Financial Risk Management

Frank J. Fabozzi

• Publisher: Wiley
• Year: 2010
• Print ISBN: 9781118108482
• eBook ISBN: 9780470944806
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Created by the experienced author team of Frank Fabozzi and Pamela Peterson Drake, Financial Risk Management examines the essential elements of this discipline and makes them accessible to a wide array of readers-from seasoned veterans looking for a review to newcomers needing to get their footing in finance.

Financial risk is the exposure of a corporation to an event that can cause a shortfall in a targeted financial measure or value and includes market risk, credit risk, market liquidity risk, operational risk, and legal risk. This material discusses the four key processes in financial risk management: risk identification, risk assessment, risk mitigation, and risk transferring. The process of risk management involves determining which risks to accept, which to neutralize, and which to transfer.

CHAPTER 16

Financial Risk Management

All firms face a variety of risks. Scandals such as Enron, WorldCom, Tyco, and Adelphia and tragic events such as 9/11 have reinforced the need of companies to manage risk. Moreover, risk management should not be placed at the end of the agenda for a board meeting as “other business,” but be a key agenda item that is discussed regularly at board meetings. In practice, the board can provide only oversight and direction. The responsibility of risk management is often delegated to either (1) the audit, finance, or compliance committee of the company’s board of directors; or (2) a risk management officer (typically called the chief risk officer) or a risk management group headed by a risk management officer. Regardless of the structure, to assure effective performance of the risk management process, the committee or group responsible for risk management should have regular interaction with the chief financial officer, internal auditors, general counsel, and managers of business units.

In this chapter we discuss the four key processes in financial risk management: risk identification, risk assessment, risk mitigation, and risk transferring. The process of risk management involves determining which risks to accept, which to neutralize, and which to transfer.

RISK DEFINED

There is no shortage of definitions for risk. In everyday parlance, risk is often viewed as something that is negative. But we know that some risks lead to economic gains while others have purely negative consequences. For example, the purchase of a lottery ticket involves an action that results in the risk of the loss equal to the cost of the ticket but potentially has a substantial monetary reward. In contrast, the risk of death or injury from a random shooting is purely a negative consequence.

In the corporate world, accepting risks is necessary to obtain a competitive advantage and generate a profit. In fact, “risk” is derived from the Italian verb riscare, which means “to dare.” Corporations “dare to” generate profits by taking advantage of the opportunistic side of risk.1 The former Delaware Supreme Court Chief Justice Norman Veasey (2000, pp. 26–27) in a decision wrote:

Potential profit often corresponds to the potential risk. . . . Stockholders’ investment interests . . . will be advanced if corporate directors and managers honestly assess risk and reward and accept for the corporation the highest available risk-adjusted returns that are above the firm’s cost of capital.

We have already seen various definitions of risk throughout this book and there will be more in later chapters. In the discussion of capital budgeting in Chapter 14, various measures of risk were introduced. However, risk as used at the corporate level has a more general meaning than does its use in capital budgeting. Outreville (1998), for example, distinguishes between the following types of risk that are useful for ultimately managing risks: financial risk, peril, accident, and hazard.

When a corporation is exposed to an event that can cause a shortfall in a targeted financial measure or value, this type of risk is called financial risk. The financial measure or value could be earnings per share, return on equity, or cash flows, to name some of the important ones. Financial risks include market risk, credit risk, market liquidity risk, operational risk, and legal risk.

Culp (2006, p. 27) defines perils, accidents, and hazards as follows:

A peril is a natural, man-made, or economic “situation” that can cause an unexpected loss for a firm, the size of which is usually not based on the realization of one or more financial variables. A peril thus is essentially a non-financial risk. An accident is a specific negative event arising from a peril that gives rise to a loss, and is usually considered unintentional. A hazard is something that increases the probability of a peril-related loss occurring, whether intentional or not.

Culp (2006, p. 27–28) provides the following types of perils faced by corporations:

• Production. Unexpected changes in the demand for products sold, increases in input costs, failures of marketing.
• Operational. Failures in processes, people, or systems.
• Social. Adverse changes in social policy (e.g., political incorrectness of a product sold), strained labor relations, changes in fashions and tastes, etc.).
• Political. Unexpected changes in government, nationalization of resources, war, and so on.
• Legal. Tort and product liability and other liabilities whose exposures are not driven by financial variables.
• Physical. Destruction or theft of assets in place, impairment of asset functionality, equipment or mechanical failure, chemical-related perils, energy-related perils, and so on.
• Environmental. Flood, fire, windstorm, hailstorm, earthquake, cyclone, and so on.

Examples of hazards that increase the likelihood that there will be a loss for different perils are:

• Human. Fatigue, ignorance, carelessness, smoking
• Environmental. Weather, noise
• Mechanical. Weight, stability, speed
• Energy. Electrical, radiation
• Chemical. Toxicity, flammability, ...

Table of contents

• Cover
• Title Page
• Copyright
• CHAPTER 16: Financial Risk Management