Corporate Risk Management

Corporate Risk Management

Edited by Donald H. Chew
Copyright Date: 2008
DOI: 10.7312/chew14362
Pages: 480
https://www.jstor.org/stable/10.7312/chew14362
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  • Book Info
    Corporate Risk Management
    Book Description:

    More than 30 leading scholars and finance practitioners discuss the theory and practice of using enterprise-risk management (ERM) to increase corporate values. ERM is the corporate-wide effort to manage the right-hand side of the balance sheet-a firm's total liability structure-in ways that enable management to make the most of the firm's assets. While typically working to stabilize cash flows, the primary aim of a well-designed risk management program is not to smooth corporate earnings, but to limit the possibility that surprise outcomes can threaten a company's ability to fund its major investments and carry out its strategic plan. Contributors summarize the development and use of risk management products and their practical applications. Case studies involve Merck, British Petroleum, the American airline industry, and United Grain Growers, and the conclusion addresses a variety of topics that include the pricing and use of certain derivative securities, hybrid debt, and catastrophe bonds.

    Contributors: Tom Aabo (Aarhus School of Business); Albéric Braas and Charles N. Bralver (Oliver, Wyman & Company); Keith C. Brown (University of Texas at Austin); David A. Carter (Oklahoma State University); Christopher L. Culp (University of Chicago); Neil A. Doherty (University of Pennsylvania); John R. S. Fraser (Hyrdo One, Inc.); Kenneth R. French (University of Chicago); Gerald D. Gay (Georgia State University); Jeremy Gold (Jeremy Gold Pensions); Scott E. Harrington (University of South Carolina); J. B. Heaton (Bartlit Beck Herman Palenchar & Scott LLP); Joel Houston (University of Florida); Nick Hudson (Stern Stewart & Co.); Christopher James (University of Florida); A. John Kearney and Judy C. Lewent (Merck & Co., Inc.); Robert C. Merton and Lisa K. Meulbroek (Harvard Business School); Merton H. Miller (University of Chicago); Jouahn Nam (Pace University); Andrea M. P. Neves (CP Risk Management LLC); Brian W. Nocco (Nationwide Insurance); André F. Perold (Harvard Business School); S. Waite Rawls III (Continental Bank); Kenneth J. Risko (Willis Risk Solutions); Angelika Schöchlin (University of St. Gallen); Betty J. Simkins (Oklahoma State University); Donald J. Smith (Boston University); Clifford W. Smith Jr. (University of Rochester); Charles W. Smithson (Continental Bank); René M. Stulz (Ohio State University); D. S

    All the articles that comprise this book were first published in the Journal of Applied Corporate Finance. Morgan Stanley's ownership of the journal is a reflection of its commitment to identifying outstanding academic research and promoting its application in the practicing corporate and investment communities.

    eISBN: 978-0-231-51300-5
    Subjects: Business, Finance

Table of Contents

  1. Front Matter
    (pp. I-IV)
  2. Table of Contents
    (pp. V-VI)
  3. Introduction
    (pp. VII-X)

    The theory of corporate risk management has changed a lot in the past 25 years. And so has corporate practice, mainly in ways predicted by the theory.

    In the 1980s and well into the 1990s, most large companies had a “risk manager” whose main job was to oversee the firm’s insurance purchases. At the same time, financially savvy corporate treasurers, with little or no input from risk managers, began using newfangled securities called “derivatives” to hedge the firm’s interest rate and currency exposures. In many of these companies, especially those where the treasury was encouraged to view itself as a...

  4. Part I: The Products
    • [Part I: Introduction]
      (pp. 1-4)

      Wall-Street bashing is a time-honored practice, even among economists. In the chapter that begins this book, “Financial Innovation: Achievements and Prospects,” Merton Miller, Nobel laureate and widely regarded as “the father of modern finance,” traces the popular skepticism about Wall Street and financial innovation to an 18th-century economic doctrine known as “Physiocracy.” According to this theory, the ultimate source of national wealth lies in the production of physical commodities. All other forms of commercial activity are considered nonproductive, if not parasitic. “Modern-day Physiocrats,” as Miller wrote, “automatically and enthusiastically consign to that nonproductive class all the many thousands on Wall...

    • CHAPTER 1 Financial Innovation: Achievements and Prospects
      (pp. 5-17)
      MERTON H. MILLER

      The wonderment of Rip Van Winkle, awakening after his sleep of 20 years to a changed world, would pale in comparison to that felt by one of his descendants in the banking or financial services industry falling asleep (presumably at his desk) in 1970 and waking two decades later. So rapid has been the pace of innovation in financial instruments and institutions over the last 20 years that nothing could have prepared him to understand such now commonplace notions as swaps and swaptions, index futures, program trading, butterfly spreads, puttable bonds, Eurobonds, collateralized mortgage bonds, zero-coupon bonds, portfolio insurance, or...

    • CHAPTER 2 The Evolution of Risk Management Products
      (pp. 18-31)
      S. WAITE RAWLS III and CHARLES W. SMITHSON

      Today, financial price risk not only can affect quarterly profits but may determine a firm’s very survival. Unpredictable movements in exchange rates, interest rates, and commodity prices present risks that cannot be ignored. It’s no longer enough to be the firm with the most advanced production technology, the cheapest labor supply, or the best marketing team—because price volatility can put even well-run firms out of business.

      Changes in exchange rates can create stiff competition where none previously existed. Similarly, commodity price fluctuations result in changes in input prices which can make substitute products—products made from different inputs—more...

    • CHAPTER 3 The Revolution in Corporate Risk Management: A Decade of Innovations in Process and Products
      (pp. 32-62)
      CHRISTOPHER L. CULP

      World War I, most historians agree, could easily have been prevented. It was the calamitous by-product of overreaction, miscommunication, and plain bad luck. But once the spark was thrown into the powder keg at Sarajevo, the chain of events that became the “Great War” was set in motion.

      When economic historians get around to telling the story of the corporate risk management revolution of the 1990s, they will reach a similar conclusion. The explosion in popularity of “enterprise-wide” risk management in the early 1990s need not have happened—or at least not the way it did. The spark in this...

    • CHAPTER 4 A Senior Manager’s Guide to Integrated Risk Management
      (pp. 63-86)
      LISA K. MEULBROEK

      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 important new opportunities for increasing shareholder value. “Integrated risk management” involves 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 rather than reduce risk. But derivatives, when used as a risk management tool, are only a...

  5. Part II: Corporate Uses of the Products
    • [Part II: Introduction]
      (pp. 87-92)

      As discussed earlier, Merton Miller described the social role of derivative markets as that of “a gigantic insurance company” whose aim is to bring about “efficient risk-sharing” throughout the economy. In “Rethinking Risk Management” (chapter 5), René Stulz presents a theory of corporate risk management that uses Miller’s idea of comparative advantage in risk-bearing to go beyond the “variance-minimization” model that dominates most academic discussions. Stulz argues that the primary goal of risk management is not to dampen swings in corporate cash flows or value but, rather, to provide protection against the possibility of costly lower-tail outcomes—situations that would...

    • CHAPTER 5 Rethinking Risk Management
      (pp. 93-120)
      RENÉ M. STULZ

      This chapter explores an apparent conflict between the theory and current practice of corporate risk management. Academic theory suggests that some companies facing large exposures to interest rates, exchange rates, or commodity prices can increase their market values by using derivative securities to reduce their exposures. The primary emphasis of the theory is on the role of derivatives in reducing the variability of corporate cash flows and, in so doing, reducing various costs associated with financial distress.

      The actual corporate use of derivatives, however, does not seem to correspond closely to the theory. For one thing, large companies make far...

    • CHAPTER 6 An Analysis of Trading Profits: How Most Trading Rooms Really Make Money
      (pp. 121-130)
      ALBÉRIC BRAAS and CHARLES N. BRALVER

      Our observation of more than 40 large trading operations has led us to conclude that most trading rooms should be managed to generate stable profits by taking little positioning risk. This prescription is founded on three basic observations, each of which is developed in one of the three main sections of this chapter:

      1. The Myth of Speculative Positioning as the Best Source of Profit. In this section we argue that, for most trading rooms, positioning is not a reliable source of revenues and profits.

      2. The Value of the Turn. Here we take the view that more money is made trading...

    • CHAPTER 7 Theory of Risk Capital in Financial Firms
      (pp. 131-161)
      ROBERT C. MERTON and ANDRÉ F. PEROLD

      This chapter develops a concept of risk capital that can be applied to the financing, capital budgeting, and risk management decisions of financial firms. The development focuses particularly on firms that act as a principal in the ordinary course of business. Principal activities can be asset related, as in the case of lending and block positioning; liability related, as in deposit-taking and writing of guarantees (including insurance, letters of credit, and other contingent commitments); or both, as in the writing of swaps and other derivatives for customers.

      For the purposes of this chapter, principal financial firms have three important distinguishing...

    • CHAPTER 8 Value at Risk: Uses and Abuses
      (pp. 162-183)
      CHRISTOPHER L. CULP, MERTON H. MILLER and ANDREA M.P. NEVES

      Value at risk (VaR) is now viewed by many as indispensable ammunition in any serious corporate risk manager’s arsenal. VaR is a method of measuring the financial risk of an asset, portfolio, or exposure over some specified period of time. Its attraction stems from its ease of interpretation as a summary measure of risk and consistent treatment of risk across different financial instruments and business activities. VaR is often used as an approximation of the “maximum reasonable loss” a company can expect to realize from all its financial exposures.

      VaR has received widespread accolades from industry and regulators alike.¹ Numerous...

    • CHAPTER 9 Allocating Shareholder Capital to Pension Plans
      (pp. 184-204)
      ROBERT C. MERTON

      Good evening, it’s a pleasure to be here and thank you all for coming. It will not come as news to any of you that adequate provision for retirement through a combination of state, employer, and personal savings is a worldwide concern. It’s a major concern in Asia and South America, in the United States and continental Europe, and, of course, here in the United Kingdom. For corporations with defined benefit (DB) pension plans, the problem has manifested itself in a funding shortfall between pension assets and pension liabilities. The shortfall is a consequence of the large decline in equities...

    • CHAPTER 10 The Uses and Abuses of Finite Risk Reinsurance
      (pp. 205-234)
      CHRISTOPHER L. CULP and J. B. HEATON

      Finite risk has become what derivatives were 10 years ago—a hot button for controversy and the likely subject of investigations, litigation, and (heaven forbid) new regulations. American International Group (AIG) has borne the brunt of the assault to date as the target of New York State Attorney General Eliot Spitzer’s scrutiny. AIG’s troubles began with an investigation by the Securities and Exchange Commission (SEC) into a relatively small finite risk deal. Before long, the company’s long-time chairman was gone and the company’s accounts faced significant restatement. Brightpoint and the now-defunct HIH Insurance in Australia—as well as an increasing...

    • CHAPTER 11 Does Risk Management Add Value? A Survey of the Evidence
      (pp. 235-256)
      Charles W. Smithson and BETTY J. SIMKINS

      In his march 8, 2003, letter to Berkshire Hathaway’s shareholders, Warren Buffett described derivatives as “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Buffett argued that derivatives “can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties….”

      Despite Buffett’s warning, corporate managers appear to believe that derivatives are capable of adding value since they continue to make extensive use of them. When the International Swaps and Derivatives Association (ISDA) examined...

  6. Part III: Practitioner Perspectives:: Case Studies and Roundtables
    • [Part III: Introduction]
      (pp. 257-262)

      In “identifying, measuring, and hedging currency risk at merck” (chapter 12), Judy Lewent and John Kearney describe the company’s effort to understand and manage the effect of exchange rate volatility on worldwide revenues and earnings. In a thought process that parallels the one laid out in preceding chapters (by Smith, Stulz, and others), Merck’s treasury arrived at the following conclusions: (1) the home currency value of cash flows regularly repatriated by its many overseas subsidiaries was vulnerable to a strengthening of the U.S. dollar; (2) although stock market analysts and investors do not appear much concerned about the exchange-related volatility...

    • CHAPTER 12 Identifying, Measuring, and Hedging Currency Risk at Merck
      (pp. 263-278)
      JUDY C. LEWENT and A. JOHN KEARNEY

      The impact of exchange rate volatility on a company depends mainly on the company’s business structure, both legal and operational, its industry profile, and the nature of its competitive environment. This article recounts how Merck assessed its currency exposures and reached a decision to hedge those exposures. After a brief introduction to the company and the industry, we discuss our methods of identifying and measuring our exchange exposures, the factors considered in deciding whether to hedge such risks, and the financial hedging program we put in place.

      Merck & Co., Inc. primarily discovers, develops, produces, and distributes human and animal health...

    • CHAPTER 13 Corporate Insurance Strategy: The Case of British Petroleum
      (pp. 279-298)
      NEIL A. DOHERTY and CLIFFORD W. SMITH JR.

      Insurable events such as product liability suits, toxic torts, and physical damage to corporate assets represent major production costs for industrial corporations. For large public companies, conventional practice is to buy insurance to hedge against large potential losses while self-insuring against smaller ones. The underlying logic of this strategy, which is reflected in insurance textbooks,¹ is essentially this: For large- and medium-sized corporations, small losses—the kind that stem from localized fires, employee injuries, vehicle crashes, and so forth—occur with such regularity that their total cost is predictable. To the extent such losses are predictable in the aggregate, buying...

    • CHAPTER 14 Hedging and Value in the U.S. Airline Industry
      (pp. 299-322)
      DAVID A. CARTER, DANIEL A. ROGERS and BETTY J. SIMKINS

      In the past few years, a growing number of companies have devoted major resources to implementing risk management programs designed to hedge financial risks, such as interest rate, currency, and commodity price risk. Because of the increasing reliance on such programs, it is important to ask the question: “Does hedging add value to corporations?”² And if it does, the obvious follow-up question is: “How does it add value?”

      Finance theorists have proposed a number of ways that hedging and, more generally, risk management can increase corporate market values. Stated briefly, risk management has the potential to add value (1) reducing...

    • CHAPTER 15 Enterprise Risk Management: Theory and Practice
      (pp. 323-347)
      BRIAN W. NOCCO and RENÉ M. STULZ

      The past two decades have seen a dramatic change in the role of risk management in corporations. Twenty years ago, the job of the corporate risk manager—typically, a low-level position in the corporate treasury—involved mainly the purchase of insurance. At the same time, treasurers were responsible for the hedging of interest rate and foreign exchange exposures. Over the last ten years, however, corporate risk management has expanded well beyond insurance and the hedging of financial exposures to include a variety of other kinds of risk—notably operational risk, reputational risk, and, most recently, strategic risk. What’s more, at...

    • CHAPTER 16 The Rise and Evolution of the Chief Risk Officer: Enterprise Risk Management at Hydro One
      (pp. 348-378)
      TOM AABO, JOHN R. S. FRASER and BETTY J. SIMKINS

      危機 the chinese symbols for risk shown at left capture a key aspect of enterprise risk management. The first symbol represents “danger” and the second “opportunity.” Taken together, they suggest that risk is a strategic combination of vulnerability and opportunity. Viewed in this light, enterprise risk management represents a tool for managing risk in a way that enables the corporation to take advantage of value-enhancing opportunities. A missed strategic opportunity can result in a greater loss of (potential) value than an unfortunate incident or adverse change in prices or markets.

      As in the past, many organizations continue to address risk...

    • CHAPTER 17 University of Georgia Roundtable on Enterprise-Wide Risk Management, ATLANTA, GEORGIA, NOVEMBER 18, 2002
      (pp. 379-412)

      James Verbrugge: Good morning, and on behalf of the University of Georgia’s Terry College of Business and the Spencer Educational Foundation, let me welcome you to this discussion of corporate risk management. I’m Jim Verbrugge, Professor of Finance at the Terry College of Business and Director of its Center for Strategic Risk Management. I will be serving as one of the moderators of this discussion. My co-moderator is Don Chew, one of the founding partners of Stern Stewart & Co. and Editor-in-Chief of the Journal of Applied Corporate Finance (JACF). As you may have heard, the JACF is now being co-published...

    • CHAPTER 18 Morgan Stanley Roundtable on Enterprise Risk Management and Corporate Strategy, NEW YORK CITY, JUNE 21, 2005
      (pp. 413-458)

      John McCormack: Good morning and, on behalf of the joint sponsors of this event—Morgan Stanley and the Committee of Chief Risk Officers, or “CCRO” for short—let me welcome you all to this discussion of corporate risk management. I’m John McCormack, I work in equity research here at Morgan Stanley, and I will be serving as moderator.

      Our topic is the potential role of derivatives and risk management in increasing the long-run profitability and value of companies. Our main focus will be on the energy and financial service sectors, where the uses of derivatives and risk management are probably...

  7. Index
    (pp. 459-470)