RSK2601
NOTES
,TOPIC 1: DEFINITION AND CLASSIFICATION OF RISK
Study unit 1: What is risk?
1. Defining risk?
• Risk is the deviation or variability of actual results from desired or expected results
• The principle in the business world is -that if risk increases, the possible return that is desired will also increase.
• Risk management consists of three distinct dimensions:
o Generating and utilizing opportunities in situations where a business has distinct advantages in
accomplishing beneficial results with improved chances of success (upside management)
o Introducing controls to prevent or restrain losses as a result of the constraints posed by the operating
environment of the business (downside management)
o Exercising methods and techniques to reduce the variance between anticipated financial outcomes and
actual results (uncertainty management)
2. Risk and uncertainty?
• Uncertainty arises from a person's imperfect state of knowledge about future events.
• Perceived uncertainty : depends on information that person can use to evaluate the likelihood of outcomes and the
ability to evaluate this information
• Uncertainty consists of the following two elements:
o uncertainty whether an event will take place
o if the event does occur what the outcome thereof will be
• The definition of risk as the deviation of an actual outcome from the expected result or outcome implies the
following:
o Uncertainty surrounds the outcome of the event. The decision maker is uncertain about the outcome, and
the actual outcome may therefore deviate from the expected outcome. If the outcome was certain and
only one outcome was possible, there would be no uncertainty and no deviation from the expected result
and therefore no risk for the decision maker.
o The degree of uncertainty surrounding the event determines the level of risk. The more uncertain the
decision maker is, firstly, about whether the event will take place, and secondly, of what the outcome will
be, the greater the possible deviation of the actual from the expected result.
o The degree of risk can therefore be interpreted in terms of the frequency with which an event will occur
and the probability that it will display a particular outcome. This event represents the deviation from the
expected outcome.
• The following summarises our discussion of risk:
o Risk is the deviation of the actual from the expected result.
o Risk implies the presence of uncertainty.
o There may be uncertainty about the occurrence of an event and uncertainty about its outcome.
o The degree of risk is calculated as the frequency with which an event, namely the deviation from the
expected outcome, occurs and the probability that it will display this particular outcome.
,3. The theory of probability and how it can be applied to risk management?
The degree of risk depends on the frequency with which an event occurs and the probability that it will display a certain
outcome.
The probability of an event occurring refers to its long-term frequency of occurrence.
All events have a probability of between 0 and 1.
Formula : chance of occurrence
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑐𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑒𝑠 (𝑛𝑜 𝑜𝑓 𝑐𝑎𝑟𝑠 𝑑𝑎𝑚𝑎𝑔𝑒𝑑)
𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑜𝑠𝑠𝑖𝑏𝑙𝑒 𝑜𝑢𝑡𝑐𝑜𝑚𝑒𝑠 (𝑡𝑜𝑡𝑎𝑙 𝑐𝑎𝑟𝑠 𝑖𝑛 𝑓𝑙𝑒𝑒𝑡)
• Probabilities have the following two basic properties:
o The number of successes cannot be more than the number of possible outcomes. Therefore the maximum
value of P is 1.
o The number of successes cannot be a negative value. Therefore the minimum value of P is 0.
If all possible events (or outcomes) are listed and a probability is assigned to each event, the listing is called a probability
distribution.
3.1 Probability distributions
3.1.1 Measures of central tendency
3.1.2 Measures of variation
3.1.2.1 Standard deviation
To calculate the standard deviation:
Step 1: Calculate the expected value .Bear in mind that the calculation of the expected value is only required in
circumstances where the probabilities of the possible outcomes differ and the expected value will therefore differ from the
mean. Where the probabilities do not differ, only the mean needs to be calculated because its value will be the same as the
expected value.
Step 2: Subtract the expected value from each of the possible outcomes.
Step 3: Square the resulting difference.
Step 4: Sum the squared differences.
Step 5: Divide the sum by the total number of measurements (probabilities) to obtain the variance.
Step 6: Calculate the square root of the variance. This is the standard deviation.
Deviation from Squared Square root of
Outcome Rainfall in mm Probability Calculate Expected value Expected value expected value deviation Veriance Variance
Step? 1 2 3 4=3x2 result of step 4 Step 2 - Step4r times 2
A 700 0.10 70 455 245 60 025
B 600 0.15 90 455 145 21 025
C 500 0.20 100 455 45 2 025
D 400 0.30 120 455 -55 3 025
E 300 0.25 75 455 -155 24 025
MEAN (or AVG) 500
Expected Value (Total) 455 TOTAL 110 125 22 025 148,41
3.1.2.2 Coefficient of variation:
The coefficient of variation is a measure of relative dispersion that is useful in comparing the risk of probability
distributions with differing expected returns.
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒
The higher the coefficient of variation, the greater the risk will be.
, Study unit 2: Classification of risks
1. Introduction
2. Enterprise objectives and sources of risks
• Factors such as consumer tastes or changes in government regulation may, increase the uncertainty of the future
demand for a company's products whereas capital market fluctuations may lead to unexpected increases in the
cost of finance, thereby increasing the variability in shareholders' returns.
• Examples of sources of risk:
o short-term sales fluctuations
o changes in consumer tastes
o changes in technology
o changes in government policy
o changes in competitor's strategy
o changes in the structure of an organisation
o changes in organisational membership
o changes in suppliers' ability to provide purchasing organisations with the required quantity of inputs
o environmental disasters that may disrupt production or demolish assets
o changes in the economic environment - escalating interest rates for organisations making use of loans
o an increase in a business's number and/or type of competitors
3. Classification of risks
• two broad categories:
• speculative - are risks that offer a chance of gain or loss - example, a reduction in interest rates will be to the
advantage of an enterprise that borrows money.
• may be treated by techniques such as hedging.
• event risks - concern the possibility of loss only, possibility of loss of an enterprise's plant and equipment due
to a fire.
• often mitigated by risk management techniques such as insurance
• risk in a corporate environment can be subdivided into four categories:
o core business risks
o incidental business risks
o operational risks
o external downside risks
3.1. Speculative risks
3.1.1. Core business risks
• Core business risks include all the activities, decisions and events which impact directly on an organisation's
operating profit.
• These risks are inherent in the organisation's
• Main business and are reflected in the mission statement.
• Cause fluctuations in profit and ultimately the earnings of the ordinary shareholder.
• For example of core business risks of a manufacturing enterprise:
o raw material prices
o demand for the products of the enterprise
o variability of costs
• Core business risks of a bank:
o interest rate fluctuations
o demand for the products/services of the bank
o variability of costs
NOTES
,TOPIC 1: DEFINITION AND CLASSIFICATION OF RISK
Study unit 1: What is risk?
1. Defining risk?
• Risk is the deviation or variability of actual results from desired or expected results
• The principle in the business world is -that if risk increases, the possible return that is desired will also increase.
• Risk management consists of three distinct dimensions:
o Generating and utilizing opportunities in situations where a business has distinct advantages in
accomplishing beneficial results with improved chances of success (upside management)
o Introducing controls to prevent or restrain losses as a result of the constraints posed by the operating
environment of the business (downside management)
o Exercising methods and techniques to reduce the variance between anticipated financial outcomes and
actual results (uncertainty management)
2. Risk and uncertainty?
• Uncertainty arises from a person's imperfect state of knowledge about future events.
• Perceived uncertainty : depends on information that person can use to evaluate the likelihood of outcomes and the
ability to evaluate this information
• Uncertainty consists of the following two elements:
o uncertainty whether an event will take place
o if the event does occur what the outcome thereof will be
• The definition of risk as the deviation of an actual outcome from the expected result or outcome implies the
following:
o Uncertainty surrounds the outcome of the event. The decision maker is uncertain about the outcome, and
the actual outcome may therefore deviate from the expected outcome. If the outcome was certain and
only one outcome was possible, there would be no uncertainty and no deviation from the expected result
and therefore no risk for the decision maker.
o The degree of uncertainty surrounding the event determines the level of risk. The more uncertain the
decision maker is, firstly, about whether the event will take place, and secondly, of what the outcome will
be, the greater the possible deviation of the actual from the expected result.
o The degree of risk can therefore be interpreted in terms of the frequency with which an event will occur
and the probability that it will display a particular outcome. This event represents the deviation from the
expected outcome.
• The following summarises our discussion of risk:
o Risk is the deviation of the actual from the expected result.
o Risk implies the presence of uncertainty.
o There may be uncertainty about the occurrence of an event and uncertainty about its outcome.
o The degree of risk is calculated as the frequency with which an event, namely the deviation from the
expected outcome, occurs and the probability that it will display this particular outcome.
,3. The theory of probability and how it can be applied to risk management?
The degree of risk depends on the frequency with which an event occurs and the probability that it will display a certain
outcome.
The probability of an event occurring refers to its long-term frequency of occurrence.
All events have a probability of between 0 and 1.
Formula : chance of occurrence
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑐𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑒𝑠 (𝑛𝑜 𝑜𝑓 𝑐𝑎𝑟𝑠 𝑑𝑎𝑚𝑎𝑔𝑒𝑑)
𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑜𝑠𝑠𝑖𝑏𝑙𝑒 𝑜𝑢𝑡𝑐𝑜𝑚𝑒𝑠 (𝑡𝑜𝑡𝑎𝑙 𝑐𝑎𝑟𝑠 𝑖𝑛 𝑓𝑙𝑒𝑒𝑡)
• Probabilities have the following two basic properties:
o The number of successes cannot be more than the number of possible outcomes. Therefore the maximum
value of P is 1.
o The number of successes cannot be a negative value. Therefore the minimum value of P is 0.
If all possible events (or outcomes) are listed and a probability is assigned to each event, the listing is called a probability
distribution.
3.1 Probability distributions
3.1.1 Measures of central tendency
3.1.2 Measures of variation
3.1.2.1 Standard deviation
To calculate the standard deviation:
Step 1: Calculate the expected value .Bear in mind that the calculation of the expected value is only required in
circumstances where the probabilities of the possible outcomes differ and the expected value will therefore differ from the
mean. Where the probabilities do not differ, only the mean needs to be calculated because its value will be the same as the
expected value.
Step 2: Subtract the expected value from each of the possible outcomes.
Step 3: Square the resulting difference.
Step 4: Sum the squared differences.
Step 5: Divide the sum by the total number of measurements (probabilities) to obtain the variance.
Step 6: Calculate the square root of the variance. This is the standard deviation.
Deviation from Squared Square root of
Outcome Rainfall in mm Probability Calculate Expected value Expected value expected value deviation Veriance Variance
Step? 1 2 3 4=3x2 result of step 4 Step 2 - Step4r times 2
A 700 0.10 70 455 245 60 025
B 600 0.15 90 455 145 21 025
C 500 0.20 100 455 45 2 025
D 400 0.30 120 455 -55 3 025
E 300 0.25 75 455 -155 24 025
MEAN (or AVG) 500
Expected Value (Total) 455 TOTAL 110 125 22 025 148,41
3.1.2.2 Coefficient of variation:
The coefficient of variation is a measure of relative dispersion that is useful in comparing the risk of probability
distributions with differing expected returns.
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒
The higher the coefficient of variation, the greater the risk will be.
, Study unit 2: Classification of risks
1. Introduction
2. Enterprise objectives and sources of risks
• Factors such as consumer tastes or changes in government regulation may, increase the uncertainty of the future
demand for a company's products whereas capital market fluctuations may lead to unexpected increases in the
cost of finance, thereby increasing the variability in shareholders' returns.
• Examples of sources of risk:
o short-term sales fluctuations
o changes in consumer tastes
o changes in technology
o changes in government policy
o changes in competitor's strategy
o changes in the structure of an organisation
o changes in organisational membership
o changes in suppliers' ability to provide purchasing organisations with the required quantity of inputs
o environmental disasters that may disrupt production or demolish assets
o changes in the economic environment - escalating interest rates for organisations making use of loans
o an increase in a business's number and/or type of competitors
3. Classification of risks
• two broad categories:
• speculative - are risks that offer a chance of gain or loss - example, a reduction in interest rates will be to the
advantage of an enterprise that borrows money.
• may be treated by techniques such as hedging.
• event risks - concern the possibility of loss only, possibility of loss of an enterprise's plant and equipment due
to a fire.
• often mitigated by risk management techniques such as insurance
• risk in a corporate environment can be subdivided into four categories:
o core business risks
o incidental business risks
o operational risks
o external downside risks
3.1. Speculative risks
3.1.1. Core business risks
• Core business risks include all the activities, decisions and events which impact directly on an organisation's
operating profit.
• These risks are inherent in the organisation's
• Main business and are reflected in the mission statement.
• Cause fluctuations in profit and ultimately the earnings of the ordinary shareholder.
• For example of core business risks of a manufacturing enterprise:
o raw material prices
o demand for the products of the enterprise
o variability of costs
• Core business risks of a bank:
o interest rate fluctuations
o demand for the products/services of the bank
o variability of costs
