Definition of Risk – Part 3

 

*/By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc./*

What is the definition of risk?  This is the question that we started to
explore in Part 1.  There I claimed that there were two basic, yet very
different definitions of risk;

The first definition is:

·        "Risk is the possibility of adverse events that prevent an
organization from achieving its goals"

A second definition is:

·        "Risk is the possibility of events that prevent an
organization from achieving its expected outcomes"

In Part 1 I gave one illustration of how the choice of the definition changes
how an entity should measure risk.  In Part 2 I argued that the choice of
definition determines whether an entity decides to use options or forward
(swap)[1] [1] type contracts to hedge its financial risks.  In this
installment I will put forward an argument that the definition of risk
determines how the risk management function should be evaluated.

Throughout most of the 1990's, CIBC and Wharton conducted a survey of risk
managers to determine risk practices of corporations.  One of the questions
concerned whether or not the Treasury function was a cost centre or a profit
centre.  The responses changed significantly depending on current events in
the market.  For instance after the P&G and Gibson Greetings debacles in the
mid 1990's the popularity of operating the Treasury function as a profit
centre quite understandably declined.

Relating the survey to our current question of the definition of risk, it
becomes quite obvious that if the firm is choosing to define risk as only
"downside" or "bad" risk, then the Treasury function should in most
cases be operated as a cost centre.  Thus a simple and relevant evaluation
metric is "losses prevented / cost".  Losses prevented of course is more
easily said than measured, but one obvious way to do this is retroactively
(perhaps on a quarterly or annually basis) calculate the realized cash flow
of the firm and subtract from it the cash flows that would have occurred
without any Treasury interaction.  Hopefully a firm that is serious about
risk management will be able to calculate to a reasonable degree the cost of
its risk management activities (which includes not only the direct costs of
its hedges, but also indirect costs such as the management time and energy
spent on developing and implementing a strategy).

If the definition of risk includes both the upside and the downside risk,
then the evaluation measure becomes "(losses prevented plus opportunities
achieved) / cost".  This gives a much fuller and complete picture of the
value of the risk management function.  The opportunities achieved should
include direct opportunities such as new markets that were entered because
the risks could be managed to indirect value added through financial
engineering that either lowered the cost of capital or created incentives
that allowed for new customers.[2] [2]

At this point I would like to make it emphatically clear that I am not
advocating that the Treasury function should ever undertake speculation. 
Rarely has that ever turned out well in the long run for a non-financial
corporation.  If the corporation wants to speculate then it should become a
hedge fund – which implies a whole different set of operating competencies
as well as risk competencies.   The point is that by accepting that risk
has both a good component as well as a bad component, and by actively
managing both the good risk as well as the bad risk, there are potential
advantages for the corporation.

This concludes this set of three articles on the "Definition of Risk". 
I have tried to argue that there are two different definitions of risk and a
firm needs to make a conscious decision as to which definition of risk it
will operate under as the choice of definition affects the risk measures
used, the hedging tools selected as well as how the Treasury and Risk
Management function gets evaluated.

------------------------------------------------------------------------------
[1] [3] Swaps can be shown to be economically equivalent to a series of
forward contracts.  Therefore this analysis uses swaps and forwards
interchangeably.

[2] [4] An example of reducing the cost of capital would be a corporate
financing that embedded a structured note that provided investors a method to
invest in a commodity while laying off a risk for a corporate.  Hull (John
C. Hull, "Futures, Options and Other Derivatives", 7th edition, Pearson,
Prentice Hall, 2009) provides an example of Standard Oil issuing bonds where
the coupon was a function of oil prices.  This structured note allowed
investors to invest in oil, while allowing Standard Oil to hedge some of its
oil price risk in a win-win solution.  An example of using risk management
to incent new customers is residential fuel companies that give customers an
alternative payment structure that caps the price of fuel over the winter
months.

 


[1] #_ftn1
[2] #_ftn2
[3] #_ftnref1
[4] #_ftnref2