Ex Ante Capital Allocation
Once a company has identified and measured its risks and monitored deviations between risk tolerances and actual risk exposures, the firm must develop mechanisms by which those deviations are managed and reduced. Perhaps the most basic such method is the use of internal capital allocation. 1 This control mechanism is not particularly useful for correcting deviations between actual and desired risk exposures, but rather to ensure that enough equity capital is allocated out of the firm's capital structure to avoid those deviations ex ante.
Chapter 3 set forth the assumptions under which the capital structure of a firm is irrelevant to the market value of that firm and its security holders. Chapters 4 to 7 then outlined a series of rationales for why risk management in many ways can simply be viewed as a substitute for equity capital. In the context of the risk control business model outlined in Chapter 10, capital allocation thus can serve as a substitute for risk reduction using financial instruments or changes to the balance sheet. When the actual risk profile of a firm departs from its risk tolerance, allocating more capital to the exposure can fix the deviation as surely as hedging—provided that the capital is allocated on a basis that makes economic sense. The remainder of this chapter outlines some of the principles under which those capital allocation decisions can make sense.
Before tackling the mechanics of capital allocation, the rationales for capital allocation are summarized. A pure risk controller might allocate capital using all the right methods and tools but might do so purely because it views equity capital allocation as a buffer against losses. In fact, capital allocation using all the right models and tools can be much, much more than a buffer against unexpected losses. Capital allocation also plays a very important
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Book title: The Risk Management Process: Business Strategy and Tactics. Contributors: Christopher L. Culp - Author. Publisher: John Wiley & Sons. Place of publication: New York. Publication year: 2001. Page number: 457.
This material is protected by copyright and, with the exception of fair use, may not be further copied, distributed or transmitted in any form or by any means.