SECURITY AND RISK MANAGEMENT

Security and Risk Management

Security and Risk Management

Introduction

The subject of risk management is evolving to be viewed as the management of the operations and activities of a corporation, and its financing practices, to construct a portfolio of risks that yield a corresponding average payoff Decisions about seemingly disparate issues are seen as integrated by their net effect on the probable risk-return balance of the corporation. This paper summarizes the literature on corporate risk management issues including the issue of whether risk management is primarily an agency cost. Risk affects all forms of business and personal activity.

While the definition of risk is the variation of actual outcomes around an expected average outcome, when practitioners use the term "risk management" they exclusively and artificially denote one of two interconnected paths. The first path deals with the pricing and selection of financial instruments, and the construction of financial hedges to manage a firm's cash flows. The second path deals with mechanical systems, decision-making processes and insurance products to preserve the firm's resources from accidental loss. Even though the shortcomings of this artificial separation of risk management are well acknowledged, risk management textbooks and professional designation societies continue to maintain this division; the abundant crop of textbooks that identify themselves using the title "Risk Management and Insurance" reinforce the view that insurance is a tool somehow separate from risk management. Insurance, however, is one (albeit the most popular) of the available financial tools for hedging against the negative economic impact of events. (George & Button 2000, 55-78)

The evolving view of risk management often depends on one's perspective. Many of the current corporate risk management positions evolved out of the insurance-buying function of corporate operations, while hedging and capital structure decisions are made in the treasury/finance department. This history both taints and defines the scope of risk management. It is only recently (apart from isolated voices in the 1970s and 1980s) that students and practitioners of risk management see the operation of a corporation, and its financing practices, as a portfolio of risks that yield a corresponding average payoff.

The sources of variation from that average payoff are varied and Shapiro and Titman [2:215] note: "Typically, these decisions--such as how much fire insurance to buy, whether to hedge a particular foreign exchange risk, and how much leverage to incorporate within the company's capital structure-are made independently of each other, presumably because each deals with a different source of risk. But because each of these decisions "affects the total risk of the firm (albeit with different costs and consequences), there are clearly benefits to integrating risk management activities into a single framework."

The Value of Corporate Risk Management

The evolution of the risk management literature is not complete. Business organizations deal with both pure and speculative risks; pure risk is associated with hazards having only a negative consequence, while speculative risks may have positive or negative consequences. (Gill 2006, 33-48)

Regardless of the effects risk management may have on systematic risk, if diversified equityholders value ...