Essay About Risk Management Primer And Integrated Risk Management Framework

Risk Management
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02-046
Copyright © 2002 Lisa K. Meulbroek
Working papers are in draft form. This working paper is distributed for purposes of comment and
discussion only. It may not be reproduced without permission of the copyright holder. Copies of working
papers are available from the author.
Integrated Risk
Management for the
Firm: A Senior
Managers Guide
Lisa K. Meulbroek
Harvard Business School
Soldiers Field Road
Boston,MA 02163
The author gratefully acknowledges the financial support of Harvard Business
Schools Division of Research. Email: [email protected]
Abstract
This paper is intended as a risk management primer for senior managers. It discusses the
integrated risk management framework, emphasizing the connections between the three
fundamental ways a company can implement its risk management objectives: modifying
the firms operations, adjusting its capital structure, and employing targeted financial
instruments. “Integration” refers both to the combination of these three risk management
techniques, and to the aggregation of all risks faced by the firm. The paper offers a
functional analysis of integrated risk management using a wide set of illustrative
situations to show how the risk management process influences, and is influenced by, the
overall business activities and the strategy of the firm. Finally, the paper provides a risk
management framework for formulating and designing a risk management system for the
firm, concluding with a perspective on the future evolution of risk management.
Introduction
Managers have always attempted to measure and control the risks within their companies.
The enormous growth and development in financial and electronic technologies,
however, have enriched the palette of risk management techniques available to managers,
offering an important new opportunity for increasing shareholder value. “Integrated risk
management” is the identification and assessment of the collective risks that affect firm
value, and the implementation of a firm-wide strategy to manage those risks. For some
managers, “risk management” immediately evokes thoughts of “derivatives,” and
strategies that magnify, not reduce, risk. Derivatives, as a risk management tool, are only
a small part of the integrated risk management process. Moreover, a proper risk
management strategy does not involve speculation, or betting on the future price of oil,
corn, currencies, or interest rates, and indeed is antithetical to such speculation. Instead,
the goal of integrated risk management is to maximize value by shaping the firms risk
profile, shedding some risks, while retaining others.
Companies have three fundamental ways of implementing risk management objectives:
modifying the firms operations, adjusting its capital structure, and employing targeted
financial instruments (including derivatives). “Integration” refers both to the
combination of these three risk management techniques, and to the aggregation of all the
risks faced by the firm. While managers have always practiced some form of risk
management, implicit or explicit, in the past, risk management was rarely undertaken in a
systematic and integrated fashion across the firm. Integrated risk management has only
recently become a practical possibility, because of the enormous improvements in
computer and other communications technologies, and because of the wide-ranging set of
financial instruments and markets that have evolved over the past decade. A sophisticated
and globally-tested legal and accounting infrastructure is now in place to support the use
of such contractual agreements on large scale and at low cost. Equal in importance to this
evolution in capital markets is the cumulative experience and success in applying modern
finance theory to the practice of risk management. Today, managers can analyze and
control various risks as part of a unified, or integrated, risk management policy.
Integrated risk management is by its nature “strategic,” rather than “tactical.” Tactical
risk management, currently more common, has a narrower and more limited focus. It
usually involves the hedging of contracts or of other explicit future commitments of the
firm such as interest rate exposures on its debt issues. Consider a U.S. dollar-based firm
that buys steel from a Japanese firm for delivery in three months. The U.S. firm may
decide to “tactically” hedge the dollar price of its steel purchase. By using forward
currency contracts, the firm locks-in the dollar cost