In this chapter we look at some of the traditional risk management practices adopted by many companies to deal with their most essential exposures. The applicability of financial hedging is discussed and the limitations of this approach are pointed out while arguing that organizations should take a more integrative look across different types of risk effects and consider exposures over different time spans. As a natural outgrowth of this discussion it appears that companies should complement their risk management activities with a more strategy-oriented perspective in their hedging considerations. Finally, the practical challenges associated with managing the myriad of risks faced by modern corporations are addressed.

The need to look across risks

It is common practice in many, if not most, companies to hedge their anticipated future foreign-currency-denominated cash flows over a certain period of time, cf. the example from the Danish pharmaceutical company Lundbeck (see Box 5.1 Lundbeck – foreign exchange exposure).

The main reason for engaging in these hedging exercises is to limit negative short- to medium-term impacts from foreign-currency-denominated cash flows when they are converted to the home currency of accounting and thereby reduce adverse earnings effects from exchange rate fluctuations in the major invoicing currencies. These exposures typically relate to transactions recorded in the books as corporate receivables or payables, the local value of which will vary with changes in the foreign exchange conversion. The bulk of booked international commercial transactions do not extend beyond the current and next accounting year and can be hedged, for example, by engaging in forward foreign exchange or financial futures contracts that, for the same reason, only rarely exceed a maturity of twelve to eighteen months.

Now the focus moves beyond conventional risk management approaches and takes the wider spectrum of risks into consideration, including commercial and strategic exposures. The focus is also extended from insurance and derivative contracts to include alternative risk-transfer mechanisms and operational flexibilities needed to cope with longer-term systemic risks and firm-specific economic exposures. There is a focused discussion of the real options logic where financial options analysis is extended to the context of option structures framed by firm-specific asset positions, dynamic capabilities and external market conditions. A framework to analyze specific business opportunities as potential responsive actions in a turbulent environment is outlined and its potential use is discussed in more detail.

Risk management in all of its aspects

The range of exposures considered in conventional risk management thinking includes various insurable hazards as well as market-related, operational and commercial risks. Insurable risks comprise a range of casualties, accidents and man-made disasters, such as fire, collisions, explosions, etc., and natural disasters caused by, for example, windstorm, flooding and earthquake events that may destroy productive assets and disrupt the production flows. Market-related risks comprise the effects of changes in various market prices, such as commodity prices, energy prices, foreign exchanges rates, interest rates and so forth, all of which have the capacity to affect corporate performance. There has been an increased focus on operational risks in recent years comprising events like processing failures, technology breakdowns, human errors, misreporting, fraud and the like.

In this chapter the critique of the existing enterprise-wide risk management approaches is extended with the aim of proposing amendments to the ERM frameworks in ways that take account of unexpected and hard-to-quantify strategic risk events. This outlines a suggestive strategic risk management paradigm that incorporates existing risk management practices into corporate strategy-making processes, while ensuring an appropriate balance between restrictive central management control systems and flexible response capabilities.

The relationship to corporate strategy

The various ERM frameworks do not establish a convincing link between the proposed formal risk management practices and the dynamic corporate strategy-making processes for framing strategic direction and adjusting operational objectives. The ERM frameworks are preoccupied with various ways in which corporate management can successfully achieve and fulfil predetermined strategic goals. Furthermore, it is common practice in many companies to consider risk management activities and the corporate planning process as two entirely separate management processes. This might be ascribed to the fact that a primary concern of current risk management approaches in many companies is to obtain protection against potential downside effects, while realizing significant cost savings. Accordingly, risk management is typically not perceived as an integral part of strategic management considerations or as part of the creation of new business opportunities, which is a central aim of dynamic strategy-making. Yet, many of the key components within the formal risk management cycle are comparable to central elements of the strategic planning process (Figure 8.1).

This chapter takes a closer look at some of the main drivers behind the demand for a new risk paradigm and outlines the risk management practices evolving from this development. The key components of enterprise risk management (ERM), as a proponent for the new risk paradigm, are described and compared with more traditional approaches to risk management. In this light we discuss the extent to which the new integrative risk paradigm enables corporations to manage their exposures in increasingly dynamic business environments, where organizations are faced with high levels of uncertainty and a decreasing ability to foresee events. The discussion identifies potentially crucial shortcomings associated with the current enterprise-wide risk management approaches, which suggest that some amendments to the generic ERM framework are required to ensure that risk events are identified in time and handled in ways that allow the company to gain foresight and become more responsive.

Drivers of the new risk paradigm

Risk management has long been considered a standard management activity, although the risk focus generally has been limited to those exposures that can be observed, measured and financed through insurance and other financial hedging products, including derivative instruments, or that can be contained through implementation of internal control systems. The main aim in conventional risk management has been to protect the company against the adverse economic effects of various risk events.

To begin the risk management discourse, this chapter outlines more conventional approaches to risk management. The starting point is common financial and market-related risks reflected in currency and interest rate exposures. The chapter provides an outline of common analytical approaches to monitor excess exposures. General measures of price sensitivities are presented and extended to assess the sensitivity of corporate equity positions to changing business conditions. The treatment of more complex market-related exposures in value-at-risk calculations is outlined and illustrated in multiple examples. The consequences of fat-tailed distributions that reflect a potential for rare but extreme events are discussed, as is the need for stress testing in corporate risk assessments.

Exposures to market risk

The overarching risk considerations in international business and multinational financial management has been the potential influence of changes in foreign exchange rates on future corporate cash flows and the related effects on long-term competitiveness. In addition to this, there have been frequent discussions of political, sovereign and country risks associated with international funds transfer and cross-border investments. Many historical events illustrate the potential effects of fluctuations in foreign exchange rates and volatile financial market prices in general. Some of these notable events include dramatic stories like those of Herstatt Bank, Franklin National and Metallgesellschaft (see Box 2.1 Bankhaus Herstatt – foreign exchange settlements, Box 2.2 Franklin National – currency speculation and Box 2.3 Metallgesellschaft – position on petroleum prices).

Contemporary institutions are exposed to a variety of risks ranging from natural catastrophes and uncontrolled human behaviours to different strategic exposures that may hit the organization in unexpected ways. This chapter describes, partially by illustrative examples, the diverse nature of the corporate risk landscape and how related exposures seem to increase. The chapter discusses how different approaches to risk management may enable corporate executives to deal more effectively with these important challenges. The relationship between positive risk management outcomes and performance is explored and the question about uncovering an effective risk management model is developed.

The nature of risk management

Risks are everywhere, as evidenced by many corporate events reported in the popular press, including major corporate scandals around once venerable companies like the Maxwell group, Baring Brothers, WorldCom, Enron, Parmalat and so on. We also witness a steady increase in man-made disasters around the world and even the emergence of mega-catastrophes caused by wilful human actions that have both direct and indirect economic effects. These developments have intensified our focus on corporate and public risks and the risk management processes that may be needed to circumvent the adverse economic impacts from such events. All the while, we have seen a public risk perception aimed at reducing system errors, operational malfunctions and uncontrolled human behaviours that affect the way in which we try to deal with corporate risks.

This chapter continues the discussion of predominant risk-transfer markets and provides a general overview of various insurance and derivative instruments with more detailed explanations of the mechanics behind some of the most common corporate hedging techniques. The observed convergence between conventional insurance and capital market instruments is explained and the mechanisms driving the development of new alternative risk-transfer instruments are discussed further. The integrated use of different risk-transfer approaches to manage corporate exposures is outlined with examples of coordinated risk management practices.

Market-related risk exposures

A series of financial techniques have evolved that allow corporate management to deal with market-related exposures. By market-related risks we refer to events that are relatively well described and where event frequencies and associated losses are measured and documented on a regular basis. In other words, we are here dealing with measurable exposures that correspond to the traditional concept of risk as opposed to uncertainty that is impossible to measure because the unpredictable nature of events defeats measurability. In the case of hazards and casualties, the registration of events and associated losses is carried out by professionals in the insurance industry, often supported by industry-wide statistics and public databases. In the case of financial markets, the market prices of foreign currencies, interest rates and commodities are registered by individual market participants, stock exchanges, official statistics, etc. Price developments, trends and patterns derive from the analyses of defined price indices registered with regular time intervals, for example, minute-by-minute, hourly or daily.

The preceding nine chapters have covered many aspects of risk management, ranging from highly developed techniques dealing with different financial market volatilities and insurable risk phenomena to newer enterprise-wide approaches that also try to incorporate operational and strategic exposures. The discussion throughout these chapters has revealed a number of technical and rather sophisticated approaches to dealing with specific types of risk in highly professionalized market contexts. This clearly illustrates that a high degree of specialization is needed if organizations want to take advantage of the wide possibilities to obtain covers for and hedge against different exposures. These professional risk markets continue to evolve and introduce new opportunities to diversify excess exposures. At the same time, the discussions uncover a need to consider how different risks may interact and thereby show potential conjoint effects on aggregate corporate exposures. To the extent that the corporation is faced with positive or negative co-variations between some of the essential risk factors, there is a need to assess corporate exposures on an enterprise-wide basis. This overarching concern has obviously been an essential motivator for the introduction of different enterprise risk management frameworks that try to embrace all types of corporate exposures. As appears, the concerns for different sets of professional risk expertise and integrative considerations of corporate exposures point towards the simultaneous needs for professional skills dispersed within the organization and centralized analytical competencies.

This chapter will discuss a variety of analytical tools that may be adopted for risk management purposes. Initially, common tools applicable to analyze trends and emerging issues within predictable and known business environments are put forward, and a resemblance to strategic management is revealed through examples. Uncertainty is added to the spectrum, and the use of templates such as scenario planning and real options is outlined. It is shown how these approaches may enable the corporation to evaluate the effect of a changing risk landscape and to take necessary precautionary measures. Environmental uncertainty affects the corporation and introduces unexpected events that can cause major deviations to plans. The relevance of contingency planning is discussed and it is argued that it may work in simple and predictable environments to handle more severe deviations. However, it is subsequently argued that it must be complemented by a culture of mindfulness known from high reliability organizations in more complex and unpredictable environments. The chapter is rounded off with a discussion of risk management under unknowable environmental conditions as it must deal with ‘unk unks’. The role of values, behaviour and corporate culture in dealing with uncertainty and unforeseeable events is considered.

Environmental scanning in a predictable world

Corporations often face environmental changes that seem to come out of thin air. The previous chapter suggested that nearly 90 per cent of the drops in shareholder value can be attributed to strategic and operational risk events.