Risk Management 02046Copyright

Unlock access to all the studying documents.

View Full Document

02-046

Working papers are in draft form. This working paper is distributed for purposes of

comment and

discussion only. It may not be reproduced without permission of the copyright holder.

Copies of working

papers are available from the author.

Integrated Risk

Management for the

Firm: A Senior

Manager Guide

Lisa K. Meulbroek

Harvard Business School

Soldiers Field Road

Boston,MA 02163

The author gratefully acknowledges the financial support of Harvard Business

School Division of Research. Email: Lmeulbroek@hbs.edu

Abstract

This paper is intended as a risk management primer for senior managers. It discusses the

integrated risk management framework, emphasizing the connections between the three

fundamental ways a company can implement its risk management objectives: modifying

the firm operations, adjusting its capital structure, and employing targeted financial

instruments. Integration refers both to the combination of these three risk management

techniques, and to the aggregation of all risks faced by the firm. The paper offers a

functional analysis of integrated risk management using a wide set of illustrative

situations to show how the risk management process influences, and is influenced by, the

overall business activities and the strategy of the firm. Finally, the paper provides a risk

management framework for formulating and designing a risk management system for the

firm, concluding with a perspective on the future evolution of risk management.

Introduction

Managers have always attempted to measure and control the risks within their companies.

The enormous growth and development in financial and electronic technologies,

however, have enriched the palette of risk management techniques available to managers,

offering an important new opportunity for increasing shareholder value. Integrated risk

management is the identification and assessment of the collective risks that affect firm

value, and the implementation of a firm-wide strategy to manage those risks. For some

managers, risk management immediately evokes thoughts of derivatives, and

strategies that magnify, not reduce, risk. Derivatives, as a risk management tool, are only

a small part of the integrated risk management process. Moreover, a proper risk

management strategy does not involve speculation, or betting on the future price of oil,

corn, currencies, or interest rates, and indeed is antithetical to such speculation. Instead,

the goal of integrated risk management is to maximize value by shaping the firm risk

profile, shedding some risks, while retaining others.

Companies have three fundamental ways of implementing risk management objectives:

modifying the firm operations, adjusting its capital structure, and employing targeted

financial instruments (including derivatives). Integration refers both to the

combination of these three risk management techniques, and to the aggregation of all the

risks faced by the firm. While managers have always practiced some form of risk

management, implicit or explicit, in the past, risk management was rarely undertaken in a

systematic and integrated fashion across the firm. Integrated risk management has only

recently become a practical possibility, because of the enormous improvements in

computer and other communications technologies, and because of the wide-ranging set of

financial instruments and markets that have evolved over the past decade. A sophisticated

and globally-tested legal and accounting infrastructure is now in place to support the use

of such contractual agreements on large scale and at low cost. Equal in importance to this

evolution in capital markets is the cumulative experience and success in applying modern

finance theory to the practice of risk management. Today, managers can analyze and

control various risks as part of a unified, or integrated, risk management policy.

Integrated risk management is by its nature strategic, rather than tactical. Tactical

risk management, currently more common, has a narrower and more limited focus. It

usually involves the hedging of contracts or of other explicit future commitments of the

firm such as interest rate exposures on its debt issues. Consider a U.S. dollar-based firm

that buys steel from a Japanese firm for delivery in three months. The U.S. firm may

decide to tactically hedge the dollar price of its steel purchase. By using forward

currency contracts, the firm locks-in the dollar cost of its steel purchase, offsetting the

effect of dollar-yen exchange rate movements that may occur before delivery and

payment. The treasurer office of the firm typically executes such tactical currency

hedging, which is generally undertaken in a non-integrated fashion without consideration

of other hedging or insuring activities carried out in the firm. This is so even when the

risks across units are significantly correlated. In contrast, strategic currency hedging

addresses the broader question of how exchange rate fluctuations affect the value of the

entire firm. It takes into account how those fluctuations affect the firm competitive

environment, including the pricing of its products, the quantity sold, the costs of its

inputs, and the response of other firms in the same industry.

Exchange rate risk is, of course, only one potential risk a firm faces. Managers using an

integrated risk management approach must depart from the standard practice of viewing

each risk in isolation. Instead, managers must devise a strategy to respond to the full

range of risks a firm faces, taking into account that a risk management policy designed

solely to respond to exchange rate risk may have other, unintended, consequences on the

firm other business operations. This article presents a managerial overview of

integrated risk management, using a series of examples to illustrate the range of

management decisions that it can influence and the benefits for the firm from its

implementation.

By applying integrated risk management, managers will benefit from new insights about

the interplay among different types of risk and traditional financial decision areas,

connections easily missed without a comprehensive framework. Because the three ways

to manage risk are functionally equivalent in their effect on risk, their use connects

seemingly-unrelated managerial decisions. For instance, because capital structure is one

component of a firm risk management strategy, effective capital structure decisions

cannot be made in isolation from the firm other risk management decisions.

Consequently, a firm capital structure choice is inextricably linked to its capital

expenditure plans, along with many other operational decisions. This paper discussion

of the integrated risk management framework emphasizes the connection between the

ternary mechanisms to alter the firm risk profile, and offers guidance on their practical

application.

There are those that question whether firm-wide risk management can add value to the

firm. Certainly in the hypothetical Modigliani-Miller world of corporate finance, neither

capital structure choices nor corporate risk management affects the value of the firm.

Indeed, if there were no value added, then direct expenses and distraction of

management attention would make risk management a negative net-present-value

proposition for the firm. Thus, the next section describes the various ways that risk

management can enhance the value of the firm in the non-frictionless environment of the

real world. With this value-proposition established, I offer a functional analysis of

integrated risk management that uses a wide set of illustrative situations to show how the

risk management process influences, and is influenced by, the overall business activities

and strategy of the firm. Finally, I present an overall managerial framework for

formulating and designing a risk management system for the firm, and conclude by

providing a perspective on the evolution of risk management going forward.

II. How risk management for the firm adds value: Understanding and measuring its

benefits

A cascade of basic decisions about objectives faces the manager who seeks to implement

a risk management program. Is the goal of the program to reduce earnings fluctuations, or

to reduce fluctuations in firm value? Should the firm fully hedge its risk exposures, or

only partially hedge them? Should it hedge only the downside risk, while retaining the

upside (as with an option or more traditional insurance contract)? Or should it hedge both

the downside and the upside (as a forward contract would permit)? None of these

questions can be answered in the abstract, because the answers will vary from firm to

firm. Still, the fundamental goal of risk management is unambiguous: As with the other

facets of firm management, the goal of risk management is to maximize shareholder

value. Having the capability to reduce risks does not automatically imply that the firm

should reduce its risk. Because the benefits (and costs) of risk management vary by firm,

a risk management strategy must be tailored to the individual company. For some firms,

targeting a particular level of earnings fluctuations will increase the value of the firm. For

other firms, the value maximizing strategy is to target a particular level of fluctuations in

market value of the firm or shareholder equity.1 To determine the optimal risk

management policy, the manager must begin by understanding how uncertainty

surrounding expected future earnings and how uncertainty surrounding expected future

firm value affect the market value of the firm. That is, to assess whether and to what

extent the firm should target its risk, the manager must first understand the channels

through which risk management can potentially affect firm value. This understanding

forms the critical underpinnings of any risk management strategy: without it, attempts to

evaluate the costs and benefits of risk management within the context of a particular firm

will prove fruitless.

A. Risk management by the firm can facilitate risk management by the firm equity

holders

Financial theory distinguishes between systematic (market or beta) risk, and total risk.

Investors can reduce the amount of total risk they bear by diversifying their holdings.

Systematic risk is the risk that remains after such diversification is fully utilized. If such

diversification opportunities are widely available to investors, systematic risk is the only

risk for which investors must be compensated with a risk premium. By definition,

diversification, by either the firm or its investors, cannot reduce systematic risk. Investors

can control their exposures to systematic risk by adjusting the mix of risky asset and safe

cash holdings or by using futures, forwards, or swap contracts. By holding a larger

fraction of cash or hedging with futures, forwards and swaps, investors decrease their