Strategic Risk Management

February 14, 2009

A.V. Vedpuriswar
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We had 20 people on the beach looking at grains of sand with microscopes
when the tsunami came along and wiped everybody out.
Cleaning up DRCM was, in the words of one UBS employee, like mopping up
spilt milk on the deck of the Titanic.
FT April 20, 2008
[OPTIONAL SLIDE]
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Objectives
Understanding risk
Getting the big picture
Taking a holistic view
Recognising human infallibilities
Being clear about our priorities
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Acknowledgements
Enterprise Risk Management: Theory and Practice, Brian W. Nocco, and
Ren M. Stulz, Journal of Applied Corporate Finance, Fall 2006
Strategic Risk Taking, Aswath Damodaran
The Black Swan, Nassim Nicholas Taleb
Integrated Risk Management for the Firm: A Senior Managers Guide,
Working paper by Lisa K. Meulbroek
Kenneth Froot, David Scharfstein & Jeremy Stein, A famework for risk
management, Harvard Business Review, Nov-Dec1994
Options, futures and Derivative Securities, John C Hull
Risk Management and Financial Institutions, John C Hull
FRM Body of Knowledge
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Ice breaker
What are the fundamental laws of Physics?
What are the fundamental laws of Economics?
What about Financial Economics?
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A problem which took 160 years to solve
Luca Pacioli, an Italian monk framed a famous problem.
Two gamblers are playing a best-of-five dice game.
They are interrupted after three games with one gambler
leading 2 to 1.
What is the fairest way to divide the pot between the two
gamblers, taking into account the current status of the
game?
Blaise Pascal and Pierre de Format solved the problem after
about 160 years.
How?
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Another teaser
I give you two options
Take Rs. 50
I toss a coin. Heads you get Rs. 100 and tails you get 0
Which will you choose?
I give you two options
Pay Rs. 50
I toss a coin. Heads you pay Rs. 100 and tails you pay 0
Which will you choose?
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A third teaser
The bird flue epidemic is expected to hit your town and it is
estimated that 600 people die. Which of the following two
drugs, A or B, will people recommend to combat the
epidemic, given the following information?
If Drug A is used: 200 will be saved.
If Drug B is used : 1/3 chance that all 600 will be saved
and 2/3 chance that nobody will be saved.
It seems a greater percentage of the respondents vote
for Drug A
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Now the second sample of doctors from the same
population, who are not exposed to the above poser, are
presented a different looking poser.
The bird flue epidemic is expected to hit your town and it is
estimated that 600 people will die. Which of the following two
drugs, C or D, will people recommend to combat the
epidemic, given the following information?
If Drug C is used : 400 will die.
If Drug D is used: 1/3 chance that nobody will die, and 2/3
chance that 600 will die.
It seems a greater percentage of the respondents vote
for Drug D.
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Key messages
Our attitudes towards risk are highly perplexing.
Risk management should not be equated with risk hedging.
The essence of good risk management is making the right
choices when it comes to dealing with different risks .
The most successful companies have risen to the top by
finding particular risks that they are better at exploiting than
their competitors.
Some risks are black swans. They come when we least
expect them but their effects can be catastrophic.
Take the example of the normal distribution.
Why manage risk?
Why not allow investors to build a diversified portfolio?
After all the market does not reward us for taking
unsystematic risk.
Inadequate information.
Transaction costs.
Distress costs.
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How Risk Management adds value
Enterprise Risk management creates value at both a
macro or company-wide level and a micro or business-
unit level.
At the macro level, ERM creates value by enabling senior
management to quantify and manage the risk-return tradeoff
that faces the entire firm .
At the micro level, ERM becomes a way of life for managers
and employees at all levels of the company.
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What determines the value of a firm?
The value of a firm can generally be considered a function of
four key inputs :
Cash flow from assets in place or investments already
made.
Expected growth rate in cash flows during a period of high
growth excess returns.
Time before stable growth sets in and excess returns are
eliminated.
Discount rate which reflects both the risk of the investment
and the financing mix used by the firm.
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What can a firm do to increase its value?
Generate more cash flows from existing assets.
Grow faster or more efficiently during the high growth phase.
Prolong the high growth phase
Lower the cost of capital.
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How hedging can help
Managers may under invest because of risk aversion.
By providing hedging tools, we can remove the disincentive
that prevents them from investing.
By hedging and smoothening earnings, firms can extend
their high growth/excess returns period .
Providing protection against firm specific risks may help
align the interest of stockholders and managers and lead to
higher firm value.
The pay off from risk hedging must be greater for firms with
weak corporate governance structures and managers with
long tenure.
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How taking risk helps
The way the firm strategically manages its risk exposure,
such as by making the right R&D investments, will clearly
help in extending the growth phase.
The pay off from risk management may be greater in
businesses that are volatile but earn high returns on
investment.
There must be unpredictable, but lucrative investment
opportunities.
Look for the positive black swans!
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Finance, Strategy and Operations
Risk management as a discipline has evolved unevenly
across different functional areas.
In finance, the preoccupation has been with hedging and
discount rates.
Little attention has been paid to the upside.
In strategy, the focus has been on competitive advantage
and barriers to entry.
Risk management at most organizations is splintered.
There is little communication between those who assess
risk and those who make decisions based on those risk
assessments.
Three ways to mange risk
Fundamentally, there are three ways to manage risk.
Which are these ways?
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Three approaches to managing risk



Targeted
financial
instruments
(Transfer)

Modifying
operations,
(Hold)
Adjusting
capital structure
(Buffer)

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Integrated risk management
Integration refers both to the combination of these three risk
management techniques, and to the aggregation of all the risks
faced by the firm.
Integrated risk management is by its nature strategic, rather
than tactical.
The three ways to manage risk are functionally equivalent .
Their use connects seemingly-unrelated decisions.
For instance, effective capital structure decisions cannot be
made in isolation from the firms other risk management
decisions.
Can we think of some examples?
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Modifying the firms operations to gain
competitive advantage
Companies are in business to take strategic and business
risks.
By reducing non-core exposures, ERM effectively enables
companies to take more strategic business risks.
Pharma R&D
Human capital management in software company
Cricket pitch during rainy season
Environmental management
Oil company
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When to hold the risk?
Companies should be guided by the principle of comparative
advantage in risk-bearing.
A company that has no special ability to forecast market
variables has no comparative advantage in bearing the risk
associated with those variables.
In contrast, the same company should have a comparative
advantage in bearing information-intensive, firm-specific
business risks because it knows more about these risks than
anybody else.
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Risk management using targeted financial instruments
When should firms use targeted financial instruments?
Some risks cannot be managed effectively through the
operations of the firm, either because no feasible operational
approach exists.
Or an operational solution is simply too expensive to
implement .
Or it is too disruptive of the firms strategic goals .
Targeted financial instruments are especially suited for firms
with large exposures to commodity prices, currencies, interest
rates, or the overall stock market.
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Risk adjustment via the capital structure
What are the implications of lower debt?
Lower debt means that the firm has fewer fixed expenses.
This translates into greater flexibility in responding to any
type of volatility that affects firm value .
Lower debt also reduces the chance that the firm becomes
financially distressed.
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Equity: An all purpose cushion
Equity provides an all-purpose risk cushion against loss.
Equity provides ideal protection against those other risks
that cannot be readily anticipated or measured, or for which
no specific targeted financial instrument exists .
The larger the amount of risk that cannot be accurately
measured or shed, the larger the firms equity cushion
should be.

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Historical perspective
Every major advance in human civilization has happened
because someone was willing to take risk .
In mans early days, physical and economic risk went hand in
hand.
The development of shipping trades facilitated the separation
of economic and physical risk.
Insurance evolved in various ways.
In recent years, more efficient derivative instruments have been
designed that facilitate risk transfer.
As a result, risk management has become increasingly
sophisticated .
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Behavioral issues in Risk Management

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The duality of risk
It is part of human nature to be attracted to risk.
At the same time, there is evidence that human beings try to
avoid risk in both physical and financial pursuits.
Some individuals take more risk than others.
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Behavioural finance and prospect theory
Decisions are affected by the way choices are framed.
Individuals may be risk seeking in some situations and risk
averse in others.
Individuals feel more pain from losses than from equivalent
gains.
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Propositions about risk aversion (1/2)
Individuals are generally risk averse and more so when the
stakes are large than when they are small.
There are big differences in risk aversion across the population
and noticeable differences across sub groups.
Individuals are far more affected by losses than by equivalent
gains.
The choices that people make when presented with risky choices
or gambles depend on how the choice is presented.
Individuals tend to be much more willing to take risk with what
they consider found money than with money they have earned.
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Propositions about risk aversion (2/2)
There are two scenarios where risk aversion seems to
decrease and is even replaced by risk seeking.
One is when individuals are offered the chance of making an
extremely large sum with a small probability of success.
The other is when individuals who have lost money are
presented with choices that will allow them to make their
money back.
When faced with risky choices, individuals often make
mistakes in assessing the probabilities of outcomes, over
estimating the likelihood of success.
The problem gets worse as the choices become more
complex.
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Risk Management vs. Risk hedging
Risk management is aimed at generating higher and more
sustainable excess returns.
The benefits of risk management will be greatest in
businesses with high volatility and strong barriers to entry.
The greater the range of firm specific risks, the greater the
potential for risk management.
Risk management will create more value if new entrants can
be kept out of business.
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Managing the upside
A simple vision of successful risk taking is that we should
expand our exposure to upside risk while reducing the
potential for downside risk.
The excess returns on new investments and the length of
the high growth period will be directly affected by decisions
on how much risk to take in new investments .
There is a positive pay off to risk taking but not if it is
reckless.
Firms that are selective about the risks they take can exploit
these risks to their advantage.
Firms that take risks without sufficiently preparing for their
consequences can be hurt badly.
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Risk Management vs. Risk Hedging: A summary
Risk Hedging Risk Management
View of risk Risk is a danger Risk is a danger & an opportunity
Objective Protect against the downside Exploit the upside
Approach Financial, Product oriented Strategy/cross functional process
oriented
Measure of success Reduce volatility in earnings,
cash flows, value
Higher value
Type of real option Put Call
Primary impact on value Lower discount rate Higher & sustainable excess returns
Ideal situation Closely held, private firms, publicly
traded firms with high financial
leverage or distress costs
Volatile businesses with significant
potential for excess returns
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Competitive advantage through superior risk
management
Information
Speed
Experience/Knowledge
Resource
Flexibility
Corporate governance
People
Reward/punishment mechanisms
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Information advantage
Firms that take risk must invest in superior information
networks.
Companies must be clear about the kind of information
needed for decision making in a crisis and put in place
necessary information systems.
Early warning information systems must trigger alerts and
preset responses.
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The speed advantage
The speed of response can be critical in a crisis .
Speed depends on the quality of information, and
understanding the potential consequences and the interests
of the stakeholders.
Organizational structure and culture also determine the
speed of response.
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The experience/knowledge advantage
Having experienced similar crises in the past can give us an
advantage.
Firms must invest in learning .
They can enter new and unfamiliar markets, expose
themselves to risk and learn from mistakes.
They can acquire firms in unfamiliar markets .
They can form strategic alliances or poach people with the
necessary expertise.
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The resource advantage
Having the resources to deal with crisis can give a company
a significant advantage over competitors.
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Flexibility
A flexible response to changing circumstances can be a generic
advantage.
For some firms, flexibility may come from production facilities that
can be modified at short notice to produce modified products that
better fit customer demand
For others, flexibility may come from lower overheads/fixed costs.
Flexibility also mean the ability to get rid of past baggage,
cannibalising existing product lines and having a paranoid
culture.
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Corporate governance
Interests of decision makers must be aligned with those of
the owners.
Both managers with too little wealth and too much wealth
tied up in their business will not take risk.
The appropriate corporate governance structure for the risk
taking firms would call for decision makers to be invested in
the equity of the firm but also to be diversified.
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People
When facing a crisis, some people panic, others freeze but a
few thrive and become better decision makers.
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Reward/Punishment mechanisms
A good compensation system must consider both process
and results.
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Five questions about risk
Question #1: Have senior managers communicated the core
values of the business in a way that people understand and
embrace?
Question #2: Have managers in the organization clearly
identified the specific actions and behaviors that are off-
limits?
Question #3: Are diagnostic control systems adequate at
monitoring critical performance variables?
Question #4: Are the control systems interactive and
designed to stimulate learning?
Question #5: Is the company paying enough for traditional
internal controls?

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Risk management: First principles (1/2)
Risk is everywhere: Our biggest risks will come from places that we
least expect them to come from and in forms that we did not anticipate
that they would take.
Risk is threat and opportunity: Good risk management is about
striking the right balance between seeking out and avoiding risk.
We are ambivalent about risks and not always rational: A risk
management system is only as good as the people manning it.
Not all risk is created equal: Different risks have different implications
for different stakeholders .
Risk can be measured: The debate should be about what tools to use
to assess risk than whether they can be assessed.
Good risk measurement should lead to better decisions : The risk
assessment tools should be tailored to the decision making process.
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Risk management: First principles (2/2)
The key to good risk management is deciding which risks to avoid, which
ones to pass through and which to exploit : Hedging risk is only a small part
of risk management.
The pay off to better risk management is higher value: To manage risk right,
we must understand the levers that determine the value of a business.
Risk management is part of everyones job : Ultimately, managing risks well is
the essence of good business practice and is everyones responsibility.
Successful risk taking organizations do not get there by accident: The risk
management philosophy must be embedded in the companys structure and
culture.
Aligning the interests of managers and owners, good and timely
information, solid analysis, flexibility and good people is key : Indeed,
these are the key building blocks of a successful risk taking organization.


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Concluding remarks
Extreme negative outcomes are always a possibility.
The effectiveness of risk management cannot be judged on
whether such outcomes materialize.
The role of risk management is to limit the probability of such
outcomes to an agreed-upon, value maximizing level.
A company where risk is well understood and well managed will
command the resources required to invest in the valuable
projects available to it because it is trusted by investors.
Investors will be able to distinguish bad outcomes that are the
result of bad luck rather than bad management.