .05
0.05
0.9
0.1
P .07695
ERROR
ASA
Screen Request
0.9
0.95
0.1
P .0855
Reimburse Or Direct Funds
ERROR
Purchaser
0.95
0.1
P .095
ERROR
SPFA
P .30745
0.05
P .05
ERROR
74
P .8145
NO ERROR
0.95
Receipt Review
ERROR
P .05
0.05
0.95
0.05
P .04287
ERROR
ASA
Screen Request
0.95
0.95
0.05
Reimburse Or Direct Funds
P .0451
ERROR
Purchaser
0.95
0.05
ERROR
P .0475
SPFA
P .1855
0.05
P .05
ERROR
75
P .9606
NO ERROR
0.95
P .01
Receipt Review
ERROR
0.01
0.99
0.01
ERROR
P .009703
ASA
Screen Request
0.99
0.99
0.01
Reimburse Or Direct Funds
ERROR
P .009801
Purchaser
0.99
0.01
ERROR
P .0099
SPFA
P .0394
0.01
ERROR
P .01
76
APPLICATION II COST RISK ASSESSMENT
77
ESTIMATING SHIPBOARD HELICOPTER OM COSTS
Life-cycle cost estimates for the helicopter are
needed. The cost analysis staff is organized
into four groups, one each for the four main
components of the life-cycle cost (1) RD (2)
Procurement (3) Operations and Maintenance and
(4) Salvage/Residual. As leader of the OM cost
estimating group you have decided to use a factor
cost estimates since
  • Relevant OM cost data produce reliable CERs for
    the three components of the OM cost POL, Parts,
    and Other as functions of the procurement
    cost.
  • The helicopter is a recently developed model and
    procurement cost is expected to be 3.7 million
    (/- 3).
  • Why not just use an OM cost factor approach
    annual OM cost 10 of acquisition cost?

78
POL/hr 112.84 30.16 ACQ error
Parts/hr -84.96 57.21 ACQ error
Other/hr 45.21 10.12 ACQ error
79
PROBABILISTIC COST ESTIMATING
y a b x e
80
PROBABILISTIC COST ESTIMATING
y a b x e
81
PROBABILISTIC COST ESTIMATING
?
y a b x e
?
82
CO,MS cPOL cParts cother H
83
164K CO,MS 676
84
164K CO,MS 672
85
158K CO,MS 511
86
190K CO,MS 463K
87
APPLICATION III PROJECT MANAGEMENT
88
FACILITIES FOR THE FLIGHT SIMULATOR
DEPARTMENT(ACTIVITIES, TIME ESTIMATES, AND
DEPENDENCIES)
89
(No Transcript)
90
P 0.482
91
P 0.048
92
SUMMARY
  • RISK is a factor in every decision with
    significant uncertainty
  • RISK is a combination of the answers to 3
    questions
  • what can go wrong?
  • how likely is it to go wrong?
  • if it does go wrong, what are the conse-quences?

93
SUMMARY
  • RISK is quantified using PROBABILITY.
  • use it to express the riskiness an alternative.
  • use it to find the least risky alternative.
  • THINK about the RISK vs COST tradeoff curve.

94
SUMMARY
  • MANAGING RISK requires the information provided
    by the tradeoff curve!
  • THINK about where you want to be on the curve.
  • THINK about changing the tradeoff curve!
  • USE THE MODEL to help find how to change things!

95
(No Transcript)
96
(No Transcript)
97
WHAT ARE THE CONSEQUENCES?(Subjective Valuation
of the Outcomes)
v(Y)
()
Outcome illegals
BAD
WORSE
GOOD
BETTER
WOW
(-)
98
ASSESSING THE RISK v(Y)
GAIN
LOSS
Reference Point Aspiration Level (Goal or
Constraint)
99
APPLICATION V HOMELAND SECURITY
100
Homeland Security
Threat Assessment evaluate the likelihood of a
terrorist attack.
Vulnerability Assessment systematically
identify weaknesses in physical structures,
personnel protection, or other areas that may be
exploited.
Criticality Assessment systematically identify
and evaluate important assets in terms of
loss-of-life, damage to economy, damage to
infrastructure, propaganda value, etc.
A Risk Management Approach Can Guide
Preparedness Efforts GAO-02-208T
101
Homeland Security
Reduce the risk and mitigate the consequences of
an attack
PA
PD
102
Homeland Security
Threat Assessment
P(A)
Vulnerability Assessment
P(SA)
Criticality Assessment
D(A,S) ? V(D)
103
Homeland Security
Threat (Measure) probability a specific target
is attacked in a specific way in a specific time
interval.
Vulnerability (Measure) probability that damage
(deaths, property, etc.) occurs, given specific
attack type, at a specific time, at a given
target.
Consequences (Measure) the expected magnitude
of damage (deaths, injuries, property damage,
etc.), given a specific type of attack, at a
specific time, that results in damage to a
specific target.
Estimating Terrorism Risk by H. H. Willis
RAND-MG-388, 2005
104
Homeland Security
Threat Measure
P(A)
Vulnerability Measure
P(SA)
Consequence Measure
E D(A,S)
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