CHAPTER 17
Advanced Topic in Risk Management
SCOPE OF CHAPTER
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Describes about modern risk management
Describes the terminology in financial risk management
Helps to understand the Enterprise risk
management(ERM)
Introduces several innovative financial solutions to
evolving the risk management problems.
Determine the amount of loss exposure to retain and
the amount to transfer
 Describe the responsibility of risk manger of
international firm
 Describe a risk management information
systems(RMISs)
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TRADITIONAL RISK MANAGEMENT VS.
MODERN RISK MANAGEMENT
The aims of traditional risk management (chapter 3)
is to solve management problems associated with
pure risk.
 Modern risk management considers losses that arise
from both pure and speculative risks.
In modern risk management approach the logic is
that a $1 million loss from currency fluctuations is
as destructive to a firm’s value as a $1 million fire
loss.
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FINANCIAL RISK MANAGEMENT VS.
ENTERPRISE RISK MANAGEMENT
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The aim of financial risk management is to describe a
program to manage efficiently potential losses arising
from things such as interest rate changes, currency
fluctuations, credit risks or commodity price changes.
Definition: Financial risk management refers to the
identification, analysis, and treatment of financial risk
which include the following risks:
Commodity price risk
Interest rate risk
Currency exchange rate risk
The aim of Enterprise risk management(ERM) is to
describe a program that considers all sources of loss at the
same time.
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Commodity price risk is the risk of losing money if
the price of a commodity changes. Producers and
users of commodities face commodity price risks.
Example:
Consider an agricultural operation that will have
thousands of bushels of grain at harvest time. At
harvest, the price of the commodity may have
increased or decreased , depending on the supply
and demand for grain. Because little storage is
available for the crop, the grain must be sold at the
current market price, even if the price is low.
In a similar fashion ,users and distributors of
commodities face commodity price risks.
Interest rate risk
Financial instructions face to interest rate risk.
Definition: Interest rate risk is the risk of loss
caused by adverse interest rate movements.
 Example:
A corporation might issue bonds at a time when
interest rates are high. For the bonds to sell at
their face value when issued, the coupon interest
rate must equal the investor required rate of
return. If interest rates later decline , the company
must still pay the higher coupon interest rate on
the bonds.
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Currency exchange rate risk
The currency exchange risk is the value for which one
nation’s currency may be converted to another
nation’s currency.
Example:
One U.S. dollar might be worth the equivalent of 1.80
of one Turkish Lira. At this currency exchange rate,
one U.S. dollar may be converted to 1.80 Turkish
Lira.
Definition : Currency exchange rate risk is the risk of
loss of value caused by changes in the rate at which
one nation’s currency may be converted to another
nation’s currency.
Example:
A U.S. company faces currency exchange rate risk
when it agrees to accept a specified amount of foreign
currency in the future as payment for goods sold or
work performed.
ENTERPRISE RISK MANAGEMENT
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Definitions: Enterprise risk management is a
comprehensive risk management program that
address an organization’s pure risks, speculative
risks, strategic risks, and operational risks.
Pure and speculative risks 
Strategic risk refers to uncertainty regarding an
organization’s strengths , weaknesses, opportunities,
and threats.
Operational risks develop out of business operations,
including the manufacture and distribution of
products and providing services to customers.
By packaging all of these risks in a single program , the
organization offsets one risk against another , and in the
process reduces its overall risk .
HEDGING
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Definition:
Hedging is a technique for transferring the risk
of unfavorable price fluctuations to a speculator
by purchasing and selling futures contracts on an
organized exchange , such as the Chicago Board
of Trade or New York Stock Exchange(NYSE).
Modern financial arrangements allow risk
managers to construct hedges against many
different types of losses.
Using derivatives securities is a way to reduce
or limit risk.
EXAMPLE OF HEDGING
The portfolio manager of a pension fund may hold a
substantial position in long-term U.S. Treasury
bonds. If interest rates rise , the value of the Treasury
bonds will decline . To hedge that risk, the portfolio
manager can sell U.S. Treasury bond futures.
Assume that the interest rates rise as expected, and
bond prices decline. The value of the futures contract
will also decline , which will enable the portfolio
manager to make an offsetting purchase at a lower
price.
“ The profit obtained from closing out the futures
option will partly or completely offset the decline in
the market value of the Treasury bonds owned”.
DERIVATIVES SECURITIES AND OTHER
FINANCIAL TRANSACTIONS
Derivatives are financial instruments that allow
risk managers to construct hedges against many
different types of losses.
 The value of derivative security is based on the
value of an underlying financial asset or commodity.
 There are 4 types of contracts under the derivatives
securities:
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Future contracts
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Forward contracts
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Swap contracts
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Option contracts
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Future contracts
These types of contract are orders placed by
traders in advance to buy or sell a commodity or
financial asset at a specified price.
 Risk manager use futures to provide a hedge when
an increase or decrease in a commodity ‘s price can
reduce profits.
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Forward contracts
These contracts are similar to futures contracts,
but forward contracts are not traded on organized
exchange, such as the Chicago Board of Trade or
New York Stock Exchange(NYSE).
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Swap contracts
A swap is a contract in which both parts of contract
settle to make payments to one another on
scheduled dates in future.
The swap contracts may used by corporations to
change foreign debt into domestic debt or domestic
debt into foreign debt.
Currency swap : two companies or two countries
lend each other currency.
Interest rate swap : Two companies lend one
currency at different interest rate, one fixed ,one
floating.
Option contracts
Options are contracts where two parts of contract
have the right to trade the certain quantity of
underlying asset at determined price within the
specific time period by paying the premium, but
they don’t have obligation to trade.
 Option holder or the party with long position has
the right to buy or sell under the agreed terms.
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Call option is an option to buy an underlying asset.
A call option would have value if the holder could
buy the asset for below the prevailing market price.
Put option is an option to sell an underlying asset.
A put option would have value if the holder could
sell the stock at above the prevailing market price.
CATASTROPHE RISK TRANSFER
Catastrophic loss because they are relatively
large compared to the size of insurance pool are
not ideally insurable loss exposure(Chapter 2).
 In spite of insuring catastrophic losses in not
ideal , financiers have provided three financial
arrangements to insurance companies faced with
catastrophic exposure:
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Contingent surplus notes
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Catastrophe bonds
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Exchange traded options
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Contingent surplus notes
This financial arrangement allow an insurance company
to protect itself from paying a“ catastrophic amount”
when its own finances may be weakened.
 Catastrophe bonds
This financial arrangement allows an insurance
company actually to transfer some or all its catastrophe
exposure to a trust account.
 Exchange traded options
If the insurer purchases this type of arrangement to
hedge catastrophic losses ,the insurance company gives
the seller this right to undertake cash payment.
 The exchange where these options are traded
guarantees the performance of the seller (speculator),
and the exchange requires the sellers of these contracts
to meet financial responsibility requirements.
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DEDUCTIBLES AND POLICY LIMITS
One common problem in risk management is to
determine how much loss exposure to retain and
how much to transfer.
 Deductibles or retention is the proportion of claim
payment that insured bear.
“ The first dollar of a loss insured bears”
 Policy limit is the proportion that insurance covers from
a loss.
“Maximum insurance recovery that is paid by insurer”
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If a loss is equal to or less than the deductible, the
insured bears the cost.
If a loss is greater than the policy limits, the insured
bears the cost of any deductibles plus the amount of
loss above the policy limit.
when choosing a deductible and policy limit, there is a
trade-off between premium payment and
deductibles(uninsured losses).
Lower premium-higher retention trade-off
Increasing the deductibles reduce the amount of
policy limit and as a result the premium also
decreases.
Policy limit + Deductibles = Total coverage
Example in fire insurance
Coverage
Policy limit
$100,000
$95,000
$100,000
$90,000
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Deductible
$5,000
$10,000
Premium
$1,000
$990
In general, increasing policy limits increases
premium costs, but the increase is not proportional.
DIFFERENT TYPE OF RETENTIONS
(DEDUCTIBLES)
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These following deductibles are commonly found in
property insurance contracts:
Straight Deductible( Each Occurrence Retention)
The retention ( or deductible ) applies to each loss and there
is no annual limit on the number of times the deductibles
applies.
Example:
Assume that Ashley has auto collision insurance on her new
Toyota, with a $500 deductible. If a collision loss is $7,000,
she would receive only $6500 and would have to pay the
remaining $500 herself.
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Aggregate Deductible( Aggregate Retention)
An aggregate deductible means that all losses that occur
during a specified time period(usually a year)are accumulated
to satisfy the deductible amount.
Once the deductible is satisfied , the insurer pays all future
losses in full.
Example :
Assume that a policy contains an aggregate deductible of $10,000.
Also assume that losses of $1000 and $2000 occur, respectively,
during, the policy year.
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The insurer pays nothing because the deductible is not met.
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If the third loss of $8000 occurs during the same time period ,
the insurer would pay $1000( $11,000 losses – $10,000 deductible)
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Any other losses occurring during the policy year would be paid in
full.
Example:
A manufacturing firm incurred the following
insured losses, in the order given, during the
current policy year.
Loss
A
B
C
Amount of Loss
$2,500
$3,500
$10,000
How much would the company’s insurer pay for
each loss if the policy contained the following
type of deductible?
1- $1,000 straight deductible
2- $15,000 annual aggregate deductible
FINANCIAL AND OTHER CONSIDERATION
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In order to solve the lower-premium-higher
retention trade-off , the risk manager should
consider the following factors:
- Tax Implications
- Ability to pay for losses
- Psychological Factors
- Social and Ethical Concern
Tax Implications
In general, commercial insurance premiums are a
tax-deductible expense, as are uninsured losses.
The main difference between the two is the
timing of the expense. Insurance premiums are
deductible when paid; losses are deductible when
incurred.
 Ability to pay for losses
To set an efficient retention limit, the firm must
consider the liquidity of assets, the stability of
net income , and the amount of net worth.
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Psychological Factors
People make decision based on their experience ,
attitudes toward risk , ability to explain and sell
their ideas to other managers, habits, and
intuition
 Social and Ethical Concerns
In the absence of adequate funding, uninsured
losses could bankrupt organizations and produce
socially or ethically undesirable consequences ,
including undercompensated, dead, or injured
employees, a polluted environment, or
unemployed workers.
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INTERNATIONAL RISK MANAGEMENT
Multinational Companies(MNCs) are firms that
have headquarters maybe in the United States ,
Europe, or Japan , but they have branches,
subsidiaries , employees , and business dealings
in dozens of different countries.
 Many U.S. firms in manufacturing industry have
foreign subsidiaries and they engage in importing
and exporting activities.
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RISK MANAGEMENT FOR MNCS
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International firms must apply all the rules for
managing domestic loss exposures(chapter 3):
1- Identify and measure all exposures to loss
2- Evaluate risk control and financing alternatives
3- Implement a cost-effective program
4- Regulatory reevaluate the program to see if
objectives are being met.
However, managing the domestic loss exposure is
not sufficient for international firms because they
face the international loss exposure as well.
ADDITIONAL CONCERNS RELATED TO RISK
MANAGEMENT OF MNCS
Although the risk management process remain the
same for domestic and international loss exposures,
the additional concerns distinguish the domestic risk
management and international risk management.
Foreign currency fluctuations enter into measurement
and financing problems.
 Political risks arise from unexpected interventions by
foreign governments.
 Risk financing arrangements and practices, including
insurance, vary widely throughout the world.
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RISK MANAGEMENT INFORMATION SYSTEMS (RMISS)
Many risk managers use RMISs to record, track,
and analyze losses.
 RMISs also are used to maintain records of plant,
property, and equipment and record how they are
protected from loss.
 Some firms also use RMISs to perform statistical
analysis of past losses and to forecast losses.
 RMISs must be tailored to the needs of individual
organizations because each organization faces
different physical hazards, liability exposures, and
property value fluctuations.
 As a system no standard RMISs can be designed to
solve a particular organization’s specific problems.
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