Finance 444 – Risk Management
Spring 2009
Professor Greg Niehaus
Course Information
Course Objectives:
This course focuses on business risk management. Students are expected to learn the
concepts, tools, and types of analyses that are utilized when managing an enterprise’s risk and apply
the concepts and tools to analyze several case studies. The course adopts an enterprise risk
management perspective, i.e., what matters most in risk management is a firm’s overall level of
risk, not the individual sources of risk. As a consequence, we will consider (from a portfolio
perspective) a variety of risk exposures, including price risk, credit risk, property and liability risks,
and weather risk.
We will begin by focusing on risk measurement, which includes the following topics: a
brief review of relevant probability and statistics, value-at-risk (VaR), cash-flow-at-risk (CFaR),
and Monte Carlo simulation. Then we will study the methods that firms use to manage risk,
including derivative contracts and insurance contracts. We will also discuss how risk is managed
by a firm’s investment decisions, including its selection of human talent.
Our analysis of risk management decisions primarily will be from a value maximization
perspective. Consequently, we will review basic valuation models from corporate finance and then
examine how risk management can increase value for a firm with well-diversified shareholders. In
addition, we will consider the relation between risk management and sustainability issues.
The perspective taken throughout the course is that risk management is an integral part of
corporate financial management. Thus, risk management decisions should be analyzed using the
same corporate finance principles that are used for making capital budgeting and financing
decisions.
Textbook:
An E-book can be purchased by following the instructions in the document
“professor_created_ebooks_updated.doc,” which is posted under “Course Information” on Blackboard.
The e-book contains selected chapters from the textbook by Harrington and Niehaus, entitled Risk
Management and Insurance, as well as some other readings and cases.
Class Schedule:
Tuesday
Thursday
3:30 - 4:45
3:30 - 4:45
A review session will be scheduled before each exam.
Office Hours: (dean’s office on 1st floor)
Tuesday
Thursday
2:30 - 3:15, 4:45 - 5:30
2:30 - 3:15, 4:45 - 5:30
And also by appointment
My schedule is kept by Henrietta Etheredge, please arrange appointments with her by
emailing Etheredge@moore.sc.edu
My e-mail is gregn@moore.sc.edu
Lecture Notes:
Lectures typically will include powerpoint presentations. Copies of the slides will be
available on blackboard prior to class (hopefully, the night before)
Guest Lecturers
We likely will have guest lecturers the week after spring break. You will be tested on the
material presented during these sessions.
Grades:
Exam 1 (Feb 12)
Exam 2 (Apr 2)
Final exam (May 2, 9:00)
Contribution to class
Homework
20%
25%
30%
5%
20%
All exams are cumulative.
To encourage you to contribute to class, your grade depends on my subjective assessment
of your contribution to class over the semester. You start the semester with a grade for
contribution to class equal to 50 percent. You can increase that grade by contributing to
class in a positive and consistent manner. You can decrease that grade by detracting from
class. Typically, most students will not change their contribution to class grade.
Arriving late for class or leaving in the middle of class disrupts other students.
Therefore, consistently arriving late will lower your contribution to class grade.
Consistently missing class also will lower your contribution to class grade.
Homework problems and possibly short writing assignments will be assigned
periodically. Late assignments will suffer a 10% penalty per day. The writing
assignments will require you to either report on a current issue or think about some issue
and present your own analysis. They will be graded on content and writing. Poorly
written assignments will be returned and you will be required to rewrite. Some
assignments may be group projects related to a case on risk management.
University of South Carolina Honor Code
It is the responsibility of every student at the University of South Carolina Columbia to adhere
steadfastly to truthfulness and to avoid dishonesty, fraud, or deceit of any type in connection with
any academic program. Any student who violates this Honor Code or who knowingly assists
another to violate this Honor Code shall be subject to discipline.
This Honor Code is intended to prohibit all forms of academic dishonesty and should be
interpreted broadly to carry out that purpose. The following examples illustrate conduct that
violates this Honor Code, but this list is not intended to be an exhaustive compilation of conduct
prohibited by the Honor Code:
1. Giving or receiving unauthorized assistance, or attempting to give or receive such
assistance, in connection with the performance of any academic work.
2. Unauthorized use of materials or information of any type or the unauthorized use of any
electronic or mechanical device in connection with the completion of any academic work.
3. Access to the contents of any test or examination or the purchase, sale, or theft of any test
or examination prior to its administration.
4. Use of another person’s work or ideas without proper acknowledgment of source.
5. Intentional misrepresentation by word or action of any situation of fact, or intentional
omission of material fact, so as to mislead any person in connection with any academic
work (including, without limitation, the scheduling, completion, performance, or
submission of any such work).
6. Offering or giving any favor or thing of value for the purpose of influencing improperly a
grade or other evaluation of a student in an academic program.
7. Conduct intended to interfere with an instructor’s ability to evaluate accurately a
student’s competency or performance in an academic program.
Whenever a student is uncertain as to whether conduct would violate this Honor Code, it is the
responsibility of the student to seek clarification from the appropriate faculty member or
instructor of record prior to engaging in such conduct.
Suspected violations of the honor code will be reported to the Office of Academic Integrity.
Violations of the honor code will result in disciplinary measures.
Specific Learning Outcomes
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Understand the different interpretations of risk
For each interpretation of risk, understand the various measures of risk
Be able to calculate various measures of risk for individual risk exposures and portfolios
of risk exposures
Describe the main characteristics of the risk management process
Understand the various methods that businesses use to manage risk
Understand the conditions under which business decisions that maximize firm value
result in an efficient allocation of resources
Describe conditions under which business decisions that maximize firm value may not
yield an efficient allocation of resources
Understand the factors that limit the extent to which risk can be diversified or traded from
one entity to another
Understand the factors that determine the price of insurance in a competitive market
Understand the types of derivative contracts and how they can be used to reduce risk
Understand basic financial valuation models and how risk is incorporated in these models
Understand the reasons that diversifiable risk can affect firm value
Evaluate circumstances under which risk reduction will increase firm value
Understand why non-traditional types of risk transfer contracts are used
Understand the various interpretations of a sustainable enterprise and how risk
management is related to sustainable enterprise
Understand the benefits and costs of using an enterprise risk management approach
Apply the tools and concepts learned in the course to cases and new situations
Finance 444 – Risk Management
Spring 2009
Professor Greg Niehaus
Outline
1.
INTRODUCTION TO BUSINESS RISK MANAGEMENT
Reading:
Ch. 1
Ch. 2
Topics:
What is risk?
Types of risks that businesses face
Risk Management Process
Overview of risk management methods
Objectives of corporate risk management
Value maximization
Conflicts between societal welfare and value maximization
2.
RISK IDENTIFICATION AND MEASUREMENT
Reading:
Ch. 3
“Theory of Risk Capital in Financial Firms”
Topics:
Risk identification
Probability distributions
Expected value, standard deviation
Correlation
Value at risk
Maximum probable loss
Frequency and severity of losses
3.
DATA ANALYSIS TOOLS USED IN RM
Reading:
Ch. 26
Topics:
Statistical tools to analyze historical data
Using the normal distribution
Monte Carlo simulation
4.
INVESTMENT DECISIONS THAT CHANGE THE PROBABILITY
DISTRIBUTION OF CASH FLOWS (LOSS CONTROL)
Reading:
Ch. 11
Topics:
Safety decisions
Contract design issues
Selection of leaders
5.
FINANCING DECISIONS - INSURANCE CONTRACTS
Reading:
Ch. 4 – Pooling Arrangements and Diversification of Risk
Ch. 8 – Insurance Pricing
Ch. 10 – Insurability of Risk, Contractual Provisions, & Legal Doctrines
Ch. 23 – Commercial Insurance Contracts
Topics:
Risk pooling
Role of insurance companies
Insurance pricing
Contractual provisions (deductibles, limits, exclusions)
Moral hazard
Adverse selection
Layering coverage
Occurrence vs. claims made coverage
6.
FINANCING DECISIONS - DERIVATIVE CONTRACTS
Reading:
Ch. 24 – Hedging with Derivative Contracts
American Barrick Resources Case
Topics:
Forward contracts
Futures contracts
Option contracts
Swap contracts
Over-the-counter market for derivatives
Exchange traded derivatives
Comparison of derivative contracts with insurance contracts
7.
HOW DOES RISK REDUCTION AFFECT SHAREHOLDER VALUE
Reading:
Ch. 20
“Corporate Insurance Strategy: The Case of British Petroleum,”
Topics:
Valuation models (WACC approach, Flow to equity approach)
Effect of risk reduction on the cost of equity capital
Effect of risk reduction on expected cash flows to equityholders
British Petroleum example
8.
TAX, REGULATORY, & ACCOUNTING FACTORS & RISK REDUCTION
Reading:
Ch. 21
Topics:
Effect of progressive tax rates
Different tax treatment of insurers and non-insurers
Interest tax shields on debt
Premium and excise taxes
Compulsory insurance laws
Excess and surplus lines market
Accounting treatment of insurance and derivatives
9.
RISK RETENTION/REDUCTION DECISIONS
Reading:
Ch. 22
American Barrick Resources Case
Topics:
Firm characteristics affecting risk reduction decisions
Bundling exposures
10.
NON-TRADITIONAL FINANCING DECISIONS (ALTERNATIVE RISK
TRANSFER)
Reading:
Ch. 25
Topics:
Loss sensitive insurance contracts
Finite risk contracts
Captive insurers
Contingent financing arrangements
Index linked notes
Catastrophe bonds
11.
SUSTAINABILITY ISSUES AND RISK MANAGEMENT
Reading:
12.
Handout
“Equator Principles: An Industry Approach to Managing Environmental
and Social Risks”
ENTERPRISE RISK MANAGEMENT
Reading:
Ch. 27, United Grain Growers Case
Topics:
Enterprise risk management
Chief risk officer
Advantages and disadvantages of bundling multiple exposures
United Grain Growers Case