risk management decision making, and application of several risk management tools. A problem set based on some of the quantitative material presented in this chapter is available at the companion website: pearsonhighered.com/rejda.
THE CHANGING SCOPE
OF RISK MANAGEMENT
Traditionally, risk management was limited in scope to pure loss exposures, including property risks, liability risks, and personnel risks. An inter- esting trend emerged in the 1990s, however, as many businesses began to expand the scope of risk management to include speculative financial risks. Some businesses have gone a step further, expand- ing their risk management programs to consider all risks faced by the organization and the strategic implications of the risks.
Financial Risk Management
Business firms face a number of speculative financial risks. Financial risk management refers to the
identification, analysis, and treatment of speculative financial risks. These risks include the following:
■
Commodity price risk
■
Interest rate risk
■
Currency exchange rate risk
Commodity Price Risk Commodity price risk is
the risk of losing money if the price of a commod- ity changes . Producers and users of commodities face
commodities face commodity price risks. Consider a cereal company that has promised to deliver 500,000 boxes of cereal at an agreed-upon price in six months. In the meantime, the price of grain—a commodity needed to produce the cereal—may increase or decrease, altering the profitability of the transaction. The first part of Exhibit 4.1 shows how futures con- tracts can be used to hedge a commodity price risk. commodity price risks. For example, consider an agri-
cultural operation that will have thousands of bushels of grain at harvest time. At harvest, the price of the commodity may have increased or decreased, depend- ing on the supply and demand for grain. Because lit- tle storage is available for the crop, the grain must be sold at the current market price, even if that price is low. In a similar fashion, users and distributors of
Exhibit 4.1
Managing Financial Risk—Two Examples
1. Hedging a Commodity Price Risk Using Futures Contracts
A corn grower estimates in May that his production will total 20,000 bushels of corn, with the harvest completed by December. Checking the price of futures contracts, he notices that the price of December corn is $4.90 per bushel. He would like to hedge the risk that the price of corn will be lower at harvest time and can do so by the appropriate use of futures contracts. Because corn futures contracts are traded in 5000 bushel units, he would sell four contracts in May totaling 20,000 bushels in the futures market. In December, he would buy four contracts to offset his futures position. As demonstrated below, it doesn’t matter whether the price of corn has increased or decreased by December. By using futures contracts and ignoring transaction costs, he has locked-in total revenue of $98,000.
If the market price of corn drops to $4.50 per bushel in December:
Revenue from sale of corn 20,000 * $4.50 $90,000
Sale of four contracts at $4.90 in May 98,000 Purchase of four contracts at $4.50 in December 90,000
Gain on futures transaction 8000
Total revenue $98,000
If the market price of corn increases to $5.00 per bushel in December:
Revenue from sale of corn 20,000 * $5.00 $100,000 Sale of four contracts at $4.90 in May 98,000
Purchase of four contracts at $5.00 in December 100,000
Loss on futures transaction (2000)
Total revenue $98,000
2. Using Options to Protect Against Adverse Stock Price Movements
Options on stocks can be used to protect against adverse stock price movements. A call option gives the owner the right to buy 100 shares of stock at a given price during a specified period. A put option gives the owner the right to sell 100 shares of stock at a given price during a specified period. While there are many options strategies used to reduce risk, one simple alternative is discussed here: buying put options to protect against a decline in the price of stock that is already owned.
Consider someone who owns 100 shares of a stock priced at $43 per share. The owner may be concerned that the price of the stock will fall. At the same time, however, the owner may not wish to sell the stock as the sale would trigger taxation of a capital gain. In addition, the owner may believe that the price of the stock could increase. The stockholder could purchase a put option to reduce the risk of a price decline.
Assume there is a put option available with a strike (exercise) price of $40. The owner of the stock could purchase the option. If the price of the stock increases, the stock owner has lost the purchase price of the option (called the premium), but the stock price has increased. But what if the price of the stock declines, say to $33 per share? In the absence of the put option, the stock owner has lost $10 ($43–$33) per share on paper. As owner of the put option, however, the stock holder has the right to sell 100 shares at $40 per share. Thus, the option is “in the money” by $7 per share ($40–$33), ignoring the option premium. The put option could be sold to offset the paper loss. Using put options in this way protects against losing money if the price of the stock declines.
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retention, risk transfer, and risk control. Speculative risks were handled by the finance division through contractual provisions and capital market instru- ments. Examples of contractual provisions that address financial risks include call features on bonds that permit bonds with high coupon rates to be retired early and adjustable interest rate provisions on mortgages through which the interest rate varies with interest rates in the general economy. A vari- ety of capital market approaches are also employed, including options contracts, forward contracts, futures contracts, and interest rate swaps.1 The
second part of Exhibit 4.1 shows how options can help to manage the risk of a decrease in the price of common stock that an investor owns.
During the 1990s, some businesses began tak- ing a more holistic view of the pure and speculative risks faced by the organization, hoping to achieve cost savings and better risk treatment solutions by combining coverage for both types of risk. In 1997, Honeywell became the first company to enter into an “integrated risk program” with American International Group (AIG).2 An integrated risk
program is a risk treatment technique that combines
coverage for pure and speculative risks in the same contract . At the time, Honeywell was generating
more than one-third of its profits abroad. Its inte- grated risk program provided traditional property and casualty insurance, as well as coverage for cur- rency exchange rate risk.
In recognition of the fact that they are treating these risks jointly, some organizations have created a new position. The chief risk officer (CRO) is
responsible for the treatment of pure and speculative risks faced by the organization .3 Combining respon-
sibilities in one area permits treatment of the risks in a unified, and often more economical way. For exam- ple, the risk manager may be concerned about a large self-insured property claim. The financial manager may be concerned about losses caused by adverse changes in the exchange rate. Either loss, by itself, may not harm the organization if the company has a strong balance sheet. The occurrence of both losses, however, may damage the business more severely. An integrated risk management program can be designed to consider both contingencies by including a double- trigger option. A double-trigger option is a provision
that provides for payment only if two specified losses occur . Thus payments would be made only if
Interest Rate Risk Financial institutions are espe-
cially susceptible to interest rate risk. Interest rate
risk is the risk of loss caused by adverse interest rate
movements . For example, consider a bank that has
loaned money at fixed interest rates to home pur- chasers through 15- and 30-year mortgages. If inter- est rates increase, the bank must pay higher interest rates on deposits while the mortgages are locked-in at lower interest rates. Similarly, a corporation might issue bonds at a time when interest rates are high. For the bonds to sell at their face value when issued, the coupon interest rate must equal the investor-required rate of return. If interest rates later decline, the com- pany must still pay the higher coupon interest rate on the bonds.
Currency Exchange Rate Risk The currency exchange rate is the value for which one nation’s cur- rency may be converted to another nation’s currency. For example, one Canadian dollar might be worth the equivalent of two-thirds of one U.S. dollar. At this currency exchange rate, one U.S. dollar may be converted to one and one-half Canadian dollars.
U.S. companies that have international opera- tions are susceptible to currency exchange rate risk. Currency exchange rate risk is the risk of loss of value
caused by changes in the rate at which one nation’s currency may be converted to another nation’s currency . For example, a U.S. company faces cur-
rency exchange rate risk when it agrees to accept a specified amount of foreign currency in the future as payment for goods sold or work performed. Likewise, U.S. companies with significant foreign operations face an earnings risk because of fluctuating exchange rates. When a U.S. company generates profits abroad, those gains must be translated back into U.S. dollars. When the U.S. dollar is strong (that is, when it has a high value relative to a foreign currency), the for- eign currency purchases fewer U.S. dollars and the company’s earnings therefore are lower. A weak U.S. dollar (that is, when it has a low value relative to a foreign currency) means that foreign profits can be exchanged for a larger number of U.S. dollars, and consequently the firm’s earnings are higher.
Managing Financial Risks The traditional separa-
tion of pure and speculative risks meant that differ- ent business departments addressed these risks. Pure risks were handled by the risk manager through risk
the Risk Management Society (RIMS) and the world’s largest insurance broker, Marsh, publish the “Excellence in Risk Management” report. The report provides results of a survey of risk management pro- fessionals concerning current issues and practices. The survey found that in 2010, 80 percent of the respondents had developed or were in the process of developing an enterprise risk management program. Seventeen percent of the respondents said their ERM program was fully integrated and addressed risks all across the organization.4 Organizations adopt ERM
for several reasons. Among the reasons often cited are: holistic treatment of risks facing the organization, competitive advantage, positive impact on revenues, a reduction in earnings volatility, and compliance with corporate governance guidelines.
Reasons cited in an earlier RIMS/Marsh survey for not adopting an ERM program include: not a priority, risk is managed at the operational or functional level, senior management does not see the need, lack of per- sonnel resources, and lack of demonstrated value.5 The
value proposition for ERM is interesting. For smaller organizations, and organizations with limited financial exposure, an ERM program may not make sense. A recent study examining ERM adoption by insurance companies found that ERM adoption enhanced the firm’s value, with a premium of about 20 percent.6 The
most recent “Excellence in Risk Management” report compared the views of C-suite respondents (chief execu- tive officers, chief financial officers, etc.) with the views of risk managers.7 The results of the study were inter-
esting, and a gap in expectations was detected. When asked about the primary focus area for developing risk management capabilities, C-suite respondents stressed the importance of strategic thinking rather than strengthening enterprise risk management capabilities. Given the ERM adoption rate reported earlier for these larger firms, it appears that C-suite respondents take ERM expertise as somewhat of a given. In contrast, risk management respondents had a narrower focus, emphasizing integrating risk management with opera- tions and focusing more on short-term activities rather than the broader, strategic view.
The presence of an ERM program does not guar- antee that an organization will be successful. A sur- vey of executives of 316 financial services executives prior to the financial crisis revealed that 18 percent of the respondents had well–formulated and fully i mplemented ERM programs and 71 percent had an a large property claim and a large exchange rate loss
occurred. The cost of such coverage is less than the cost of treating each risk separately.
Enterprise Risk Management
Background and Use Encouraged by the success of
financial risk management, some larger organizations took the next logical step. Enterprise risk management is a comprehensive risk management program that
addresses an organization’s pure risks, speculative risks, strategic risks, and operational risks . Pure and
speculative risks were defined previously. Strategic
risk refers to uncertainty regarding an organization’s
goals and objectives, and the organization’s strengths, weaknesses, opportunities, and threats. Operational
risks develop out of business operations, including
the manufacture and distribution of products and providing services to customers. By packaging all of these risks in a single risk management program, the organization offsets one risk against another, and in the process reduces its overall risk. As long as the risks combined are not perfectly and positively corre- lated, the combination of loss exposures reduces risk. Indeed, if some of the risks are negatively correlated, risk can be reduced significantly.
Many examples of such combinations of risk could be cited. Consider a simple illustration, a petro- leum company that owns and operates a refinery and service stations. Assume the business also sells heating oil to business and residential customers. During sum- mer months, the company may agree to deliver heating oil to customers in the fall at a specified price. Between summer and the delivery date, the price of heating oil may increase. Considering this risk in isolation and assuming the company lacks sufficient storage, the company may use heating oil futures contracts to hedge the company’s price risk. However, recall that the com- pany also has service stations which provide a natu- ral hedge position. If the price of fuel increases in the summer months, the company will make money on its service station operations but lose money covering the promised heating oil delivery. Likewise, if the price of heating oil and gasoline decreases between the summer and fall, the company will make money delivering the fuel oil at a price higher than the market price at a time when service stations operations may not be profitable. To what extent have large businesses adopted enterprise risk management programs? Each year,
T H E C H A N G I N G S C O P E O F R I S K M A N A G E M E N T 6 7
After the 9/11 attacks, insurers began to exclude losses attributable to terrorism. Congress passed the Terrorism Risk Insurance Act (TRIA) in 2002 to cre- ate a federal backstop for terrorism claims. This Act was extended in 2005, and again in 2007 through the Terrorism Risk Insurance Program Reauthorization Act (TRIPRA). Terrorism insurance coverage is avail- able through standard insurance policies or through separate, stand-alone coverage. Organizations with the greatest exposure (e.g., large metropolitan office buildings, defense contractors, ports, etc.) often pur- chase coverage for terrorism losses. Insurance under- writing has evolved to consider the terrorism risk. For example, workers compensation underwriters consider whether employees are concentrated at one location or geographically dispersed.
Climate Change Risk Losses attributable to natu- ral catastrophes have increased significantly in recent years.10 Such losses include earthquakes, hurricanes,
tsunamis, typhoons, droughts, floods, and tornadoes. Many of these losses are attributable to the changing climate, which in turn may be attributable to carbon emissions. Greater volatility in weather patterns has occurred in recent years—wider temperature ranges, droughts, floods, and an increase in the frequency and severity of storms. The increased losses when storms occur are also related to demographic factors. For example, much of the population growth in the U.S. is in areas that are exposed to greater risk from hurri- canes (e.g., coastal Florida, Texas, and South Carolina).
Governments, insurers, and businesses have all responded to this increased risk. Governments have sought to reduce carbon emissions by restricting the amount of carbon dioxide released by businesses. Several carbon trading markets developed through which companies that are below their emissions limit can sell credits to companies above the standard. Other governmental approaches to dealing with cli- mate change are tougher zoning and building code requirements for structures in areas where the hazard is greater. Insurers have also responded by provid- ing discounts for energy efficient (“green”) buildings and premium credits for structures with superior loss control. Businesses must be careful about where they locate structures, risk control measures deployed, and in procuring the appropriate insurance coverage given the increased risk. Businesses may also employ weather derivatives, discussed later in this chapter, to address climate change risk.
ERM strategy that was in the implementation stage.8
Even with an enterprise risk management program in place and a Chief Risk Officer, insurer American International Group (AIG) needed a federal govern- ment bailout to prevent the company from becoming insolvent. AIG’s near-demise was caused by loan guar- antees called credit default swaps issued by its financial products division.
Emerging Risks As noted, ERM programs are
designed to address all of the risks faced by an organi- zation. Two emerging risks that merit additional discus- sion are terrorism-related losses and losses attributable to climate change.
Terrorism Risk While the terrorist attacks on 9/11
served as a wake-up call to many, the risk of terror- ism is not new. The World Trade Center was attacked previously (1993) and the Murrah Federal Building in Oklahoma City was attacked in 1995. Foreign and domestic terrorists can attack property directly through bombs and other explosives, or they can stage a cyber-attack on an organization’s sensitive data (e.g., bank records, credit card numbers, and social secu- rity numbers) or introduce a virus into the computer system. Another risk from terrorists is a “CRBN” attack—use of chemicals, radioactive material, bio- logical material, and nuclear material. An example of a chemical attack would be the release of a lethal gas, such as sarin. Radioactive material would be released in a radiological attack. Terrorists could release a contagious disease or anthrax spores in a biological attack. Nuclear material could also be used by terror- ists. These materials could be used with conventional explosives in an attack. For example, a dirty bomb combines explosives with radiological material. The results of such an attack could be devastating.9
The risk of terrorism can be addressed through risk control and insurance. Numerous risk control measures can be deployed. For example, physical barriers may be erected to prevent suicide bombers from using a vehicle to reach a building. Screening devices can check for metal (weapons) and also test air samples to see if explosives are present. Computer networks can be protected by impenetrable fire walls to prevent a cyber-attack. Key company personnel can be instructed on how to reduce the probability of being kidnapped by terrorists.
Prior to the 9/11 attack, terrorism exclusions