Computer Simulation in Financial Risk Management: A Guide for Business Planners and Strategists

By Roy L. Nersesian | Go to book overview

buyers and sellers interacting with one another. A market made up of only sellers is not a market. Therefore, the collateral value protecting mortgages on homes does not decline, but disappears. The appraised value of a house when there are no buyers is fictitious.

Thus a problem in the oil field becomes a problem for everyone in real estate. It becomes a problem for merchants who sell their wares to those involved in the oil industry and in the real estate business. It becomes a problem for those who run the municipal government when they cannot collect property taxes from those whose livelihoods depend on the oil industry, real estate, and local businesses. Then it becomes a problem for school teachers who are laid off because the school budget has to be cut back to balance the municipal budget. Finally, it becomes a problem for the financial institutions who have lent money to individuals and businesses that are being wiped out by the downturn in oil prices. Therefore, everyone is affected by the collapse in oil prices even though their paychecks are not actually written by companies in the oil business.

It is interesting to note that individuals and firms under financial pressure may take on an unusual degree of risk at the very time when they should not be doing so. An individual without a job and with $10,000 cash might not keep that money in a safe 5 percent savings account. With the prospects of employment being nil, the individual might be tempted to invest that money in a highly risky venture. If he leaves the nest egg alone, he can calculate to the minute when he will be unable to feed his family. He is not that much worse off if he risks the money in some sort of venture that only has a remote chance of success. If the venture goes bust, he merely files bankruptcy earlier than anticipated. If the venture is a success, he has survived the financial holocaust.

Corporations do the same thing. There is no reason why corporations should behave any differently than individuals because corporations are run by individuals. Corporations which sense the writing on the wall may take on very risky undertakings for the same reason. Doing nothing does not delay the inevitability of liquidation. Plunging into risky undertakings at least has the prospect of avoiding the inevitable.


APPENDIX

Two programs are used to generate the exhibits shown in this chapter. The LOSSES program generates a simulator for a thousand years of losses and the PREMIUM program determines an appropriate risk premium to address these losses. A more general purpose program can be written to measure the performance of different sets of rules in adjusting the premium rate and various levels of loan loss reserves to arrive at an optimal choice of a set of rules and a desired level of reserves.


LOSSES

This program simulates the losses inherent in a portfolio of one thousand loans. The SIMTWO program is run twice to generate the two tables in the chapter concerning the

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