Accounting

CURRENT DEFINITION OF CORPORATE RISK MANAGEMENT

The goal of corporate risk management is to create a reference framework that will allow companies to handle risk and uncertainty. Risks are present in nearly all firms’ financial and economic activities. The risk identification, assessment, and management process is part of companies’ strategic development; it must be designed and planned at the highest level, namely the board of directors. The risk appetite of the company must also be defined by the board. An integrated risk management approach must evaluate, control, and monitor all risks and their dependencies to which the company is exposed. In general, a pure risk is a combination of the probability or frequency of an event and its consequences, which are usually negative.

Risk can be measured by the volatility of results, but higher moments of the distribution are often necessary. Uncertainty is less precise because the probability of an uncertain event is often unknown or subjective, as is its consequence. In this case, we would refer to precautionary rather than preventive activities to protect against uncertainty. Lastly, financial risk management consists in undertaking opportunistic activities related to future risks that may generate positive or negative results.

Corporate risk management is defined as a set of financial and operational activities that maximize the value of a company or a portfolio by reducing the costs associated with risk (Stulz, 1996, 2003). The main risk management activities are diversification and risk hedging using various instruments, including derivatives and structured products, market insurance, self-insurance, and self-protection. The main costs firms seek to minimize are costs of financial distress, risk premium to partners (stakeholders), expected income taxes, and investment financing. Managers’ behavior toward risk (risk appetite and risk aversion) and corporate governance also affect the choice of risk management activities.

There are five main risks:

  1. Pure risk (often insurable, and not necessarily exogenous in the presence of moral hazard and known in the presence of adverse selection);
  2. Market risk (variation in prices of commodities, exchange rates, asset returns);
  3. Default risk (probability of default, recovery rate, exposure at default);
  4. Operational risk (employee or management errors, fraud, IT system breakdown, derivative mispricing);
  5. Liquidity risk: risk of not possessing sufficient funds to meet short-term financial, obligations without affecting prices. May degenerate into default risk.

References:

  • Dionne, Georges, 2019, Corporate risk management : theories and applications, Wiley, ISBN 9781119583172 (Epdf)
  • Stulz, R.M., 1996. “Rethinking Risk Management.” Journal of Applied Corporate Finance 9, 8–24.
  • Stulz, R.M., 2003. Risk Management and Derivatives. Thomson/South-Western.

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Silvia Dewiyanti, S.E., M.Si., Ak., CA., CSRA, Cert.DA.