Corporate Risk Management

By Barrese, James; Scordis, Nicos | Review of Business, Fall 2003 | Go to article overview

Corporate Risk Management


Barrese, James, Scordis, Nicos, Review of Business


Corporate risk management is evolving to be viewed as the management of the operations and activities of a corporation, and its financing practices, to construct a portfolio of risks that yield a corresponding average payoff Decisions about seemingly disparate issues are seen as integrated by their net effect on the probable risk-return balance of the corporation. This paper summarizes the literature on corporate risk management issues including the issue of whether risk management is primarily an agency cost.

Introduction

Risk affects all forms of business and personal activity. While the definition of risk is the variation of actual outcomes around an expected average outcome, when practitioners use the term "risk management" they exclusively and artificially denote one of two interconnected paths. The first path deals with the pricing and selection of financial instruments, and the construction of financial hedges to manage a firm's cash flows. The second path deals with mechanical systems, decision-making processes and insurance products to preserve the firm's resources from accidental loss. Even though the shortcomings of this artificial separation of risk management are well acknowledged, risk management textbooks and professional designation societies continue to maintain this division; the abundant crop of textbooks that identify themselves using the title "Risk Management and Insurance" reinforce the view that insurance is a tool somehow separate from risk management. Insurance, however, is one (albeit the most popular) of the available financial tools for hedging against the negative economic impact of events.

The evolving view of risk management often depends on one's perspective. Many of the current corporate risk management positions evolved out of the insurance-buying function of corporate operations, while hedging and capital structure decisions are made in the treasury/finance department. This history both taints and defines the scope of risk management. It is only recently (apart from isolated voices in the 1970s and 1980s) that students and practitioners of risk management see the operation of a corporation, and its financing practices, as a portfolio of risks that yield a corresponding average payoff. The sources of variation from that average payoff are varied and Shapiro and Titman [2:215] note: "Typically, these decisions--such as how much fire insurance to buy, whether to hedge a particular foreign exchange risk, and how much leverage to incorporate within the company's capital structure-are made independently of each other, presumably because each deals with a different source of risk. But because each of these decisions "affects the total risk of the firm (albeit with different costs and consequences), there are clearly benefits to integrating risk management activities into a single framework."

The Value of Corporate Risk Management

The evolution of the risk management literature is not complete. Business organizations deal with both pure and speculative risks; pure risk is associated with hazards having only a negative consequence, while speculative risks may have positive or negative consequences. From a finance perspective, the distinction between pure and speculative risk blurs because the rate of return shareholders require depends on its non-diversifiable risk (systematic risk) or core risk, which can include pure and speculative risk components, investors do not accept a lower rate of return for the stock of a firm that does, through a risk management program, what the shareholders can do for themselves at lower cost through portfolio diversification. In fact, the opposite may be true. Viewing the firm as a combination of assets-in place and future growth opportunities, as the total risk of the firm declines the systematic risk of growth opportunities increases hi relative importance but the proportion of the total shareholder value attributable to growth declines. …

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