Reading: Enterprise Risk Management Flashcards
Sentences that are nice to use
Over the past two decades, the role of risk management in corporations has undergone significant transformation. Beyond traditional areas like insurance and financial hedging, it now involves operational, reputational, and strategic risks.
ERM
Enterprise risk management:
How a corporation can mange risk: all risks viewed together within a coordinated and strategic framework (compared to viewing one risk at a time).
Creating an effective ERM have a long-run competitive advantage over those that manage and monitor risk individually. ERM effectively enables companies to take more strategic business risk and greater advantage of the opportunities in their core business.
ERM essay structure
How ERM
- give companies competitive advantage
- add value to shareholders
- describe the process and challenges involved in implementing ERM
- how a company should assess its risk appetite
- how much and which risk to retain and which to lay off
- difficulties that arise when implementing ERM
How does ERM create shareholder value?
At both macro and micro levels, ERM has profound effects on companies.
On a macro level, ERM enables senior management to assess and manage the risk-return tradeoff across the entire firm. It helps maintain access to capital markets and other essential resources needed to execute the company’s strategy and operations successfully.
Micro: Everyone, from employees to managers to executives, is actively engaged in identifying, assessing, and managing risks relevant to their roles and responsibilities. ERM becomes a way of life.
Macro level
In the real world, where investors may lack complete information and financial troubles can disrupt operations, adverse outcomes from diversifiable risks, such as unexpected currency or commodity price spikes, can incur costs far beyond immediate impacts on cash flow and earnings.
If a company forecasts future cash flow but experiences a loss, it can lower market growth expectations. Even if cash flow rebounds quickly, long-lasting effects remain. This situation may force the company to reduce planned investments to fund strategic opportunities. Passing on a positive NPV project due to funding constraints results in a permanent value reduction for the firm.
Therefore it is important to manage risk by limiting large cash shortfall and protecting a company’s ability to carry out its business plan.
Which risks should a company lay off and which should it retain?
Laying off risk:
Corporate exposures to currency fluctuations, interest rates, and commodity prices can pose significant risks. For instance, implementing a foreign exchange hedging program using forward contracts usually incurs minimal transaction costs. This makes it cost-effective to transfer risk, thereby strengthening the case for mitigating economic risks that could otherwise hinder a company’s strategic objectives.
Retain risk:
When a company have plans to expand its business. If the company were to seek a counterparty to bear such business risks, the costs of transferring such risks would likely to be prohibitively high. The company should understands the risks of such expansion.
Risk-return trade off and micro benefits of ERM
An increase in overall risk can diminish value by leading companies to forgo valuable projects or disrupt the normal operations of the firm. When a company undertakes a project that increases the firm’s overall risk, the project should yield a satisfactory return after covering the costs associated to the risk increase. RISK-RETURN TRADEOFF therefore must be evaluated for all corporate decisions that are expected to have a material impact on total risk. Company should ensure that decision-making occurs by senior management AND by business managers throughout the firm to take proper account for risk-return trade-off.
Without ERM, promising projects could be rejected when risks are overstated. Systems that ignore risk will end up encouraging high-risk projects, in many cases without the returns to justify them. Implementing ERM compels business managers to assess the impact of all significant risks on their investment and operational choices.
The purpose of risk-based capital allocation system is to provide business managers with more information about how their own investment and operating decisions are likely to affect both corporate-wide performance and the measures by which their performance will be evaluated.
Determining the right about of risk
- Determining the costs associated with the cash shortfalls. Costs include maintaining a larger reserve of equity capital invested in liquid assets.
Through ERM, management aims not to minimise or eliminate risk entirely, but rather to limit the probability of financial distress to a level agreed upon by management and the board, optimising firm value.
Bond ratings: Management may conclude that firms should give up valuable projects if the rating falls to Baa. A study done by Moody’s shows that the probability of a company with an Aa rating having its rating to drop to Baa or lower within a year time is 1.05% on average. Even a 1% change to forgo such investment may be too risky to some companies.
- Management starts by defining the firm’s risk appetite, which includes selecting the level of financial distress probability expected to optimize firm value. When credit ratings serve as the primary gauge of financial risk, the firm establishes an optimal or target rating aligned with its risk appetite and the cost associated with reducing the likelihood of financial distress.
- Given the firm’s target rating, management estimates the amount of capital it requires to support the risk of its operation.
- Management determines the optimal combination of capital and risk that is expected to yield its target rating through hedging and project selection. Alternatively, increasing its capital to achieve its target rating.
- Top management decentralises the risk-capital tradeoff with the help of a capital allocation and performance evaluation system that motivates managers throughout the organisation to optimise this tradeoff.
Decentralised meaning
This decentralisation is facilitated by a capital allocation and performance evaluation system that encourages managers at all levels of the organisation to optimize this tradeoff according to their specific roles and responsibilities.
Implementing ERM
Is challenging. First step is identifying the types of risks that will be measured: market, credit, and operational. For an inventory of risk to be useful it should be collected, made comparable, and continuously updated. Business often resits such monitoring efforts because they are time-consuming and distract from other activities.
Measuring risk
Market risks: returns on a portfolio of securities having normal or symmetric distribution unlike the other two.
Credit risk: either creditors pay in full what is owed or nothing at all. Therefore when a creditor defaults, the loss can be large.
Operational risk: tends to be a large number of small losses, so small operational losses are predictable with some chance that there are large losses creating a distribution of a “long tail”.
The probability experiencing simultaneously high adverse market, credit, and operational outcomes is typically very low. However, the tendency for correlations to increase in highly stressed environment.
However, some risks like strategic and reputational risks are hard most difficult to quantify.
