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Enterprise Risk Management

A.V. Vedpuriswar

September 16, 2016

Objectives
Understanding risk
Getting the big picture
Taking a holistic view
Recognising human infallibilities

Being clear about our priorities

Acknowledgements
Enterprise Risk Management: Theory and Practice, Brian W. Nocco, and
Ren M. Stulz, Journal of Applied Corporate Finance, Fall 2006
Strategic Risk Taking, Aswath Damodaran
The Black Swan, Nassim Nicholas Taleb

Integrated Risk Management for the Firm: A Senior Managers Guide,


Working paper by Lisa K. Meulbroek
Kenneth Froot, David Scharfstein & Jeremy Stein, A famework for risk
management, Harvard Business Review, Nov-Dec1994
Options, futures and Derivative Securities, John C Hull
Risk Management and Financial Institutions, John C Hull
FRM Body of Knowledge

Coping with a VUCA Environment


Volatile
Uncertain
Complex
Ambiguous

Geopolitical risks

Understanding Brexit

Why did the pound fall after the referendum results came in?

How Britain has benefited from the EU.

Source: The Economist

The implications of Brexit for Britain


Trade
Investments
Immigration
Budget contribution
Globalization
Withdrawal strategy

Technology as a disruptor

The tale of 3 Mobile Sellers

Ref: Code Halos, by Malcolm Frank, Paul Roehrig, Ben Pring

The Tale of 3 Book Sellers

Ref: Code Halos, by Malcolm Frank, Paul Roehrig, Ben Pring

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The rise of Uber


Founded in 2009, Uber is now the worlds most valuable startup,
worth around $70 billion.
Its services are consumed by some 30 million monthly
users in more than 425 cities in 72 countries around the world.

In 2016, Uber will generate around $4 billion in net revenues,


more than double the figure in 2015.
Uber wants to make cab hiring so cheap and convenient that
people may over time give up car ownership altogether.
The $100-billion-a-year taxi business is just the start.
Uber has its eye on the far bigger market for personal transport,
estimated to be $10 trillion a year globally.
Draws from The Economist, Sep 3-9, 2016

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Risk Management Basics

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Ice breaker
What are the fundamental laws of Physics?
What are the fundamental laws of Economics?
What about Financial Economics?

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A problem which took 160 years to solve


Luca Pacioli, an Italian monk framed a famous problem.
Two gamblers are playing a best-of-five dice game.

They are interrupted after three games with one gambler


leading 2 to 1.
What is the fairest way to divide the pot between the two
gamblers, taking into account the current status of the
game?

Blaise Pascal and Pierre de Format solved the problem after


about 160 years.
How? Assume all the 5 games are played.

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Another teaser
I give you two options
Take Rs. 50

I toss a coin. Heads you get Rs. 100 and tails you get 0
Which will you choose?
I give you two options
Pay Rs. 50

I toss a coin. Heads you pay Rs. 100 and tails you pay 0
Which will you choose?

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A third teaser(1)
The bird flue epidemic is expected to hit your town and it is
estimated that 600 people die. Which of the following two
drugs, A or B, will people recommend to combat the
epidemic, given the following information?
If Drug A is used: 200 will be saved.
If Drug B is used: 1/3 chance that all 600 will be saved and
2/3 chance that nobody will be saved.
It seems a greater percentage of the respondents vote
for Drug A

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A third teaser(2)
The bird flue epidemic is expected to hit your town and it is
estimated that 600 people will die. Which of the following two
drugs, C or D, will people recommend to combat the
epidemic, given the following information?
If Drug C is used : 400 will die.

If Drug D is used: 1/3 chance that nobody will die, and 2/3
chance that 600 will die.
It seems a greater percentage of the respondents vote
for Drug D.

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Key messages
Our attitudes towards risk are highly perplexing.
The essence of good risk management is making the right
choices when it comes to dealing with different risks.

Risk management should not be equated with risk hedging.


The most successful companies rise to the top by embracing
risks they can exploit better than their competitors.

Some risks are black swans.


They come when we least expect them but their effects can be
catastrophic.

An integrated approach to risk management can be highly


rewarding.
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How Enterprise Risk Management adds value


Enterprise Risk management creates value at both a macro
or company-wide level and a micro or business-unit level.
At the macro level, ERM enables senior managers to quantify
and manage the risk-return tradeoff that faces the entire firm .
At the micro level, ERM becomes a way of life for managers
and employees at all levels of the company.

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What determines the value of a firm?


The value of a firm can generally be considered a function of
four key inputs:
Cash flow from assets in place or investments already
made
Expected growth rate in cash flows during a period of high
growth excess returns
Time before stable growth sets in and excess returns are
eliminated
Discount rate which reflects both the risk of the investment
and the financing mix used by the firm

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What can a firm do to increase its value?


Generate more cash flows from existing assets
Grow faster or more efficiently during the high growth phase
Prolong the high growth phase
Lower the cost of capital
What is the role of risk management in adding value to firm?

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How risk hedging can help


Managers often under invest because of risk aversion.
By providing hedging tools, we can remove the disincentive
that prevents them from investing.

By hedging and smoothening earnings, firms can extend


their high growth/excess returns period .
Hedging firm specific risks can align the interest of
stockholders and managers, leading to higher firm value.
The pay off from risk hedging is greater for firms with weak
corporate governance structures.
The payoff is also greater in case of managers with long
tenure.
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How taking risk helps


The way the firm strategically manages its risk exposure,
such as by making the right R&D investments, will clearly
help in extending the growth phase.
Taking risk has higher pay offs in businesses that are
volatile but yield high returns on investment.
We must look for the positive black swans!

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Benefits of Risk management: A Summary


Risk management can lead to reduction in expected costs related
to the following:

Tax payments,
Financial distress,
Underinvestment,

Asymmetric information,
Undiversifiable stakeholders

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Risk Management vs. Risk hedging


Though risk management and risk hedging are used
interchangeably, they are not the same.
Risk management is aimed at generating higher and more
sustainable excess returns.

The benefits of risk management will be greatest in


businesses with high volatility and strong barriers to entry.
The greater the range of firm specific risks, the greater the
potential for risk management.
Risk management will create more value if new entrants can
be kept out of business.

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Managing the upside


Successful risk taking implies expanding our exposure to
upside risk while reducing the potential for downside risk.
The excess returns on new investments and the length of
the high growth period will be directly affected by decisions
on how much risk to take in new investments .
There is a positive pay off to risk taking but not if it is
reckless.
Firms that are selective about the risks they take can exploit
these risks to their advantage.
Firms that take risks without sufficiently preparing for their
consequences can be hurt badly.

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Risk Management vs. Risk Hedging: A summary


Risk Hedging

Risk Management

View of risk

Risk is a danger

Risk is a danger & an opportunity

Objective

Protect against the downside

Exploit the upside

Approach

Financial, Product oriented

Strategy/cross functional process


oriented

Measure of success

Reduce volatility in earnings,


cash flows, value

Higher value

Type of real option

Put

Call

Primary impact on value

Lower discount rate

Higher & sustainable excess returns

Ideal situation

Closely held, private firms, publicly


traded firms with high financial
leverage or distress costs

Volatile businesses with significant


potential for excess returns

Ref : Strategic Risk Taking, Aswath Damodaran

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ERM : Managing the upside and the downside

Ref : Ten Common misconceptions about ERM, , by John R. S. Fraser, Hydro


One, and Betty J. Simkins, Journal of Applied Corporate Finance, Fall 2007
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Dealing with risk

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ERM Maturity levels (As defined by S&P)


Maturity Level

Description

Weak

Lacks reliable loss control systems for one or more major


risks.

Adequate

Has reliable loss control systems.


But may still be managing risks in silos instead of
coordinating risks across the firm.

Strong

Has progressed beyond silo risk management to deal


with risks in a coordinated approach.
Has the capability to envision and handle emerging risks,
and well-developed risk-control processes.
Has a focus on optimizing risk-adjusted returns
necessary for effective strategic risk management.

Excellent

Has the same characteristics as a strong ERM program.


But is even better in terms of implementation,
effectiveness, and execution of the program.
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Reasons for Risk Management Failures

Failure to use appropriate risk metrics.


Wrong measurement of known risks.
Failure to take known risks into account.
Failure to communicate risks to top management.

Failure to monitor and managing risks.

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Strategy, Finance, Operations : Need for integration


Risk management as a discipline has evolved unevenly
across different functional areas.
In strategy, the focus has been on competitive advantage and
barriers to entry.
In finance, the preoccupation has been with hedging and
discount rates.
Finance people tend to pay little attention to the upside.
People in charge of operations may not have the big picture.

Risk management at most organizations is splintered.


There is little communication between those who assess risk
and those who make the decisions.
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Three ways to manage risk


Fundamentally, there are three ways to manage risk.
Which are these ways?

Different approaches to managing risk

Adjusting
capital
structure
(Buffer)

Targeted
financial
instruments
(Transfer)

Modifying
operations,
(Hold)

Integrated Risk Management for the Firm: A Senior Managers Guide, Working paper
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by Lisa K. Meulbroek

Integrated risk management


Integration refers to :
the combination of the three risk management techniques,
the aggregation of all the risks faced by the firm

Integrated risk management is by its nature strategic, rather


than tactical.
The three ways to manage risk are functionally equivalent in
their effect on risk.

So their use connects seemingly-unrelated managerial


decisions.
For instance, capital structure decisions cannot be decided in
isolation from the firms other risk management decisions.
Can we think of some examples?
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Modifying operations to gain competitive advantage


Companies are in business to take strategic and business
risks.
By reducing non-core exposures, ERM effectively enables
companies to take more strategic business risks.
Consider the following :
Pharma R&D
Human capital management in software company

Cricket pitch during rainy season


Environmental management

Oil company

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When to hold the risk.


Companies should be guided by the principle of comparative
advantage in risk-bearing.
A company that has no special ability to forecast market
variables has no comparative advantage in bearing the risk
associated with those variables.

But the same company may have a comparative advantage in


bearing information-intensive, firm-specific business risks.
That is because it knows more about these risks than
anybody else.

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Risk transfer using targeted financial instruments.


When should firms use targeted financial instruments?

Some risks cannot be managed effectively through the


operations of the firm.
Either because no feasible operational approach exists.

Or an operational solution is simply too expensive to implement.


Or it is too disruptive of the firms strategic goals.
Targeted financial instruments are especially suited for firms
with large exposures to market risk :
commodity prices,
currencies,
interest rates,
the stock market.
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Risk adjustment via the capital structure


By decreasing the amount of debt in the capital structure,
managers can reduce the shareholders total risk exposure.

Lower debt means that the firm has fewer fixed expenses.
This translates into greater flexibility in responding to any
type of volatility that affects firm value.

Lower debt also reduces the chance that the firm becomes
financially distressed.

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Equity: An all purpose cushion


Equity provides an all-purpose risk cushion against loss.
There are some risks that a firm can both anticipate and
measure relatively precisely.

Such risks can be shed through targeted risk management.


Equity provides ideal protection against
risks that cannot be readily anticipated or measured.
or for which no specific targeted financial instrument exists.

The larger the amount of risk that cannot be accurately


measured, the larger the firms equity cushion should be.

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Liquidity, model and market risks


Liquidity, market and model risks are interrelated.
Breakdown of markets leads to liquidity problems.
When markets are not in place, models become necessary.

Models pose various risks.

Credit and Market risks


Credit and market risks are inter related.
Consider bonds.
Change in credit rating can lead to change in bond price

Consider swaps.
Change in value can lead to credit risk.
Financial disintermediation has led to more integration.

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Market and Operational Risks


Market and operational risks are interrelated
When positions move, losses may have to be booked.
Traders psychology may lead to breach of systems and processes.

More risks may be taken than warranted.


Sound systems and processes can help.

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Competitive advantage through superior risk management


Information
Speed
Experience/Knowledge
Resource
Flexibility

Corporate governance
People
Reward/punishment mechanisms

Ref : Strategic Risk Taking, Aswath Damodaran

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The Information Advantage


Firms that take risk must invest in superior information
networks.

Companies must be clear about the kind of information


needed for decision making in a crisis.
They must put in place necessary information systems.
Early warning information systems must trigger alerts and
preset responses.

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The Speed Advantage


The speed of response can be critical in a crisis.
Speed depends on the quality of information, and
understanding the potential consequences and the interests
of the stakeholders.

Organizational structure and culture also determine the


speed of response.

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The Experience/Knowledge Advantage


Having experienced similar crises in the past can give us an
advantage.
Firms must invest in learning.

They can enter new and unfamiliar markets, expose


themselves to risk and learn from mistakes.
They can acquire firms in unfamiliar markets.

They can form strategic alliances or recruit people with the


necessary expertise.

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The Resource Advantage


Having the resources to deal with a crisis can give a company
a significant advantage over competitors.

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Flexibility
A flexible response to changing circumstances can be a generic
advantage.
Flexibility may come from production facilities that can be
modified at short notice to produce modified products that better
fit customer demand.

Flexibility may also come from lower overheads and fixed costs.
Flexibility also implies getting rid of past baggage, cannibalising
existing product lines and having a paranoid culture.

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Corporate governance
Interests of decision makers must be aligned with those of
the owners.
Both managers with too little wealth and too much wealth
tied up in their business will not take risk.
The appropriate corporate governance structure for the risk
taking firms would call for decision makers to be invested in
the equity of the firm but also to be diversified.

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People
When facing a crisis, some people panic, others freeze but a
few thrive and become better decision makers.

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Reward/Punishment mechanisms
A good compensation system must consider both process
and results.

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Behavioral issues in Risk Management

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The duality of risk


It is part of human nature to be attracted to risk.
At the same time, there is evidence that human beings try to
avoid risk in both physical and financial pursuits.

Some individuals take more risk than others.

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Behavioural finance and prospect theory


Decisions are affected by the way choices are framed.
Individuals may be risk seeking in some situations and risk
averse in others.

Individuals feel more pain from losses than from equivalent


gains.

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Propositions about risk aversion (1/2)


Individuals are generally risk averse and more so when the
stakes are large than when they are small.

There are big differences in risk aversion across the population


and noticeable differences across sub groups.
Individuals are far more affected by losses than by equivalent
gains.
The choices that people make when presented with risky choices
depend on how the choice is presented.
Individuals tend to be much more willing to take risk with what
they consider found money than with money they have earned.

Ref : Strategic Risk Taking, Aswath Damodaran

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Propositions about risk aversion (2/2)


There are two scenarios where risk aversion seems to
decrease and is even replaced by risk seeking.
One is when individuals are offered the chance of making an
extremely large sum with a small probability of success.
Second when individuals who have lost money are given a
chance to get their money back.
When faced with risky choices, individuals often make
mistakes in assessing the probabilities of outcomes, over
estimating the likelihood of success.
The problem gets worse as the choices become more
complex.
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Summing Up

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Five questions about risk


Question #1: Have senior managers communicated the core
values of the business in a way that people understand and
embrace?
Question #2: Have managers in the organization clearly
identified the specific actions and behaviors that are offlimits?
Question #3: Are diagnostic control systems adequate at
monitoring critical performance variables?
Question #4: Are the control systems interactive and
designed to stimulate learning?
Question #5: Is the company paying enough for traditional
internal controls?
Ref : Strategic Risk Taking, Aswath Damodaran

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Risk management: First principles (1/2)


Risk is everywhere: Our biggest risks will come from places that we
least expect them to come from and in forms that we did not anticipate
that they would take.

Risk is threat and opportunity: Good risk management is about


striking the right balance between seeking out and avoiding risk.
We are ambivalent about risks and not always rational: A risk
management system is only as good as the people manning it.
Not all risk is created equal: Different risks have different implications
for different stakeholders.
Risk can be measured: The debate should be about what tools to use
to assess risk than whether they can be assessed.
Good risk measurement should lead to better decisions : The risk
assessment tools should be tailored to the decision making process.

Ref : Strategic Risk Taking, Aswath Damodaran

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Risk management: First principles (2/2)


The key to good risk management is deciding which risks to avoid, which
ones to pass through and which to exploit: Hedging risk is only a small
part of risk management.
The pay off to better risk management is higher value: To manage risk
right, we must understand the levers that determine the value of a business.
Risk management is part of everyones job : Ultimately, managing risks well
is the essence of good business practice and is everyones responsibility.
Successful risk taking organizations do not get there by accident :The
risk management philosophy must be embedded in the companys structure
and culture.
Aligning the interests of managers and owners, good and timely
information, solid analysis, flexibility and good people is key : Indeed,
these are the key building blocks of a successful risk taking organization.

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Concluding remarks
Extreme negative outcomes are always a possibility. Effectiveness of risk
management cannot be judged on whether such outcomes materialize.
The role of risk management is to limit the probability of such outcomes to
an agreed-upon, value maximizing level.
A company where risk is well understood and well managed will be trusted
by investors. Such a firm will command the resources required to invest in
the valuable projects available to it.

In such cases, investors will be able to distinguish bad outcomes that are
the result of bad luck rather than bad management, and that should give
them confidence to keep investing in the firm.

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