Corporate Risk Management

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Corporate Risk Management
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Outline

• Theoretical Foundations
• Individual
• Corporation
• Types of risk risk management tools
• Insurance
• Hedging

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Risk - Defined

• Risk represents the chance that actual events
  turn out to be significantly different than what
  was initially expected.
• Future events governed by a probability
  distribution.
• Characterized by
• Expected outcomes
• Variation around the expected gt RISK

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Risk Aversion - Individual

• Utility of Wealth U(W)
• Assume
• Marginal Utility gt 0 ? more wealth increases
  your utility
• Decreasing Marginal Utility ? each additional
  dollar of wealth adds less utility than the
  previous dollar

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Utility of Wealth Graph (Assume We .5W1 .5W2)
U(W)
U(We))
EU(W)
W
We
W1
W2
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Risk Aversion

• A person is Risk Averse if that person is
  unwilling to accept a fair bet.
• Fair bet ? expected change in wealth 0
• Intuition Marginal utility of a 1 gained is
  less than the marginal utility of a 1 lost
• Implications
• Willing to pay to avoid risk ? insurance
• Require premium to take risk ? risk premium

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Corporation

• Since V E(CF)/R
• Reducing risk valuable if
• Decreases opportunity cost of capital, R
• Increases E(CF)
• Consider R
• Diversifiable Risk
• Market Risk
• Most Risk Reduction is likely firm specific

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Corporation

• Possible Benefit
• Reducing variability of CFs ? Specifically,
  AVOIDING LOW CASH FLOW OUTCOMES
• Insurance ? additionally may offer efficient
  claims processing and loss control services

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Low CF Outcome Avoidance

• Reduce expected cost of financing
• If lack internal funds have to sell securities
• Avoid Under-investment problem
• Reduce Likelihood of Financial Distress, and gain
  better terms from
• Employees
• Customers
• Suppliers
• Reduce expected tax payment if rates progressive

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Steps in the Risk Management Process
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Types of Risk

• Pure Risk ? only the possibility of loss or no
  loss
• Damage to Assets
• Legal Liability
• Worker Injury
• Employee Benefits

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Types of Risk

• Speculative Risk ? involves the possibility of
  gain or loss
• Price Risk / Financial Risk
• Commodity Price Risk
• Exchange Rate Risk
• Interest Rate Risk
• Strategic Risks (Business risk)
• Operational Risks (Business Risk)

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Appropriate Techniques

• Risk Control techniques that reduce the
  frequency and severity of losses
• Risk Financing techniques that provide for the
  funding of losses once they occur

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Risk Control

• Avoidance not acquiring a certain loss
  exposure, or abandoning an existing exposure
• Ex asbestos, childrens toys, alcohol at BOD
  meetings, riding motorcycles
• Disadvantages
• Cannot avoid all losses (premature death)
• Have to give up activities

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Loss Control

• Loss prevention methods to reduce the frequency
  of loss
• Drivers education DWI laws locking doors
• Loss reduction methods to reduce the severity
  of loss
• Sprinkler systems floor lighting in planes,
  segregation of exposure units (inventories)
• Very effective for Workers Comp

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Risk Financing

• Retention retaining all or part of the loss
• Non-insurance risk transfers contractually
  transferring risk to others
• Commercial Insurance transfer through insurance

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Risk Financing, cont.

• Hedging
• Options
• Futures
• Swaps
• Hedging is the method generally used for
  speculative risks

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Retention

• Active intentionally retain losses
• Passive unintentionally retain losses
• Necessary conditions for retention
• No other effective method available
• Worst possible loss is not serious
• Losses are highly predictable frequency and
  severity can be reasonably estimated

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Retention

• Retention level dollar amount of losses firm is
  willing to retain
• What is maximum possible loss that can be
  absorbed without adversely affecting earnings
• What is maximum percentage of NWC, or capital

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Insurable Risk

• Large number of exposure units
• Loss must be accidental and unintentional
• Loss must be determinable measurable
• Loss should not be catastrophic
• Chance of loss should be calculable
• Premium must be economically feasible

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Insurance

• Pooling arrangements reduce risk when losses are
  independent (uncorrelated)
• Each party splits loss (share equally)
• Ex Lose 0 80 probability
• Lose 2,500 20 probability
• Expected loss 500
• Standard Dev 1,000

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Insurance pool w/2

• Expected loss 500
• Standard Dev 707

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Insurance

• Expected loss is same standard dev. Lower
• As number in pool increases
• Amount of loss becomes more predictable
• Probability of extreme outcomes goes down
• Statistically
• Distribution becomes more bell shaped and
  centered on expected value
• Law of Large Numbers

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Hedging

• Used for Speculative Risks
• Objective Find a derivative that is highly
  correlated with the event or asset creating the
  potential loss
• Tools
• Options
• Futures (Forwards)
• Swaps

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Options

• Call gives the owner the right to buy the
  underlying asset at a predetermined price (strike
  price) on or before expiration
• Put gives the owner the right to sell the
  underlying asset at a predetermined price on or
  before expiration
• Buying v. writing

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Futures (Forward)

• Contract entered into today for future delivery
  of an asset at price agreed upon today
• In contrast to forwards, futures
• Traded on exchanges
• Standardized
• Regulated
• Marked to market each day

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Swaps

• A Swap is the trading of one asset for another
• Examples
• Fixed rate / variable rate
• Interest rate / equity
• Currency
• Usually net difference is settled

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Financial Risk Management

• What is risk?
• Farmer gt prices fall
• Trucking / airline company gt prices rise
• Jewelry producer gt prices rise
• What position in options/futures/swaps will
  benefit if the risk occurs?
• What quantity in the position should be taken?

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Financial Risk Mgmt Ex

• Suppose 55 of your companys sales occur in
  Germany. (Production is in US)
• What risk do you face?
• What position would you take to hedge the risk?
• With options?
• Futures?
• Swaps?

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Hedging a Commodity Price Risk
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Airline/Trucking

• 1. Source of Risk ? increase in price of fuel
• 2. What position will benefit if fuel price inc.
• Options ? call
• Futures ? buy now
• 3. Outcomes
• Price Rises ? Buy higher spot (lose) sell
  futures (call) for gain
• Price Falls ? Buy lower spot (gain) sell
  futures (call) for a loss

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Insurance v. Hedging

• Both transfer risk no new risk created
• Insurance involves insurable risks hedging
  generally is used for uninsurable risks
• Insurance can reduce the the objective risk of
  the insurer through the law of large numbers
• Hedging does not involve risk reduction only
  risk transfer