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Risk management can be defined as the culture, processes, and structures that are directed towards the effective management of potential opportunities and adverse effects. This broad definition can quite rightly apply in nearly all fields of management from financial and human resources management through to environmental management. However in the context of contaminated sites, risk management can be taken to mean the process of gathering information to make informed decisions to minimize the risk of adverse effects to people and the environment. Risk assessment involves estimating the level of risk – estimating the probability of an event occurring and the magnitude of effects if the event does occur. Essentially risk assessment lies at the heart of risk management, because it assists in providing the information required to respond to a potential risk. In a resource management setting, environmental risk assessment may be used to help manage, for example: Natural hazards (flooding, landslides), Water supply and waste water disposal systems, and Contaminated sites. Human health risk assessment is one form of risk assessment, focusing on assessing the risk to people and communities from hazardous substances or discharge of contaminants. Ecological risk assessment is another form of risk assessment that can be used to assist management of risks to ecological values. The focus of risk assessment for contaminated sites is usually human health, as a large proportion of the known potentially contaminated sites are located in urban areas. However, where valued natural environments are present, the focus of ecological risk assessment is on assessing the risks to plants, animals and ecosystem integrity from chemicals present at or discharging from a contaminated site
What is financial risk management? Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them. Financial risk management can be qualitative and quantitative. As a specialization of risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk. In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks. Financial risk management is a method of producing or adding value to a company through utilizing financing mediums for handling vulnerability to risk, specifically market risk and credit risk. Financial risk management is an important form of risk management. About financial risk management: Financial risk management is a type of risk management, which tries to add value in a company through implementation of financing mediums (cash instruments and derivative instruments) to handle risk exposure, especially from market risk and credit risk . With the help of financial risk management, a number of financial risks can be handled, which include the following: Shape risk 1. Foreign exchange risk The characteristics of financial risk management resemble the features of common risk management and the process of financial risk management involves identification of financial risk, evaluating the financial risk and strategies to deal with those risks.
operational risk and market risks usually choose the Basel Accords . multinational or global banking institutions for identifying.Financial risk management concentrates on the appropriate time and manner for hedging implementation of cash instruments and derivative instruments to address pricey risk exposures In the banking industry all over the world. describing and disclosing credit risk.
Application of Financial Risk Management Theories of financial economics suggest that a company should go for a project at the time it grows shareholder value. Financial risk is normally any risk associated with any form of financing. which the shareholders are able to hedge on their own at similar expenses. a company is not able to perform value creation through hedging a risk while the cost of carrying the risk within the company is equal to the cost of carrying it away from the company. There will be uncertainty in every business. the level of uncertainty present is called risk . no financial market is a perfect market. in financial sector it is the probability of actual return being less than expected return. which the shareholders are able to perform for themselves at equal expenses. In addition. which says that in case of a perfect market. . Risk is probability of unfavorable condition. This idea is corroborated by the hedging irrelevance proposition. All these risk management processes play a significant role behind the growth of an organization in the long term. In reality. financial theory demonstrates that the management of the company is not able to produce shareholder (who are also known as the investors of the company) value through undertaking a project. This indicates that the management of a company has a large number of options to generate value for the shareholders utilizing financial risk management. At the time when this concept is implemented towards financial risk management. There are different types of risk management and the characteristics and a procedure of each type of risk management is different from the other. it denotes that management of a company should not go for hedging risks.
This is referred to as currency risk. This risk is therefore often referred to as capital risk. Assets that are easily sold are termed liquid: therefore. commercial property) or the market has a small capacity and may therefore take time to sell.g. Many forms of investment may not be readily salable on the open market (e. High-risk investments have greater potential rewards. there is a risk that currency movements alone may affect the value. but also have greater potential consequences.Investment related: Depending on the nature of the investment. A common concern with any investment is that the initial amount invested may be lost (also known as "the capital"). this type of risk is termed liquidity risk Business Releated . the type of 'investment' risk will vary. If the invested assets are being held in another currency.
Companies that issue more debt instruments would have higher financial risk than companies financed mostly or entirely by equity. financial markets are not likely to be perfect . This notion is captured by the hedging irrelevance proposition: In a perfect market. some communities had developed a system of intermediaries who can warehouse and trade goods. Finance theory also shows that firm managers cannot create value for shareholders. thus causing the business to file for bankruptcy. intermediaries often suffered from financial risk. However. To overcome this mutual coincidence problem. Financial risk is the additional risk a shareholder bears when a company uses debt in addition to equity financing.. For example a high risk mortgage client may be required to pay a higher interest rate on their mortgage repayments in order to be accepted as a bank's customer.e. In practice. Higher interest rates for high risk borrowers make the borrowers even less likely to be able to pay back the loan. Bilateral barter can depend upon a mutual coincidence of wants. each party must be able to supply something the other party demands. However. When applied to financial risk management. by taking on projects that shareholders could do for themselves at the same cost. this higher mortgage rate will in itself increase the risk to the bank that the customer cannot meet their interest payments. Before any transaction can be undertaken. the firm cannot create value by hedging a risk when the price of bearing that risk within the firm is the same as the price of bearing it outside of the firm.The risk that a company or project will not have adequate cash flow to meet financial obligations. also called its investors. this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost. financial economics) prescribes that a firm should take on a project when it increases shareholder value. this is not always the case. Whilst higher risk normally implies higher overall rewards. further increasing the risk. further increasing the default risk WHEN TO USE FINANCIAL RISK MANAGEMENT? Finance theory (i. The 2007/8 sub-prime crisis may have some links to this argument. This circular risk problem can lead to markets not existing for high risk borrowers.
the risk that stock prices will change. Currency risk. crude oil) will change. 2. the risk that foreign exchange rates will change. Multinational Corporations are faced with many different obstacles in overcoming these challenges. This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management. transactions exposure. The concepts of financial risk management change dramatically in the international realm. Interest rate risk. TYPES OF FINANCIAL RISK MANAGEMENT:• • • • • • Market risk Corporate governance Liquidity risk Risk adjusted return on capital Risk modeling Risk pool Market risk is the risk that the value of an investment will decrease due to moves in market factors. and economic exposure. Equity risk. 4. Research has specifically identified three kinds of foreign exchange exposure for various future time horizons. The trick is to determine which risks are cheaper for the firm to manage than the shareholders. The four standard market risk factors are: 1. Commodity risk. accounting exposure]. Research by many. corn.g. A general rule of thumb. copper. is that market risks that result in unique risks for the firm are the best candidates for financial risk management. the risk that commodity prices (e. .markets. however. including Raj Aggarwal has started to disclose much of the decisions and impacts firms must make when operating in many countries. 3. the risk that interest rates will change.
embedded options. customs. Traditionally.S. CORPORATE GOVERNANCE: Corporate governance is the set of processes. and so on are ignored in this single period modeling technique. a section on market risk is mandated by the SEC in all annual reports submitted on Form 10-K. administered or controlled. USE IN ANNUAL REPORTS OF U. For short time horizons. management.Measuring As with other forms of risk. Other stakeholders include labour (employees). The principal stakeholders are the shareholders/members. an investor who believes he is investing in a normal milk company that the company is in fact also carrying out non-dairy activities such as investing in complex derivatives or foreign exchange futures. customers. bond holders). Value at risk is well established as a risk management technique. and the board of directors. Intervening cash flow. . for example. banks. changes in floating rate interest rates. laws. CORPORATIONS: In the United States. and institutions affecting the way a corporation (or company) is directed. RISK MANAGEMENT: All businesses take risks based on two factors: the probability an adverse circumstance will come about and the cost of such adverse circumstance. The company must detail how its own results may depend directly on financial markets. market risk may be measured in a number of ways. The first assumption is that the composition of the portfolio measured remains unchanged over the single period of the model. For longer time horizons. this is done using a Value at Risk methodology. suppliers. this limiting assumption is often regarded as acceptable.g. many of the transactions in the portfolio may mature during the modeling period. policies.. Corporate governance also includes the relationships among the many stakeholders involved and the goals for which the corporation is governed. For Not-For-Profit Corporations or other membership Organizations the "shareholders" means "members" in the text below (if applicable). but it contains a number of limiting assumptions that constrain its accuracy. This is designed to show. regulators. and the community at large. creditors (e.
and hence good corporate governance is a tool for socio-economic development. There has been renewed interest in the corporate governance practices of modern corporations since 2001.S.S. firms such as Enron Corporation and MCI Inc. particularly due to the high-profile collapses of a number of large U.Corporate governance is a multi-faceted subject. A related but separate thread of discussions focuses on the impact of a corporate governance system in economic efficiency. The positive effect of corporate governance on different stakeholders ultimately is a strengthened economy. with a strong emphasis on shareholders' welfare. such as the stakeholder view and the corporate governance models around the world (see section 9 below). There are yet other aspects to the corporate governance subject. (formerly WorldCom). For example. In 2002. federal government passed the Sarbanes-Oxley Act. MECHANISMS & CONTROLS: Corporate governance mechanisms and controls are designed to reduce the inefficiencies that arise from moral hazard and adverse selection. INTERNAL CORPORATE GOVERNANCE CONTROLS Internal corporate governance controls monitor activities and then take corrective action to accomplish organizational goals. an independent third party (the external auditor) attests the accuracy of information provided by management to investors. Examples include: . An ideal control system should regulate both motivation and ability. the U. An important theme of corporate governance is to ensure the accountability of certain individuals in an organization through mechanisms that try to reduce or eliminate the principal-agent problem. to monitor managers' behavior. intending to restore public confidence in corporate governance.
Executive directors possess superior knowledge of the decision-making process and therefore evaluate top management on the basis of the quality of its decisions that lead to financial performance outcomes. It could be argued. with its legal authority to hire. It may be in the form of cash or non-cash payments such as shares and share options. audit committee. therefore. One group may propose company-wide administrative changes. Balance power: He simplest balance of power is very common. and can elicit myopic behavior. Remuneration: Performance-based remuneration is designed to relate some proportion of salary to individual performance. employees) outside the three groups are being met. superannuation or other benefits. management.Monitoring by the board of directors: The board of directors. require that the President be a different person from the Treasurer. that executive directors look beyond the financial criteria. the ability of the board to monitor the firm's executives is a function of its access to information. safeguards invested capital. however. operating efficiency. they may not always result in more effective corporate governance and may not increase performance. Whilst non-executive directors are thought to be more independent. Regular board meetings allow potential problems to be identified. shareholders. Moreover. fire and compensate top management. and other personnel to provide reasonable assurance of the entity achieving its objectives related to reliable financial reporting. another group review and can veto the changes. Different board structures are optimal for different firms. ex ante. Internal auditors are personnel within an organization who test the design and implementation of the entity's internal control procedures and the reliability of its financial reporting. and compliance with laws and regulations. Internal control procedures and internal auditors: Internal control procedures are policies implemented by an entity's board of directors. are reactive in the sense that they provide no mechanism for preventing mistakes or opportunistic behavior. and a third group check that the interests of people (customers. This application of separation of power is further developed in companies where separate divisions check and balance each other's actions. Such incentive schemes. discussed and avoided. .
2.Risk that liabilities: 1.essentially a sub-set of market risk. Types of Liquidity Risk: 1. Examples include: Competition Debt covenants Demand for and assessment of performance information (especially financial statements) Government regulations Managerial labour market Media pressure Takeovers LIQUIDITY RISK In finance. Cannot be met when they fall due 2. Asset Liquidity . This can be accounted for by: Widening bid/offer spread Making explicit liquidity reserves 3. Lengthening holding period for VAR calculations 2. Can only be met at an uneconomic price Can be name-specific or systemic Causes of Liquidity Risk 1.An asset cannot be sold due to lack of liquidity in the market .EXTERNAL CORPORATES GOVERNANCE CONTROLS External corporate governance controls encompass the controls external stakeholders exercise over the organization. . Funding liquidity . liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).
comprehensive metrics of liquidity risk do not exist. Futures contracts were used to hedge an Over-the-counter finance OTC obligation. the firm will have to raise cash from other sources to make its payment. or some other event causes counterparties to avoid trading with or lending to the institution. but it was the liquidity crisis caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions. since it affects their ability to trade. This is why liquidity risk is usually found higher in emerging markets or low-volume markets. An institution might lose liquidity if its credit rating falls. Liquidity risk tends to compound other risks. Here. In all but the most simple of circumstances. If a trading organization has a position in an illiquid asset. the market is saying that the asset is worthless. Certain . Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset. In case of a drop of an asset's price to zero. A position can be hedged against market risk but still entail liquidity risk. this can potentially be only a problem of the market participants with finding each other. Should it be unable to do so. This is true in the above credit risk example—the two payments are offsetting. Accordingly. liquidity risk is compounding credit risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. it experiences sudden unexpected cash outflows. its limited ability to liquidate that position at short notice will compound its market risk. Because of its tendency to compound other risks. it is difficult or impossible to isolate liquidity risk. However. Liquidity risk is financial risk due to uncertain liquidity. liquidity risk has to be managed in addition to market. Another example is the 1993 Metallgesellschaft debacle. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. credit and other risks. Manifestation of liquidity risk is very different from a drop of price to zero. If the counterparty that owes it a payment defaults. so they entail credit risk but not market risk.Causes of Liquidity RiskLiquidity risk' arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that asset. It is debatable whether the hedge was effective from a market risk standpoint. if one party cannot find another party interested in trading the asset. it too will default.
such as cash flows from derivatives or mortgage-backed securities. The BIS mentions ". Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults. If an organization's cash flows are largely contingent. A general approach using scenario analysis might entail the following high-level steps: Construct multiple scenarios for market movements and defaults over given period of time Assess day-to-day cash flows under each scenario Because balance sheets differ so significantly from one organization to the next. Regulators are primarily concerned about systemic implications of liquidity risk.. a number of institutions are exploring the use of liquidity . Another adjustment is to consider VAR over the period of time needed to liquidate the portfolio. It can be defined at VAR + ELC (Exogenous Liquidity Cost). Such an analysis can be supplemented with stress testing. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. there is little standardization in how such analyses are implemented. liquidity risk may be assessed using some form of scenario analysis.. Analyses such as these cannot easily take into account contingent cash flows. MANGEING LIQUIDITY RISK Liquidity-adjusted Value At Risk Liquidity-adjusted VAR incorporates exogenous liquidity risk into Value at Risk. Any day that has a sizeable negative net cash flow is of concern.techniques of asset-liability management can be applied to assessing liquidity risk. VAR can be calculated over this time period. The ELC is the worst expected half-spread at a particular confidence level.
" .adjusted-VAR. in which the holding periods in the risk assessment are adjusted by the length of time required to unwind positions.
For example. It might be possible to express a standard in terms of the probabilities of different outcomes. or the loss of a large depositor or counterparty. The American Academy of Actuaries wrote "While a company is in good financial shape. such as 95 percent of the time. Meissner and Youn discuss five derivatives created specifically for hedging liquidity risk: Withdrawal option: A put of the illiquid underlying at the market price.  Greenspan's liquidity at risk concept is an example of scenario based liquidity risk management. including a sudden inability to securitize assets. Scenario analysis-based contingency plans The FDIC discuss liquidity risk management and write "Contingency funding plans should incorporate events that could rapidly affect an institution’s liquidity. it may wish to establish durable.e. Diversification of liquidity providers If several liquidity providers are on call then if any of those providers increases its costs of supplying liquidity. In addition. tightening of collateral requirements or other restrictive terms associated with secured borrowings. the impact of this is reduced. credit spreads. The credit issuer should have an appropriately high credit rating to increase the chances that the resources will be there when needed. commodity prices. ever-green (i. ." Derivatives Bhaduri. etc. countries could be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowing for one year with a certain ex ante probability. always available) liquidity lines of credit."..Liquidity at Risk Greenspan (1999) discusses management of foreign exchange reserves. A country's liquidity position under a range of possible outcomes for relevant financial variables (exchange rates. an acceptable debt structure could have an average maturity--averaged over estimated distributions for relevant financial variables--in excess of a certain limit. The Liquidity at risk measure is suggested.) is considered.
The concept was developed by Bankers Trust in the late 1970s. The economic capital is the amount of money which is needed to secure the survival in a worst case scenario that is it is a buffer against heavy shocks. however.Bermudan-style return put option: Right to put the option at a specified strike. Note. RAROC is defined as the ratio of risk adjusted return to economic capital. Return swaption: Option to enter into the return swap. BASIC FORMULA RAROC = (Expected Return)/(Economic Capital)or RAROC = (Expected Return)/(Value at risk) Broadly speaking. or any business in which capital is placed at risk for an expected return above the risk-free rate. Liquidity option:"Knock-in" barrier option. insurance companies. This use of capital based on risk improves the capital allocation across different functional areas of banks. whereby the risk adjustment of Capital is based on the capital adequacy guidelines as outlined by the Basel Committee. Return swap: Swap the underling’s return for LIBOR paid periodically. in business enterprises. and operational risk. . and is often calculated by VaR. where the barrier is a liquidity metric Risk adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analyzing risk-adjusted financial performance and providing a consistent view of profitability across businesses. that more and more Risk Adjusted Return on Risk Adjusted Capital (RARORAC) is used as a measure. Economic capital is a function of market risk. risk is traded off against benefit. credit risk. currently Basel II.
RAROC system allocates capital for 2 basic reasons: Risk management Performance evaluation For risk management purposes. Many large financial intermediary firms use risk modeling to help portfolio managers assess the amount of capital reserves to maintain and to help guide their purchases and sales of various classes of financial assets. Risk modeling is one of many subtasks within the broader area of financial modeling. risk analysis was done qualitatively but now with the advent of powerful computing software. it becomes more likely that high . not all risks can be effectively pooled. insurance companies come together to form a pool. While risk pooling is necessary for insurance to work. quantitative risk analysis can be done quickly and effortlessly. it allows banks to assign capital to business units based on the economic value added of each unit. the main goal of allocating capital to individual business units is to determine the bank's optimal capital structure—that is economic capital allocation is closely correlated with individual business risk. Formal risk modeling is required under the Basel II proposal for all the major international banking institutions by the various national depository institution regulators. Risk pooling is an important concept in supply chain management. Under this system. As a performance evaluation tool. Risk modeling refers to the use of formal econometric techniques to determine the aggregate risk in a financial portfolio. Risk pool A risk pool is one of the forms of risk management mostly practiced by insurance companies. which can provide protection to insurance companies against catastrophe risks such as floods. In the past. earthquakes etc.] Risk pooling suggests that demand variability is reduced if one aggregates demand across locations because as demand is aggregated across different locations. The term is also used to describe the pooling of similar risks that underlies the concept of insurance. In particular. it is difficult to pool dissimilar risks in a voluntary insurance market. unless there is a subsidy available to encourage participation.
the greater the benefit obtained from centralized systems. This reduction in variability allows a decrease in safety stock and therefore reduces average inventory. we say that the demands from the market are positively correlated. Thus the benefits derived from risk pooling decreases as the correlation between demands from the two markets becomes more positive. This is explained as follows: If we compare two markets and when demands from both markets are more or less than the average demand. For example: in the centralized distribution system. Centralized inventory saves safety stock and average inventory in the system. TYPES OF FINANCIAL RISK MANAGEMENT: . The higher the coefficient of variation. The three critical points to risk pooling are: 1. the greater the benefit from risk pooling. which leads to a reduction in variability measured by either the standard deviation or the coefficient of variation. The benefits from risk pooling depend directly on the relative market behavior.demand from one customer will be offset by low demand from another. the warehouse serves all customers. that is.
Narrowly defined. For purposes of clarity in this report. one party to a contract defaults after having received settlement payments from another party. Instead. First. This risk may contain elements of either credit risk or liquidity risk. the term is not used or discussed further. or settlement. they bear credit risk. including payments due within specific clearing systems. the loss would again be for a principal amount (less recoveries). and will never be able to meet that obligation for full value. much larger liquidity difficulties in an economy. including its liabilities in a payment system. The bankruptcy of counterparty is often associated with such difficulties. or be part of. Forgone interest can also be an important loss. operational difficulties of various kinds. even though one or more counterparties do have sufficient assets and net worth ultimately to make them. The usage of the term "settlement risk" varies considerably. the concepts of credit or liquidity risk are employed when one of these is the ultimate financial risk being addressed. or both. a temporary inability to convert assets to cash. with reference to a whole range of obligations that participants in financial markets incur. . but there may be other causes as well. payments will not be made when due. • The concept of liquidity risk is usually defined more broadly. • Second.Participants in both clearing systems and typical financial markets are exposed to several types of financial risk. For example. This is the risk that a counterparty will not meet an obligation when due. The risk is that a financial market participant will have insufficient liquid resources to make all its payments on the due date. • The risk that a party will default on clearing obligations to one or more counterparties is sometimes referred to as settlement risk. This notion is useful because it implicitly recognizes that liquidity problems in a payment system can add to. or the inability of correspondents to perform settlement functions will all create liquidity problems. In a payment netting system. If. In an obligations netting system. however. this is the risk that clearing. but before making required counterpayments (in the same or another currency). losses from defaults due to the bankruptcy of counterparties can be measured as the principal amount due less recovery from defaulting parties. losses from the default of counterparty would typically be calculated from the replacement costs of one or more contracts that are not settled. participants bear liquidity risk. and may also depend on the situation being analyzed.
These tended to define risks in terms of their effects on a firm's accounting results—such as earnings.. payment systems and financial markets generally can be subject to system. If a unifying theme emerged. or in the financial markets.g. including derivatives and securitization. risk. The proliferation of off-balance sheet tools. • Financial risk management (FRM) had its origins in trading floors and the Basel Accords on banking regulation during the 1980s and 1990s. For some analytical purposes it is possible to distinguish "systemic liquidity risk" from "systemic credit risk". Of the various kinds of risk. This is the risk that the inability of one participant in a payment system.• Third. Till Guldimann (1994) captured the new spirit: Across markets. have gone hand in hand with changes in management practices: a movement away from management based on accrual accounting toward risk management based on marking-to-market of positions. These developments. to meet obligations when due will cause other participants to fail to meet their obligations when due. traded securities have replaced many illiquid instruments. were rendering those metrics of performance easy to manipulate. net interest income. e. it is usually systemic risk in some form that is of most concern in assessing the risks associated with payment systems. . along with technological breakthroughs in data processing. and return on assets. it was a need to update asset-liability management (ALM) techniques. loans and mortgages have been securitized to permit disintermediation and trading. The solution of financial risk management was to ignore accounting metrics of value and focus exclusively on market values. Global securities markets have expanded and both exchange traded and over-the-counter derivatives have become major components of the markets. or systemic.
adapting techniques to suit their own needs. Operational risk was also assessed in terms of its actual or potential direct costs. factory equipment. depending on such factors as size. . New credit risk models assessed potential defaults or credit deteriorations in terms of their mark-tomarket impact. It encompasses a variety of techniques drawn from both FRM and ALM. industry. etc. but also those of business lines of financial institutions that are not engaged in trading or investment management. pension liabilities. corporate risk management is a more elusive notion than is financial risk management. Generally.Financial risks came to be divided into three categories: Market risk. Market values were difficult or impossible to secure for items such as private equity. sources of capital. Credit risk Operational risk. is risk due to uncertainty in future market values. This was the realm of book value accounting. where market values were readily available. Extending them to other parts of the bank. diversity of business lines. Such techniques proved effective on bank trading floors. Corporate risk management emerged as a catch-all phrase for practices that serve to optimize risk taking in a context of book value accounting. or even to non-financial corporations. Market risk. this includes risks of non-financial corporations. Risks vary from one corporation to the next. For this reason. intellectual property or natural resource reserves. New techniques for assessing and managing these risks all focused on their impact on market value. by definition. Practices that are appropriate for one corporation are inappropriate for another. This article is an overview. proved problematic. Corporations pick and choose from these.
if a liquid market existed for it. so that techniques of FRM can be directly applied. Both approaches are discussed below Economic Value Techniques of the first form focus on a concept called economic value.Market risk. This is the approach employed with economic value added (EVA) analyses. If a market value doesn't exist. modifying or adapting techniques of FRM and ALM as appropriate. . In a nutshell. The other approach is to construct some model to predict what value the asset might command. Techniques for addressing business risk take two forms" Those that treat business risks as market risks. One is to start with accounting metrics of value and make suitable adjustments. Operations risk. Credit risk. If a market value exists for an asset. so they are more reflective of some intrinsic value. Business risk. Corporations do face some market risks. In this respect. Economic values can be assigned in two ways. This is a vague notion that generalizes the concept of market value. and Those that address business risks from a book value standpoint. then that market value is the asset's economic value. a derogatory name for economic value is mark-to-model value. such as commodity price risk or foreign exchange risk. the challenge of corporate risk management is the management of business risk. then economic value is the "intrinsic value" of the asset—what the market value of the asset would be. These are usually dwarfed by business risks. if it had a market value.
This economic approach to managing business risk is applicable if most of a firm's balance sheet can be marked to market.. it isn't enough to assign economic values. These dubious techniques were widely (but not universally) adopted by US energy merchants in the late 1990s and early 2000s. Most of its balance sheet comprises physical and forward positions in commodities. producers also hold significant investments in plants and equipment—and these cannot be marked to market. Economic values then only need to be assigned to a few items in order for techniques of FRM to be applied firm wide. Book Value The second approach to addressing business risk starts by defining risks that are meaningful in the context of book value accounting. which means that an economic value for the asset must reflect a hypothetical 50-year forward curve. Suppose some energy trades spot and forward out three years. The forward curve does not exist. An example would be a commodity wholesaler. Assigning these to 50year forward prices that are themselves hypothetical is essentially meaningless—yet. Often. The most publicized of these was Enron Corp. can be marked to market. In this context. More controversial has been the use of economic valuations in power and natural gas markets. However. An asset that produces the energy has an expected life of 50 years. The actual energies trade and. they are arbitrary. so a model must construct one. those standard deviations and correlations determine the reported VaR. . The 2001 bankruptcy of Enron and subsequent revelations of fraud tainted mark-to-model techniques. Standard techniques of financial risk management—such as value-at-risk (VaR) or economic capital allocation —are then applied. these are treated like market values. for the most part. VaR analyses require standard deviations and correlations as well. assigned economic values are highly dependent on assumptions. Consequently.Once some means has been established for assigning economic values. which went beyond using economic values for internal reporting and incorporated them into its financial reporting to investors. which can be mostly marked to market.
earnings and market values don't pay the bills. A firm can report high earnings while its long term franchise is eroded away by lack of investment or competing technologies." When a firm gets into difficulty. well. which is risk due to uncertainty in future reported earnings. VaR is routinely calculated over a one-day horizon. value-at-risk (VaR) becomes earnings-at-risk (EaR) or cash-flow-at-risk (CFaR). as with earnings risk. which is then used to value the desired metric of EaR or CFaR. with horizons of three months or a year. cash flow risk offers only an imperfect picture of a firm's business risk. Yet. Typically. A problem with looking at earnings risk is that earnings are. In this context.Most typical of these are: Earnings risk. "cash is king. A firm's accounting earnings are a well defined notion. Earnings may be suggestive of economic value. and Cash flow risk. and steady cash flows may hide corporate decline. These are long-term risk metrics. earnings risk is more akin to market risk. Financial transactions can boost short-term earnings at the expense of long-term earnings. They also adapt techniques of FRM. For example. After all. As anyone who has ever worked with distressed firms can attest. non-economic. That generates a probability distribution for the period's earnings or cash flow. traditional techniques of ALM focus on earnings. Techniques for managing earnings risk and cash flow risk draw heavily on techniques of ALM—especially scenario analysis and simulation analysis. It relates more to liquidity than the value of a firm. multiplied by minus one). Also. However. EaR and CFaR are driven by rules of accounting while VaR is driven by financial engineering principles. EaR might be reported as the 10% quantile of this quarter's earnings (which is the same as the 90% quantile of reported loss. . but they can be misleading and are often easy to manipulate. and their shortcomings remain today. which is risk due to uncertainty in future reported cash flows Of the two. Cash flow is the life blood of a firm. Cash flow risk is less akin to market risk. EaR or CFaR are calculated by first performing a simulation analysis. Cash flows can also be manipulated. but this is only partly true. The actual calculations of EaR or CFaR differ from those for VaR. it avoids the arbitrary assumptions of economic valuations.
the horizon will start at three months on the first day of the quarter and gradually shrink to zero by the end of the quarter. The alternative is to use a constant three-month horizon. should the analysis actually assess risk to the current quarter's earnings? If that is the case. .One decision that needs to be made with EaR or CFaR is whether to use a constant or contracting horizon. Both approaches are used. If management wants an EaR analysis for quarterly earnings. After the first day of the quarter. or does it simply reflect a shortened horizon. The advantage of a contracting horizon is that it addresses an actual concern of management—will we hit our earnings target this quarter? A disadvantage is that the risk metric keeps changing—if reported EaR declines over a week. but to some hypothetical earnings over a shifting three-month horizon. results will no longer apply to that quarter's actual earnings. does this mean that actual risk has declined.
they can complement each other. etc. This article has focused on the unique challenges of corporate risk management. the role of corporate culture. . There is much else about corporate risk management that overlaps with financial risk management—the need for a risk management function. Some firms use them side-byside to assess different aspects of business risk. technology issues. See the article Financial Risk Management for a discussion of these and other topics.Conclusion While the two approaches to business risk management—that based on economic value and that based on book value—are philosophically different. independence. .
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