MIT OpenCourseWarehttp://ocw.mit.edu 15.997 Practice of Finance: Advanced Corporate Risk Management Spring 2009 For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.Lecture Notes on Advanced Corporate Financial Risk Management John E. Parsons and Antonio S. Mello Chapter 2: How Companies Manage Risk 2.1 Everyone is a Risk Manager The term risk management can mean different things to different people. In the last few decades, with the rise of financial engineering, the term risk management has become strongly associated with the derivatives trading desks of investment banking houses and hedge funds. In a few commodity industries certain firms have developed profitable trading operations built on the same principles. In non-financial corporations, risk management evokes an image of the treasury office buying or selling foreign currency futures to lock in the dollar value of foreign product sales. There is also an entirely distinct discipline that goes by the same label, risk management, and that is involved in identifying and limiting the probability of calamatous events, such as plant explosions or the theft of corporate secrets or the loss of key personnel. Insurance companies both cover and help to manage and minimize these sorts of risks. In truth, risk management is not a specialized activity properly relegated to any single type of financial institution nor to any single office of the firm. Managers in all parts of a company regularly make all types of decisions involving choices and tradeoffs about risk. The marketing department designs types of contracts for customers that share risk between the firm and its customers. Business unit managers evaluate alternative lines of business with different risk characteristics. Asset development teams alter project designs so as to minimize risk without sacrificing return. Supply chain management regularly evaluates alternative means of sourcing based on risk factors. The tax, legal and accounting departments are concerned with risk, with hedging and with the corporate governance issues. At the highest level of the company key questions about the firm’s strategy and its ability to fund its operations must be answered with an eye on the risks of each alternative and strategic decisions that can secure the greatest value for shareholders. Most business decisions involve a choice about risk. Everybody is a risk manager. Risk management is the science of assessing these tradeoffs involving risk – quantifying the exposure, determining the cost of risk to the activities of your department or business unit or customer, understanding how the marketplace values and prices risk, and using this knowledge toChapter 2: How Companies Manage Risk execute your tasks successfully for the benefit of the business. Risk is an important element of decisions facing managers throughout a company’s many departments, and risk management should be everybody’s business. Therefore, this book develops one common toolkit for analyzing risk, and then shows how these tools are used across diverse activities within the business. The next section of this chapter provides a brief overview of some of the different types of activities and decisions involving risk which arise in various parts of a business. The objective is to give the student a fuller sense of the diverse settings in which a thorough understanding of risk can benefit the business. This overview helps to illustrate that risk management is not a specialized function carried out separate from the other parts of the firm, but instead a general management issue relevant throughout the firm. Throughout the remainder of the course and these lecture notes, we will be going into much more detail on each of these individual problems. By the end of the course, the student should be able to spot and identify the risk management element of each case or story. 2.2 The Different Types of Corporate Risk Management Although the many different parts of the firm all face problems involving risk, the problems are very different. The problem facing a commodity trader is not the same problem that faces the business unit manager and not the same problem that faces the CFO. To gain a comprehensive view of what risk management is requires a short tour through the various types of problems facing managers who play these different roles within the firm. Valuation and Pricing Valuation is central to a wide range of business decisions, from the price to pay for an asset to the price to charge for a product. And risk is central to valuation. Better measurement of risk and better pricing of risk leads to a more accurate valuation. Armed with more accurate valuations, management is able to make better decisions. The workhorse for valuations is the discounted cash flow (DCF) model. In many cases the DCF model produces a reasonably accurate estimate of the value. This is true because the risk profile fits the usual assumptions employed by the DCF model, at least to the degree of precision at hand in real world cases. But in certain situations the structure of the risk is markedly different from the usual one, and the standard DCF calculation gets the valuation wrong. In these cases, a page 2Chapter 2: How Companies Manage Risk more thorough analysis of risk is needed in order to get the valuation right. Amending the DCF model to handle this more complicated risk structure is possible. The tools of risk management show how it can be done. There are many complicated patterns for which a more careful treatment of risk is needed. However, two very common patterns requiring more careful analysis are: • Risk is not symmetric; this happens, for example, when risk is truncated by a guarantee clause, by the option to switch or abandon, by floor or ceiling price structures, and so on; • Risk changes through time; this happens, for example, when the success or failure of a project is decided within a concentrated window of time or when a project goes through markedly different stages during which specific risks become resolved. Once you start thinking carefully about it, many projects and assets exhibit these features. Companies often enter into supply agreements with various floor and ceiling price clauses. Supply contracts often have quantity options of various sorts. If the market price of a critical input rise too far, engineers will be put to work to find substitutes or to