The Risk Management Process: Business Strategy and Tactics

by Christopher L. Culp

Overview

Integrates essential risk management practices with practical corporate business strategies
Focusing on educating readers on how to integrate risk management with corporate business strategy-not just on hedging practices-The Risk Management Process is the first financial risk management book that combines a detailed, big picture discussion of firm-wide risk management with a comprehensive discussion of derivatives-based hedging strategies and tactics.
An essential component of any corporate business strategy today, risk management has become a mainstream business process at the highest level of the world's largest financial institutions, corporations, and investment management groups. Addressing the need for a well-balanced book on the subject, respected leader and teacher on the subject Christopher Culp has produced a well-balanced, comprehensive reference text for a broad audience of financial institutions and agents, nonfinancial corporations, and institutional investors.

Product Details

ISBN-13:	9780471405542
Publisher:	Wiley
Publication date:	04/06/2001
Series:	Wiley Finance , #81
Pages:	624
Product dimensions:	6.10(w) x 9.49(h) x 1.42(d)

About the Author

CHRISTOPHER L. CULP is Managing Director at CP Risk Management LLC in Chicago and is also Adjunct Associate Professor of Finance at the University of Chicago. A former president of Risk Management Consulting Services, Inc. and senior examiner in the Supervision and Regulation Department of the Federal Reserve Bank of Chicago, Dr. Culp is a managing editor of Derivatives Quarterly and Senior Fellow in Financial Regulation with the Competitive Enterprise Institute in Washington, DC. Dr. Culp holds a PhD in finance from the Graduate School of Business of the University of Chicago and a BA in economics from Johns Hopkins University.

Read an Excerpt

Chapter 1: The Nature of Risk

• A man walks across the street and faces it: A car could spin out of control and accidentally run into him.
• A woman sits down in first-class sleeper seat 1A to cross the ocean on Airline FlyByNight and confronts it: A flight delay could cause her to be late to the crucial meeting that prompted her to spend $10,000 on her ticket, or the plane could end up in the ocean and she could miss the meeting in a more permanent sense.
• A child plays in its new crib and bears it: A design defect could cause the child to trap its head in the bars and get stuck, perhaps causing permanent harm.
• Harrison Ford accepts it when he takes a role in a new movie where he plays a drug-dealer cheating on his wife: His wholesome image as Han Solo, Indiana Jones, and Jack Ryan might never be the same.

It of course is risk. Risk is everywhere. You do not have to look very hard to find risk. When you want to preoccupy yourself, it is easy to convince yourself that the world is so inherently unsafe that it is better to be the Boy in the Bubble. It is easy to worry about the risks in the food you eat, the machines you operate, the stocks you purchase, and the air you breathe. Most of us do not opt for the Howard Hughes solution. Instead, we manage risks. The man crossing the street at risk from being hit by a car might manage that risk by never crossing the street. Or he might a bit more reasonably adopt intermediate solutions designed to reduce his risk without completely eliminating it, such as looking both ways. The woman on Airline FIyByNight can manage risk by checking the frequency of on-time arrivals of her air carrier, calling ahead to see if the flight is on time, and generally avoiding airlines whose planes have a tendency to fall from the sky. Concerned parents can investigate their child's crib manufacturer and look for prior problems or complaints in places like Consumer Reports. And Harrison Ford can say no to bad scripts and stick to playing Jack Ryan.

Like it or not, the world is an unpredictable place. And as long as there is some uncertainty about the future that could result in an adverse outcome for individuals, the world is a place in which risk must be managed.

Is the World A Riskier Place?

Many argue that the world has become "a riskier place." This is certainly what the proponents of health and safety risk management like to argue. As a society, America has become obsessed with risk. Americans are among the healthiest, wealthiest people in history. And yet, we are among the most seemingly risk-averse. We worry about alar in apple juice, cholesterol in red meat, bovine somatotropin in milk, and more.

In finance, as well, many contend that the world has become more dangerous, both for individuals whose wealth is exposed to seemingly larger and larger swings in global equity markets and for corporations whose cash flows seem to depend more and more on unpredictable cross-border variables.

In fact, the evidence that risk is greater today than it was 10, 100, or even 1,000 years ago is hardly compelling-both in health and safety and in finance. How many more people are killed today by tainted pharmaceuticals than were killed 100 years ago when home remedies were the only thing available to combat disease? How many more people die from accidental electrocution than froze or starved to death before the advent of alternating current? How many more people threw themselves out of windows after the stock market crash of October 1987 compared to the crash of 1929? The answer to all these questions is not many, if any.

The tendency to claim that the world is a riskier place comes not from any real empirical evidence, but rather from the illusory temptation to pursue change without experiencing risk. But as Wildavsky (1988) argues, the effort to experience progress without risk is both paradoxical and futile.

Innovation without risk is paradoxical because the process by which risk is most naturally addressed quite often is innovation-replacing the old with the new often makes the world a safer place. Unfortunately, nostalgia makes it all too easy to forget the risks of the old while listening to a news broadcast with sound bites about the risks of the new. Smith (1988) argues, "When we think of travel by horse in the pre-automotive era, we tend to forget the huge disposal problems created by horse wastes and carcasses. When we think of man's effect on nature, we forget nature's often cataclysmic effects, and we underestimate the extent to which material progress has enabled us to temper those effects."

The evolution of financial products in a risk sense has closely paralleled the evolution of health and safety risks. The good old days when the only real financial instruments to understand were stocks and bonds have been replaced by the arrival of new and often more complex financial products like index amortizing swaps, exotic options, finite risk insurance products, and other fancy instruments. But just as society had to take a risk on the canning process in order to reduce the danger of botulism from home canning, financial society has had to risk financial innovation. And that financial innovation has, like canning, led to opportunities to further reduce risk.

True, change often creates new risks. In that, the advent of canning and derivatives are not so different. With the reduced risks of infection that accompanied canning came the increased risks of injury to workers during mechanized processing, lead poisoning, and so on. Likewise, the interest rate, currency, and commodity price risks that derivatives help firms eliminate also pose a greater threat when derivatives are abused or misused.

Progress without risk is not just paradoxical, but also futile. As Wildavsky (1988) says, "Playing it safe, doing nothing, means reducing possible opportunities to benefit from chances taken, and can hurt people." The man who decides to stay at home rather than cross the street may appear to be reducing his risk, but what if staying at home stopped him from inventing penicillin? What if Henry Ford decided safer was better and never took what must have seemed like a huge risk of creating dangerous metal objects that roll around and threaten pedestrians? And what if the desire to play it safe had kept the Wright brothers from stepping off Kill Devil Hill in the wind that day in their terrifying artificial birdlike device that paved the way for modern commercial airline travel? How many other innovations would be lost without the mobility that air travel has brought us?

Three Common Fallacies About Risk

If we recognize that risky changes can be beneficial and choose not to sit i idly by while the risky world evolves around us, how can we begin to develop a framework for managing risk responsibly? The answer to that question, in very broad terms, is that a healthy and responsible risk management framework that neither lends itself to over-caution nor to carelessness is a framework that avoids three basic fallacies. If risk management can be implemented without falling into these three traps, the groundwork for a healthy risk management program has been laid.

Fallacy 1: Risk Is Always Bad

The first important thing to realize about risk is that it can represent either a threat or an opportunity. The most common attitude toward risk is to...

Table of Contents

Introduction.

RISK MANAGEMENT AND CORPORATE FINANCE.

The Nature of Risk.

Risk Aversion, Insurance, and Hedging.

The Irrelevance of Corporate Financing and Risk Management Decisions.

Increasing Expected Cash Flows or Reducing the Cost of Capital by Managing Risk.

Reducing Conflicts between Security Holders and Managers by Managing Risk.

Reducing Conflicts amongst Security Holders by Managing Risk.

Controlling and Exploiting Informational Asymmetries by Managing Risk.

Value versus Cash Flow versus Earnings Risk Management.

Total versus Selective Risk Management.

RISK MANAGEMENT AND BUSINESS STRATEGY.

Risk Culture and Risk Management Business Models.

Integrating People, Technology, and Processes through Enterprise-Wide Risk Management.

Identifying Market Risk Exposures and Defining Risk Tolerances.

Spot, Forward, and Forward-Like Exposures.

Identifying Option, Option-Like, and Real Option Exposures.

Measuring and Monitoring Market Risk.

Identifying, Measuring, and Monitoring Credit Risk.

Identifying, Measuring, and Monitoring Liquidity Risk.

Identifying, Measuring, and Monitoring Operational Risk.

Identifying and Managing Legal Risk.

THE TACTICS OF RISK CONTROL.

Ex Ante Capital Allocation.

Ex Post Performance Measurement and Compensation.

Internal Controls.

Tactical Risk Control with Derivatives.

Tactical Risk Control through Actual and Synthetic Asset Divestitures.

Strategic Risk Control with Structured Liabilities.

Insurance and ART.

Notes.

Bibliography.

Index.

Editorial Reviews

Asset pricing, risk measurement, and financial engineering are omitted from this text which focuses on the link between how and why firms hedge. Risk management and corporate finance are discussed at the outset to demonstrate their inextricable relationship. Culp (editor of a financial journal and director of a risk management firm) then defines risk and explains the reasons models of individual hedging don't extend to models of corporate hedging. Also discussed are the strategic issues of whether to focus risk management on value, cash flow, or earnings and the distinction between total and selective risk management. The audience will be primarily senior managers and corporate directors and graduate students in business administration. Annotation c. Book News, Inc., Portland, OR (booknews.com)

Booknews

"Risk management is much more than guessing how much an investment can lose. Culp has collected the best thinking on the many dimensions of risk management and presents it in an accessible and thoughtful way. This is valuable reading for corporate treasurers, fund managers, and investors alike."
-- Todd E. Petzel President and Chief Investment Officer Commonfund Asset Management Company

"Culp offers corporate treasurers a number of insights into risk. They can now use explanations in the book to educate nonfinancial executives, from the board level on down, as to what the risks are and how to manage them. His book will elevate discussions far beyond the notion that risk management is simply `hedging with derivatives.' I only wish this valuable book had been on my shelf while I was treasurer at McDonald's Corporation. I would have drawn from its pages many times."
-- Carleton D. Pearl President and CEO, System Capital Corp.

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