Risk management and corporate strategy

Corporate managers have grown progressively more aware of the risks faced in today's markets. In response to this awareness, a number of new financial instruments have emerged to assist with managing risk. Three fundamental approaches are available for dealing with risk. 1. Avoidance: Steps can be taken to eliminate it. 2. Insurance: A contract or insurance policy can be obtained to compensate for losses produced by certain risks. 3. Hedge: A countervailing position can be established to offset or ameliorate certain risks. Although we address all three of these alternatives, overwhelming emphasis is directed toward the third alternative, hedging.

Risk profiles

One of the key devices used to understand risk is the development of risk profiles. To create a risk profile one must identify the fundamental relationship between outcomes of interest and important causative factors. The payoff from some subordinate venture or even the entire value of a firm are common outcomes that risk profiles describe with respect to causative factors known as underlying variables. The risk profile shows how the value of interest changes along with prescribed changes in the underlying variable. The degree or magnitude of risk that an organization faces in a specific situation is often called its exposure. Typically, risk profiles are illustrated on a Cartesian coordinate system. The independent variable typically shown on the horizontal or X axis is the underlying variable and the impact in the form of gains or losses is typically shown on the vertical or Y axis.
To a great extent, the slope of the profile illustrates the significance of that risk. More steep slopes indicate greater sensitivity of the outcome being examined to the underlying variable being considered.

Value at risk introduction

Expected shortfall

Sample risk problems