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An in-depth exploration into individual and firms’ attitudes toward risk appears in Chapter 3 "Risk Attitudes: Expected Utility Theory and Demand for Hedging". Here we touch upon this important subject, since it is key to understanding behavior associated with risk management activities. The following box illustrates risk as a psychological process. Different people have different attitudes toward the risk-return tradeoff. People are risk averseRefers to shying away from risks and preferring to have as much security and certainty as is reasonably affordable. when they shy away from risks and prefer to have as much security and certainty as is reasonably affordable in order to lower their discomfort level. They would be willing to pay extra to have the security of knowing that unpleasant risks would be removed from their lives. Economists and risk management professionals consider most people to be risk averse. So, why do people invest in the stock market where they confront the possibility of losing everything? Perhaps they are also seeking the highest value possible for their pensions and savings and believe that losses may not be pervasive—very much unlike the situation in the fall of 2008.
A risk seekerSomeone who will enter into an endeavor as long as a positive long run return on the money is possible, however unlikely., on the other hand, is not simply the person who hopes to maximize the value of retirement investments by investing the stock market. Much like a gambler, a risk seeker is someone who will enter into an endeavor (such as blackjack card games or slot machine gambling) as long as a positive long run return on the money is possible, however unlikely.
Finally, an entity is said to be risk neutralWhen one’s risk preference lies between the extremes of risk averse and risk seeking. when its risk preference lies in between these two extremes. Risk neutral individuals will not pay extra to have the risk transferred to someone else, nor will they pay to engage in a risky endeavor. To them, money is money. They don’t pay for insurance, nor will they gamble. Economists consider most widely held or publicly traded corporations as making decisions in a risk-neutral manner since their shareholders have the ability to diversify away riskTo take actions that are seemingly not related or have opposite effects or to invest in many possible unrelated products or entities such that the impact of any one event decreases the overall risk.—to take actions that seemingly are not related or have opposite effects, or to invest in many possible unrelated products or entities such that the impact of any one event decreases the overall risk. Risks that the corporation might choose to transfer remain for diversification. In the fall of 2008, everyone felt like a gambler. This emphasizes just how fluidly risk lies on a continuum like that in Figure 1.3 "Roles (Objectives) Underlying the Definition of Risk". Financial theories and research pay attention to the nature of the behavior of firms in their pursuit to maximize value. Most theories agree that firms work within risk limits to ensure they do not “go broke.” In the following box we provide a brief discussion of people’s attitudes toward risk. A more elaborate discussion can be found in Chapter 3 "Risk Attitudes: Expected Utility Theory and Demand for Hedging".
Early in our lives, while protected by our parents, we enjoy security. But imagine yourself as your parents (if you can) during the first years of your life. A game called “Risk Balls” was created to illustrate tangibly how we handle and transfer risk.Etti G. Baranoff, “The Risk Balls Game: Transforming Risk and Insurance Into Tangible Concept,” Risk Management & Insurance Review 4, no. 2 (2001): 51–59. See, for example, Figure 1.4 "Risk Balls" below. The balls represent risks, such as dying prematurely, losing a home to fire, or losing one’s ability to earn an income because of illness or injury. Risk balls bring the abstract and fortuitousA matter of chance. (accidental or governed by chance) nature of risk into a more tangible context. If you held these balls, you would want to dispose of them as soon as you possibly could. One way to dispose of risks (represented by these risk balls) is by transferring the risk to insurance companies or other firms that specialize in accepting risks. We will cover the benefits of transferring risk in many chapters of this text.
Right now, we focus on the risk itself. What do you actually feel when you hold the risk balls? Most likely, your answer would be, “insecurity and uneasiness.” We associate risks with fears. A person who is risk averse—that is, a “normal person” who shies away from risk and prefers to have as much security and certainty as possible—would wish to lower the level of fear. Professionals consider most of us risk averse. We sleep better at night when we can transfer risk to the capital market. The capital market usually appears to us as an insurance company or the community at large.
As risk-averse individuals, we will often pay in excess of the expected cost just to achieve some certainty about the future. When we pay an insurance premium, for example, we forgo wealth in exchange for an insurer’s promise to pay covered losses. Some risk transfer professionals refer to premiums as an exchange of a certain loss (the premium) for uncertain losses that may cause us to lose sleep. One important aspect of this kind of exchange: premiums are larger than are expected losses. Those who are willing to pay only the average loss as a premium would be considered risk neutral. Someone who accepts risk at less than the average loss, perhaps even paying to add risk—such as through gambling—is a risk seeker.
Figure 1.4 Risk Balls