There are some fundamentals about risk that need to be carefully understood.
Risk can neither be avoided nor eliminated completely. Indeed, without taking risk, no business can grow. If there were no risks to take, managers would be without jobs!
The Pharaoh in the earlier example was obviously taking a risk in the sense that his investment would have been unproductive had there been no famine. Microsoft has laid huge bets on its next operating system, Windows 7. But without this investment, Microsoft realises it may lose its market share as the threat from Google intensifies. Similarly, Tata Motors has made a huge investment in buying out Daewoo's truck division in South Korea. The Tatas have also purchased the luxury marque, Jaguar, realising that without this kind of investment they may become a marginal player in the global automobile market.
In short, risk management is as much about managing the upside as the downside. But as John Fraser and Betty Simkins [“Ten common misconceptions about Enterprise Risk Management,” Journal of Applied Corporate Finance, fall 2007] mention, the upside should not become a distraction and dilute the focus of tactical risk management. The upside should be dealt with during periodic strategic planning exercises or when circumstances change in a big way. But once the strategy is in place, ERM should focus on the downside: “By keeping shifts in strategy and discussions of the upside apart from normal operations, companies avoid having their management and staff distracted by every whim or misunderstood opportunity.”
Risk management should not be viewed in absolute terms. It is often about making choices and tradeoffs between various kinds of risk. These choices and tradeoffs are closely related to a company's assumptions about its external environment. In the Indian pharma industry, players like Dr Reddy's Laboratories are challenging the patents of global players as the generics market in the US opens up with many blockbuster drugs going off patent. But another leading player, Nicholas Piramal (Nicholas), believes in a different approach - partnering with global majors. Nicholas does not want to challenge patents but wants to join hands with large players in various areas such as contract manufacturing. CEO Ajay Piramal believes that Nicholas' capabilities in managing strategic alliances with the big guns in the pharma industry will stand the company in good stead in the coming years.
All risks are not equally important. Without a clear understanding of the impact and frequency of different risks, some relatively unimportant risks may receive more attention than they warrant. As a result, there may be sub optimal utilization of corporate resources. Risks must be classified according to their frequency and potential impact, to facilitate prioritization.
Not all risks are external. Very often, the risks organizations assume have more to do with their own strategies, internal processes, systems and culture than any external developments. For example, the collapse of the Hyderabad based Global Trust Bank (GTB) in 2004 had more to do with poor management control systems than any other kind of risk. GTB took heavy risks while lending money to low credit worthy customers and investing money in the capital markets. The board failed to ask the right questions and impose the necessary checks and balances.
The crisis at UTI in 2001 was again due more to internal than external factors. UTI made a number of questionable investments in the late 1990s. There is considerable evidence that systems and processes were routinely violated when UTI's fund managers purchased risky stocks.
Every company needs to grow its revenues and generate adequate profits to survive in the long run. Unprofitable or stagnating companies are doomed to failure. So, investments, which are needed to stay ahead of competitors, cannot be avoided. And any investment does carry some amount of risk. Risk management ensures that these risks are identified, understood, measured and controlled. By understanding and controlling risk, a firm can take better decisions about pursuing new opportunities and withdrawing from risky areas.
Risk management cannot be completely outsourced. Companies must be clear about what risks to retain inhouse and what risks to transfer. In general, retaining risks makes sense when the cost of transferring the risk is out of proportion to the probability and impact of any damage. The first step for managers is to understand what risks they are comfortable with and what they are not. Often, companies are not comfortable with risks caused by external factors. This is probably why financial risk management, which deals with volatility in interest and exchange rates, has become popular among non banking organisations in the past few decades. Companies also tend to transfer those risks which are difficult to measure or analyze. A good example is earthquakes, where an insurance cover often makes sense. On the other hand, companies often prefer to retain risks closely connected to their core competencies. Thus, a software company like Microsoft would in normal circumstances, not transfer technology risk, but would in all likelihood hedge currency risk. These are only general guidelines. Ultimately whether to retain the risk or to transfer it should be decided on a case-to-case basis.
Showing posts with label Introduction to Risk Management. Show all posts
Showing posts with label Introduction to Risk Management. Show all posts
Monday, 4 January 2010
A very brief history of risk management
Risk management is not exactly a new idea. One of the earliest examples of risk management appears in the Old Testament of the Bible. An Egyptian Pharaoh had a dream. His adviser, Joseph interpreted this dream as seven years of plenty to be followed by seven years of famine. To deal with this risk, the Pharaoh purchased and stored large quantities of corn during the good times. As a result, Egypt prospered during the famine. Similarly, in Matsya Avatar, Lord Vishnu asked Sage King Satyavratha to put one pair of each species safely on board the ship that would help them escape the deluge the Lord was planning to unleash. This ensured the perpetuation of different flora and fauna.
The modern era of risk management probably goes back to the Hindu Arabic numbering system, which reached the West about 800 years back. The Indians developed the system while the Arabs played a key role in spreading the knowledge to the west. Without numbers, it would have been impossible to quantify uncertainty. But mathematics alone was not sufficient. What was needed was a change in mindset. This happened during the Renaissance, when long-held beliefs were challenged and scientific enquiry was encouraged. The Renaissance was a period of discovery, investigation, experimentation and demonstration of knowledge. As theories of probability, sampling and statistical inference evolved, the risk management process became more scientific. Many risk management tools used by traders today originated during the 1654-1760 period. The pioneers of the Renaissance age included Luca Paccioli, Girolamo Cardano, Galileo, Blaise Pascal, Pierre de Fermat, Chevalier de Mere and Christian Huygens.
Strangely enough, gamblers played a major role in the advancement of probability theory. A landmark problem they tried to solve was how to estimate the probability of a win for each team after an unfinished game of cards. These ideas were later supplemented by advances such as the regression to the mean by Francis Galton in 1885 and the concept of portfolio diversification by Harry Markowitz in 1952.
More sophisticated risk management tools have been developed in recent decades. These include models for estimating value-at-risk, volatility, probability of default, exposure at default and loss given default. A landmark event in the history of risk management was the development of the Black Scholes Merton Option Pricing Model in 1973. Thanks to better understanding of various domains, quantitative models and the availability of computing power, it has become possible to quantify risk to a large extent. Yet, as the recent sub prime crisis has demonstrated, these numbers are of little use if mature human judgment is not exercised, by the people involved.
The modern era of risk management probably goes back to the Hindu Arabic numbering system, which reached the West about 800 years back. The Indians developed the system while the Arabs played a key role in spreading the knowledge to the west. Without numbers, it would have been impossible to quantify uncertainty. But mathematics alone was not sufficient. What was needed was a change in mindset. This happened during the Renaissance, when long-held beliefs were challenged and scientific enquiry was encouraged. The Renaissance was a period of discovery, investigation, experimentation and demonstration of knowledge. As theories of probability, sampling and statistical inference evolved, the risk management process became more scientific. Many risk management tools used by traders today originated during the 1654-1760 period. The pioneers of the Renaissance age included Luca Paccioli, Girolamo Cardano, Galileo, Blaise Pascal, Pierre de Fermat, Chevalier de Mere and Christian Huygens.
Strangely enough, gamblers played a major role in the advancement of probability theory. A landmark problem they tried to solve was how to estimate the probability of a win for each team after an unfinished game of cards. These ideas were later supplemented by advances such as the regression to the mean by Francis Galton in 1885 and the concept of portfolio diversification by Harry Markowitz in 1952.
More sophisticated risk management tools have been developed in recent decades. These include models for estimating value-at-risk, volatility, probability of default, exposure at default and loss given default. A landmark event in the history of risk management was the development of the Black Scholes Merton Option Pricing Model in 1973. Thanks to better understanding of various domains, quantitative models and the availability of computing power, it has become possible to quantify risk to a large extent. Yet, as the recent sub prime crisis has demonstrated, these numbers are of little use if mature human judgment is not exercised, by the people involved.
The benefits of risk management
What is the rationale for risk management? Ultimately, risk management must benefit the shareholders. After all many of the risks a company faces, are specific to it. Portfolio theory argues that shareholders are rewarded only for systematic risk. Unsystematic risk, i.e., risk specific to a company can be diversified away by purchasing shares in a reasonably large number of companies. If shareholders can manage risk more efficienty on their own, by buying shares in various corporations, should companies really manage risk? The answer is an emphatic yes.
For starters, shareholders do not have all the information needed to manage the risks a company faces. Moreover, even if they had, individual shareholders would find it inefficient and expensive to manage risks on their own. The transaction costs would be too high if a large number of small hedging transactions are undertaken. Finally, distress situations are eminently avoidable. During such situations, significant value destruction takes place as the assets of the company trade at unrealistically low prices. Recall the collapse of Bear Stearns in March 2008 and Lehman in September 2008.
Prudent risk management ensures that the firm’s cash flows are healthy so that the immediate obligations and future investment needs of the firm are both adequately taken care of. Firms typically run into cash flow problems because they fail to anticipate or handle risks efficiently. These risks include market risks such as vulnerability to interest rate, stock index and exchange rate movements. Then there are credit risks which arise because of excessive investments in the same asset class or lending to the same customer segment. They also include liquidity risks such as liquidity black holes, which result when the entire market shifts to one side, with sellers finding it difficult to find buyers. Firms may also fail to anticipate business risks when the demand suddenly falls or a rival starts taking away market share aggressively with a new business model or technological innovation. Then there are various examples of companies failing to manage operational risk effectively because of poor systems and processes.
Risk management helps in sustaining the staying power of an organization. In 1993, Metallgesellschaft which tried to cover the risk associated with its long term contracts through oil futures ended up losing a huge amount. The star studded team at hedge fund, Long Term Capital Management could do little as unexpected interest rate and currency movements brought the fund to the edge of bankruptcy in 1998. In both the cases, the positions taken were fundamentally sound. But there were serious doubts about their ability to tide through the crisis. Indeed, much of the sub prime crisis has been about liquidity. Under the circumstances, liquidity has become the most potent weapon in many sectors. Liquidity gives the comfort to sustain day-to-day operations and more importantly make those vital investments that are needed to sustain the company’s competitiveness in the long run. Sound risk management goes a long way in ensuring that the organization has the required liquidity to function effectively even in bad times.
For starters, shareholders do not have all the information needed to manage the risks a company faces. Moreover, even if they had, individual shareholders would find it inefficient and expensive to manage risks on their own. The transaction costs would be too high if a large number of small hedging transactions are undertaken. Finally, distress situations are eminently avoidable. During such situations, significant value destruction takes place as the assets of the company trade at unrealistically low prices. Recall the collapse of Bear Stearns in March 2008 and Lehman in September 2008.
Prudent risk management ensures that the firm’s cash flows are healthy so that the immediate obligations and future investment needs of the firm are both adequately taken care of. Firms typically run into cash flow problems because they fail to anticipate or handle risks efficiently. These risks include market risks such as vulnerability to interest rate, stock index and exchange rate movements. Then there are credit risks which arise because of excessive investments in the same asset class or lending to the same customer segment. They also include liquidity risks such as liquidity black holes, which result when the entire market shifts to one side, with sellers finding it difficult to find buyers. Firms may also fail to anticipate business risks when the demand suddenly falls or a rival starts taking away market share aggressively with a new business model or technological innovation. Then there are various examples of companies failing to manage operational risk effectively because of poor systems and processes.
Risk management helps in sustaining the staying power of an organization. In 1993, Metallgesellschaft which tried to cover the risk associated with its long term contracts through oil futures ended up losing a huge amount. The star studded team at hedge fund, Long Term Capital Management could do little as unexpected interest rate and currency movements brought the fund to the edge of bankruptcy in 1998. In both the cases, the positions taken were fundamentally sound. But there were serious doubts about their ability to tide through the crisis. Indeed, much of the sub prime crisis has been about liquidity. Under the circumstances, liquidity has become the most potent weapon in many sectors. Liquidity gives the comfort to sustain day-to-day operations and more importantly make those vital investments that are needed to sustain the company’s competitiveness in the long run. Sound risk management goes a long way in ensuring that the organization has the required liquidity to function effectively even in bad times.
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