Risk management is a set of procedures that minimizes risks and costs for businesses. The corporate risk management department identifies potential sources of problems, analyzes them, and takes necessary measures to prevent losses. Financial risks are the primary concern for corporations, and derivatives are the primary way business risk is transferred. Business risk is especially relevant during difficult economic times.
Business risk refers to the liabilities and dangers a company faces. Risk management is a set of procedures that minimizes risks and costs for businesses. The task of a corporate risk management department is to identify potential sources of problems, analyze them and take the necessary measures to prevent losses.
The term “risk management” once applied only to physical threats such as theft, fire, employee injury and traffic accidents. By the end of the 20th century, the term also came to apply to financial risks such as interest rates, exchange rates, and e-commerce. These financial risks are the type most applicable to corporations.
There are several steps in any risk management process. The department must identify and measure the exposure to the loss, select alternatives to that loss, implement a solution and monitor the results of their solution. The goal of a risk management team is to protect and ultimately enhance the value of a company.
For example, a company has locations in California that are prone to earthquakes, while those in Florida are likely to experience hurricanes. The risk management team identifies these physical risks and purchases the appropriate insurance for those situations. Insurance companies of any kind are truly managing the risk associated with different scenarios.
With corporations, financial risks are the primary concern. Just as with standard bodily injury insurance policies, some financial risks can be passed on to other parties. Derivatives are the primary way business risk is transferred.
A derivative is a financial contract that has value based on or derived from something else. These other things can be stocks and commodities, interest and exchange rates, or even the weather when applicable. The three main types of derivatives used by corporate risk managers are futures, options and swaps.
A future is an agreement to purchase an asset at a future date for a specified price. Options give the buyer the option, but not the obligation, to buy that asset by a specified date and price. Swaps are agreements to exchange cash flows before a certain date. All of these add value to the company and some provide support if something goes wrong.
In 2008, credit swaps in particular were subject to numerous scrutiny following the bursting of the housing bubble of previous years. During the housing bubble, subprime lenders traded the risk associated with their subprime loans. The firms that bought the risk were then obliged to pay off the debts of those lenders. Those companies that took the risk ended up paying far more money than they ever thought possible. The calculated risk they took did not pay off, while the original lenders’ risk management teams played it safe.
Business risk is especially relevant during difficult economic times. Risk management teams will stand fewer chances when the economy is less forgiving. They will do whatever it takes to avoid further risk, which in some cases can help reduce credit availability and reduce overall spending.
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