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This document discusses strategic risk management. It addresses how risk management adds value by enabling companies to quantify risk-return tradeoffs and manage risk at both the company-wide and business-unit levels. There are three main approaches to managing risk: modifying operations, using targeted financial instruments, and adjusting capital structure. Integrated risk management combines these approaches and considers all risks faced by a firm. The document also explores behavioral issues around risk and provides examples of managing risk through a company's operations.
This document discusses strategic risk management. It addresses how risk management adds value by enabling companies to quantify risk-return tradeoffs and manage risk at both the company-wide and business-unit levels. There are three main approaches to managing risk: modifying operations, using targeted financial instruments, and adjusting capital structure. Integrated risk management combines these approaches and considers all risks faced by a firm. The document also explores behavioral issues around risk and provides examples of managing risk through a company's operations.
This document discusses strategic risk management. It addresses how risk management adds value by enabling companies to quantify risk-return tradeoffs and manage risk at both the company-wide and business-unit levels. There are three main approaches to managing risk: modifying operations, using targeted financial instruments, and adjusting capital structure. Integrated risk management combines these approaches and considers all risks faced by a firm. The document also explores behavioral issues around risk and provides examples of managing risk through a company's operations.
A.V. Vedpuriswar 1 We had 20 people on the beach looking at grains of sand with microscopes when the tsunami came along and wiped everybody out. Cleaning up DRCM was, in the words of one UBS employee, like mopping up spilt milk on the deck of the Titanic. FT April 20, 2008 [OPTIONAL SLIDE] 2 Objectives Understanding risk Getting the big picture Taking a holistic view Recognising human infallibilities Being clear about our priorities 3 Acknowledgements Enterprise Risk Management: Theory and Practice, Brian W. Nocco, and Ren M. Stulz, Journal of Applied Corporate Finance, Fall 2006 Strategic Risk Taking, Aswath Damodaran The Black Swan, Nassim Nicholas Taleb Integrated Risk Management for the Firm: A Senior Managers Guide, Working paper by Lisa K. Meulbroek Kenneth Froot, David Scharfstein & Jeremy Stein, A famework for risk management, Harvard Business Review, Nov-Dec1994 Options, futures and Derivative Securities, John C Hull Risk Management and Financial Institutions, John C Hull FRM Body of Knowledge 4 Ice breaker What are the fundamental laws of Physics? What are the fundamental laws of Economics? What about Financial Economics? 5 A problem which took 160 years to solve Luca Pacioli, an Italian monk framed a famous problem. Two gamblers are playing a best-of-five dice game. They are interrupted after three games with one gambler leading 2 to 1. What is the fairest way to divide the pot between the two gamblers, taking into account the current status of the game? Blaise Pascal and Pierre de Format solved the problem after about 160 years. How? 6 Another teaser I give you two options Take Rs. 50 I toss a coin. Heads you get Rs. 100 and tails you get 0 Which will you choose? I give you two options Pay Rs. 50 I toss a coin. Heads you pay Rs. 100 and tails you pay 0 Which will you choose? 7 A third teaser The bird flue epidemic is expected to hit your town and it is estimated that 600 people die. Which of the following two drugs, A or B, will people recommend to combat the epidemic, given the following information? If Drug A is used: 200 will be saved. If Drug B is used : 1/3 chance that all 600 will be saved and 2/3 chance that nobody will be saved. It seems a greater percentage of the respondents vote for Drug A 8 Now the second sample of doctors from the same population, who are not exposed to the above poser, are presented a different looking poser. The bird flue epidemic is expected to hit your town and it is estimated that 600 people will die. Which of the following two drugs, C or D, will people recommend to combat the epidemic, given the following information? If Drug C is used : 400 will die. If Drug D is used: 1/3 chance that nobody will die, and 2/3 chance that 600 will die. It seems a greater percentage of the respondents vote for Drug D. 9 Key messages Our attitudes towards risk are highly perplexing. Risk management should not be equated with risk hedging. The essence of good risk management is making the right choices when it comes to dealing with different risks . The most successful companies have risen to the top by finding particular risks that they are better at exploiting than their competitors. Some risks are black swans. They come when we least expect them but their effects can be catastrophic. Take the example of the normal distribution. Why manage risk? Why not allow investors to build a diversified portfolio? After all the market does not reward us for taking unsystematic risk. Inadequate information. Transaction costs. Distress costs. 11 How Risk Management adds value Enterprise Risk management creates value at both a macro or company-wide level and a micro or business- unit level. At the macro level, ERM creates value by enabling senior management to quantify and manage the risk-return tradeoff that faces the entire firm . At the micro level, ERM becomes a way of life for managers and employees at all levels of the company. 12 What determines the value of a firm? The value of a firm can generally be considered a function of four key inputs : Cash flow from assets in place or investments already made. Expected growth rate in cash flows during a period of high growth excess returns. Time before stable growth sets in and excess returns are eliminated. Discount rate which reflects both the risk of the investment and the financing mix used by the firm. 13 What can a firm do to increase its value? Generate more cash flows from existing assets. Grow faster or more efficiently during the high growth phase. Prolong the high growth phase Lower the cost of capital. 14 How hedging can help Managers may under invest because of risk aversion. By providing hedging tools, we can remove the disincentive that prevents them from investing. By hedging and smoothening earnings, firms can extend their high growth/excess returns period . Providing protection against firm specific risks may help align the interest of stockholders and managers and lead to higher firm value. The pay off from risk hedging must be greater for firms with weak corporate governance structures and managers with long tenure. 15 How taking risk helps The way the firm strategically manages its risk exposure, such as by making the right R&D investments, will clearly help in extending the growth phase. The pay off from risk management may be greater in businesses that are volatile but earn high returns on investment. There must be unpredictable, but lucrative investment opportunities. Look for the positive black swans! 16 Finance, Strategy and Operations Risk management as a discipline has evolved unevenly across different functional areas. In finance, the preoccupation has been with hedging and discount rates. Little attention has been paid to the upside. In strategy, the focus has been on competitive advantage and barriers to entry. Risk management at most organizations is splintered. There is little communication between those who assess risk and those who make decisions based on those risk assessments. Three ways to mange risk Fundamentally, there are three ways to manage risk. Which are these ways? 18 Three approaches to managing risk
Targeted financial instruments (Transfer)
Modifying operations, (Hold) Adjusting capital structure (Buffer)
19 Integrated risk management Integration refers both to the combination of these three risk management techniques, and to the aggregation of all the risks faced by the firm. Integrated risk management is by its nature strategic, rather than tactical. The three ways to manage risk are functionally equivalent . Their use connects seemingly-unrelated decisions. For instance, effective capital structure decisions cannot be made in isolation from the firms other risk management decisions. Can we think of some examples? 20 Modifying the firms operations to gain competitive advantage Companies are in business to take strategic and business risks. By reducing non-core exposures, ERM effectively enables companies to take more strategic business risks. Pharma R&D Human capital management in software company Cricket pitch during rainy season Environmental management Oil company 21 When to hold the risk? Companies should be guided by the principle of comparative advantage in risk-bearing. A company that has no special ability to forecast market variables has no comparative advantage in bearing the risk associated with those variables. In contrast, the same company should have a comparative advantage in bearing information-intensive, firm-specific business risks because it knows more about these risks than anybody else. 22 Risk management using targeted financial instruments When should firms use targeted financial instruments? Some risks cannot be managed effectively through the operations of the firm, either because no feasible operational approach exists. Or an operational solution is simply too expensive to implement . Or it is too disruptive of the firms strategic goals . Targeted financial instruments are especially suited for firms with large exposures to commodity prices, currencies, interest rates, or the overall stock market. 23 Risk adjustment via the capital structure What are the implications of lower debt? Lower debt means that the firm has fewer fixed expenses. This translates into greater flexibility in responding to any type of volatility that affects firm value . Lower debt also reduces the chance that the firm becomes financially distressed. 24 Equity: An all purpose cushion Equity provides an all-purpose risk cushion against loss. Equity provides ideal protection against those other risks that cannot be readily anticipated or measured, or for which no specific targeted financial instrument exists . The larger the amount of risk that cannot be accurately measured or shed, the larger the firms equity cushion should be.
25 Historical perspective Every major advance in human civilization has happened because someone was willing to take risk . In mans early days, physical and economic risk went hand in hand. The development of shipping trades facilitated the separation of economic and physical risk. Insurance evolved in various ways. In recent years, more efficient derivative instruments have been designed that facilitate risk transfer. As a result, risk management has become increasingly sophisticated . 26 Behavioral issues in Risk Management
27 The duality of risk It is part of human nature to be attracted to risk. At the same time, there is evidence that human beings try to avoid risk in both physical and financial pursuits. Some individuals take more risk than others. 28 Behavioural finance and prospect theory Decisions are affected by the way choices are framed. Individuals may be risk seeking in some situations and risk averse in others. Individuals feel more pain from losses than from equivalent gains. 29 Propositions about risk aversion (1/2) Individuals are generally risk averse and more so when the stakes are large than when they are small. There are big differences in risk aversion across the population and noticeable differences across sub groups. Individuals are far more affected by losses than by equivalent gains. The choices that people make when presented with risky choices or gambles depend on how the choice is presented. Individuals tend to be much more willing to take risk with what they consider found money than with money they have earned. 30 Propositions about risk aversion (2/2) There are two scenarios where risk aversion seems to decrease and is even replaced by risk seeking. One is when individuals are offered the chance of making an extremely large sum with a small probability of success. The other is when individuals who have lost money are presented with choices that will allow them to make their money back. When faced with risky choices, individuals often make mistakes in assessing the probabilities of outcomes, over estimating the likelihood of success. The problem gets worse as the choices become more complex. 31 Risk Management vs. Risk hedging Risk management is aimed at generating higher and more sustainable excess returns. The benefits of risk management will be greatest in businesses with high volatility and strong barriers to entry. The greater the range of firm specific risks, the greater the potential for risk management. Risk management will create more value if new entrants can be kept out of business. 32 Managing the upside A simple vision of successful risk taking is that we should expand our exposure to upside risk while reducing the potential for downside risk. The excess returns on new investments and the length of the high growth period will be directly affected by decisions on how much risk to take in new investments . There is a positive pay off to risk taking but not if it is reckless. Firms that are selective about the risks they take can exploit these risks to their advantage. Firms that take risks without sufficiently preparing for their consequences can be hurt badly. 33 Risk Management vs. Risk Hedging: A summary Risk Hedging Risk Management View of risk Risk is a danger Risk is a danger & an opportunity Objective Protect against the downside Exploit the upside Approach Financial, Product oriented Strategy/cross functional process oriented Measure of success Reduce volatility in earnings, cash flows, value Higher value Type of real option Put Call Primary impact on value Lower discount rate Higher & sustainable excess returns Ideal situation Closely held, private firms, publicly traded firms with high financial leverage or distress costs Volatile businesses with significant potential for excess returns 34 Competitive advantage through superior risk management Information Speed Experience/Knowledge Resource Flexibility Corporate governance People Reward/punishment mechanisms 35 Information advantage Firms that take risk must invest in superior information networks. Companies must be clear about the kind of information needed for decision making in a crisis and put in place necessary information systems. Early warning information systems must trigger alerts and preset responses. 36 The speed advantage The speed of response can be critical in a crisis . Speed depends on the quality of information, and understanding the potential consequences and the interests of the stakeholders. Organizational structure and culture also determine the speed of response. 37 The experience/knowledge advantage Having experienced similar crises in the past can give us an advantage. Firms must invest in learning . They can enter new and unfamiliar markets, expose themselves to risk and learn from mistakes. They can acquire firms in unfamiliar markets . They can form strategic alliances or poach people with the necessary expertise. 38 The resource advantage Having the resources to deal with crisis can give a company a significant advantage over competitors. 39 Flexibility A flexible response to changing circumstances can be a generic advantage. For some firms, flexibility may come from production facilities that can be modified at short notice to produce modified products that better fit customer demand For others, flexibility may come from lower overheads/fixed costs. Flexibility also mean the ability to get rid of past baggage, cannibalising existing product lines and having a paranoid culture. 40 Corporate governance Interests of decision makers must be aligned with those of the owners. Both managers with too little wealth and too much wealth tied up in their business will not take risk. The appropriate corporate governance structure for the risk taking firms would call for decision makers to be invested in the equity of the firm but also to be diversified. 41 People When facing a crisis, some people panic, others freeze but a few thrive and become better decision makers. 42 Reward/Punishment mechanisms A good compensation system must consider both process and results. 43 Five questions about risk Question #1: Have senior managers communicated the core values of the business in a way that people understand and embrace? Question #2: Have managers in the organization clearly identified the specific actions and behaviors that are off- limits? Question #3: Are diagnostic control systems adequate at monitoring critical performance variables? Question #4: Are the control systems interactive and designed to stimulate learning? Question #5: Is the company paying enough for traditional internal controls?
44 Risk management: First principles (1/2) Risk is everywhere: Our biggest risks will come from places that we least expect them to come from and in forms that we did not anticipate that they would take. Risk is threat and opportunity: Good risk management is about striking the right balance between seeking out and avoiding risk. We are ambivalent about risks and not always rational: A risk management system is only as good as the people manning it. Not all risk is created equal: Different risks have different implications for different stakeholders . Risk can be measured: The debate should be about what tools to use to assess risk than whether they can be assessed. Good risk measurement should lead to better decisions : The risk assessment tools should be tailored to the decision making process. 45 Risk management: First principles (2/2) The key to good risk management is deciding which risks to avoid, which ones to pass through and which to exploit : Hedging risk is only a small part of risk management. The pay off to better risk management is higher value: To manage risk right, we must understand the levers that determine the value of a business. Risk management is part of everyones job : Ultimately, managing risks well is the essence of good business practice and is everyones responsibility. Successful risk taking organizations do not get there by accident: The risk management philosophy must be embedded in the companys structure and culture. Aligning the interests of managers and owners, good and timely information, solid analysis, flexibility and good people is key : Indeed, these are the key building blocks of a successful risk taking organization.
46 Concluding remarks Extreme negative outcomes are always a possibility. The effectiveness of risk management cannot be judged on whether such outcomes materialize. The role of risk management is to limit the probability of such outcomes to an agreed-upon, value maximizing level. A company where risk is well understood and well managed will command the resources required to invest in the valuable projects available to it because it is trusted by investors. Investors will be able to distinguish bad outcomes that are the result of bad luck rather than bad management.