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Summary Corporate Risk Management (Y55127)
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All lectures are incorporated (+ notes). MODULE 1: risk management.
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SUMMARY CORP. RISK MANAGEMENTMBA Corporate Finance
KU Leuven 2021-2022
Robin Bakker
,Content
1. Introduction ......................................................................................................................................... 2
1.1 Risk, Uncertainty & Risk Management .............................................................................................. 2
Introduction to risk and uncertainty ................................................................................................... 4
Identifying risks: overview major risks ................................................................................................ 6
Identifying risks: financial risks............................................................................................................ 6
Identifying risks: non‐financial risks .................................................................................................... 7
Identifying risks: mini case .................................................................................................................. 8
Evolution of risk management ............................................................................................................ 8
Enterprise risk management (ERM): concept ..................................................................................... 9
Evolution of risk management: Enterprise risk management – ERM ................................................. 9
ERM is characterized by 5 dimensions.............................................................................................. 10
Step 1: Risk transparency and insight............................................................................................ 10
Step 2: Risk appetite and strategy ................................................................................................. 11
Step 3: Risk-related processes and decisions ................................................................................ 13
Step 4: Risk organization and governance .................................................................................... 13
Step 5: Risk culture ........................................................................................................................ 13
ERM implementation ........................................................................................................................ 14
ERM implementation: risk frameworks ............................................................................................ 14
ERM implementation: structure & process ....................................................................................... 16
ERM implementation: collaborating among internal risk management functions........................... 16
Current major global risks: introduction ........................................................................................... 17
Current major global risks: 2022 ....................................................................................................... 18
Interconnectedness of risks .............................................................................................................. 19
Current major business risks in Europe: 2022 ................................................................................... 19
From Risk Management To Integrated Risk Management................................................................. 19
Exercises, practitioners’ corner & active learning ............................................................................. 19
Risk correlation .............................................................................................................................. 19
Black swans.................................................................................................................................... 20
Risk culture .................................................................................................................................... 20
1.2 The Value of Risk Management....................................................................................................... 20
Getting started exercise .................................................................................................................... 21
The value of risk management: why do firms engage in risk management practices? .................... 21
MANAGERS’ PERSPECTIVE ............................................................................................................. 22
SHAREHOLDER VALUE MAXIMIZATION ......................................................................................... 23
STAKEHOLDERS’ PERSPECTIVE ...................................................................................................... 26
, Exercises, practitioners’ corner & active learning ............................................................................. 27
MM recap: overview basic model ..................................................................................................... 27
2.1 Corporate interest rate risk management ...................................................................................... 27
Importance of interest risk management ......................................................................................... 28
Importance of interest rate risk management: Vestia ...................................................................... 28
Recap : International Parity Conditions............................................................................................. 28
International parity conditions in equilibrium .............................................................................. 29
Interest rates and exchange rates ................................................................................................. 29
Prices and exchange rates ............................................................................................................. 33
International parity conditions: exercise ...................................................................................... 34
Corporate interest rate risk management ........................................................................................ 34
Interest rate risk exposure ............................................................................................................ 34
Management of interest rate risk ................................................................................................. 35
Management of interest rate risk: Mini‐case ................................................................................ 38
Management of interest rate risk: exercise .................................................................................. 40
Management of interest rate risk: Case ........................................................................................ 41
Interest rate management: empirical evidence ............................................................................ 44
A1‐ Advanced interest rate risk instruments (don’t need to know this for the exam) ................. 45
2.2 Corporate foreign exchange (FX) risk management ....................................................................... 46
Introduction & prevailing practices ................................................................................................... 46
Foreign exchange terminology - recap .......................................................................................... 53
Foreign exchange exposure ........................................................................................................... 54
Transaction exposure ........................................................................................................................ 56
The concept of foreign currency hedging ..................................................................................... 56
Why Hedge? Impact of Hedging on the Expected Cash Flows of the Firm ................................... 57
Management of transaction exposure .......................................................................................... 58
Managing transaction exposure: instruments .............................................................................. 58
Management of FX exposure: empirical evidence ........................................................................ 58
Managing transaction exposure: Case .......................................................................................... 59
Accept transaction risk .................................................................................................................. 60
Forward risk hedging ..................................................................................................................... 61
Money market hedging ................................................................................................................. 63
Option hedging .............................................................................................................................. 65
Hedging FX Risk Management Cycle ............................................................................................. 66
Exercises, practitioners’ corner & active learning ......................................................................... 67
Economic exposure ........................................................................................................................... 68
, Economic exposure: concept ........................................................................................................ 68
Measuring economic exposure ..................................................................................................... 69
Management of economic exposure: techniques......................................................................... 72
Management of economic exposure: case ................................................................................... 72
Practitioners’ corner: Applications & examples ............................................................................ 76
Translation exposure ......................................................................................................................... 77
Translation exposure: concept ...................................................................................................... 77
Translation methods and FX rate .................................................................................................. 78
Concept check exercise ................................................................................................................. 79
Managing Translation Exposure .................................................................................................... 80
Exercises, practitioners’ corner & active learning ......................................................................... 80
3 Corporate credit risk management .................................................................................................... 81
Some effects of the Russian invasion on credit risk/ratings ......................................................... 82
Concept of credit risk: definition ................................................................................................... 83
Concept of credit risk: Why credit risk management matters ...................................................... 84
Concept of credit risk: Sources of credit risk ................................................................................. 84
3.1 Business credit risk management ................................................................................................ 85
Business credit risk management: concept ................................................................................... 85
The credit decision ........................................................................................................................ 85
Concept check exercice ................................................................................................................. 87
Business credit risk management process .................................................................................... 88
Measuring business credit risk: approaches ................................................................................. 89
Measuring business credit risk: data-driven and statistical models ............................................ 89
Managing business credit risk ....................................................................................................... 90
Managing business credit risk: Operational techniques .............................................................. 92
Managing business credit risk: credit default swap (CDS) ............................................................ 92
3.2 Counterparty credit risk management ........................................................................................ 93
Counterparty credit risk: concept ................................................................................................. 93
Measuring counterparty credit risk ............................................................................................... 93
Managing counterparty credit risk ................................................................................................ 94
Netting: example ........................................................................................................................... 95
Counterparty credit risk management process ............................................................................. 96
Exercises, practitioners’ corner & active learning ......................................................................... 97
Active Learning Corner .................................................................................................................. 98
Exercises ........................................................................................................................................ 98
A/ own ........................................................................................................................................... 99
, A/ own Credit Risk Areas to Consider ......................................................................................... 100
A/ own models for simulation ..................................................................................................... 101
CVA .............................................................................................................................................. 102
Measuring business credit risk .................................................................................................... 102
Concept of credit risk: approaches.............................................................................................. 103
Measuring business credit risk: approaches ............................................................................... 103
Credit default swap ..................................................................................................................... 103
3.3 Topics in Corporate Risk Management ..................................................................................... 104
COVID‐19 ..................................................................................................................................... 104
Covid‐19 and effect on corporate risk (management) ................................................................ 104
Exercises, practitioners’ corner & active learning ....................................................................... 104
,1. Introduction
First observation is that risks are inherent to the business environment. Poor risk management can be
very costly, take the example of General Motors case. This case is interesting because after the
events, they decided to set up an integrated risk management system. First of all you need to be able
to identify risk and think about possible consequences and then see how you will deal with it. If you
analyze the exposure of the firm to this risk, do you think that this is in line with your risk appetite?
Based on that you might take different actions. You might accept the risk as it is. On the other hand
you could try to manage risk in order to mitigate its effects or just avoid risk. This leads to the third
observation which comes down to the fact that people in general and also firms are risk averse. Given
that we are risk averse and confronted with risks and that poor risk management can be costly, there
is value in corporate risk management. If you would set up an integrated risk management system,
you could actually add value to the firm. This is essentially the general frame of where you have to
situate this course.
Exam: 5 questions
First question: about terminology, concepts, compare certain concepts, give examples (details!)
Second and third question: ability to reproduce or apply to what we’ve seen, broader questions,…
(pay attention to the structure of the course, be able to give an overview)
Fourth and fifth question: applying, calculating, relating to current events like COVID,… explain why
you use a certain formula, give advice, give structure and write a conclusion.
1.1 Risk, Uncertainty & Risk Management
Starting exercise: You can start as a risk manager in an industrial firm… With which risks will you be
confronted? Can you apply any kind of classification to the identified risks? What information would
you like to have in order to manage the risks effectively?
Examples
Business risk like miss estimation of inventory/demand. This risk is on the demand side. Here you will
have to try to what the demand is, if there are errors this might have an effect in terms of inventory
or profit margins, etc.
Another type of risk is financial risk in terms of interest rate risk. Interests are very low thanks to the
monetary policy. But given that the inflation is rising very quickly, we see that the interest rates might
rise and that will affect your outstanding debt you have. If there are floating rates it will affect the
debt serving cost you have. But it might also affect your M&A activities in the sense that if the interest
rates go up, normally you would try to leverage your position and try to finance a part of the
acquisition that you will do. But of course when the costs of this debt becomes more expensive it
becomes harder to become a good deal.
Cyber risk is a type of risk that firms are increasingly faced with now. Because more and more
elements/activities are done in a digital way. Also because of the pandemic, more activities are done
online (homework). Think about the cases of Ransomware, where the operations of the firm were
blocked. They were asked to pay your ransom in order to release an essential machinery that they
need. The companies we are talking about are large companies. In Belgium we have Picano for
example.
2
,Commodity risk: resources might cause risk because of different elements. For example, the
commodity prices are increasing, or becoming very scarce. Think about chips. We now see that cars
are unable to finish them in a reasonable time because the chips were simply not present.
Announcement of Audi: we are going to move more to high-end cars, which was partly due the fact
that there was a scarcity of chips at the time. With this in mind, they decided to use the chips they
have on the most profitable cars. Here you see a clear example of a consequence in terms of activities
and decision making. It could also be that there is a problem in terms of the value in your supply
chain. It could be that there are enough resources, but there is a problem in the supply chain. You
can’t get the products in time to produce your stuff. Think about the cases in Canada, where you have
this blocked bridge. The resources are there but they just cannot get the products through the supply
chain as planned.
Other risks: climate risks, legal risks, reputational risks, etc.
In the cases above we have identified risk and possible consequences of operational activities or other
types of risk. What is key in this story is that you look at the different kinds of risks that are connected
with each other and not just take each risk aside and analyze as such. Because this way, you will miss
out certain elements that might be important to manage them in a proper way. Always keep that
overview of all different kinds of risk.
If you don’t have the right information, it will be impossible to try and manage these risks. So every
risk management system needs a decent information flow. In terms of risk but also in terms of
information from within the firm. Because otherwise you have someone at a certain level that has the
right information, but the information flow is not set up well. Maybe the board is unaware, or vice
versa. The board is aware, but the operational level is not informed about the possible consequences.
You also need a good information flow, not only to identify the possible risks and estimate the
exposure, but also to make sure that somebody will act. Make sure you have thought about who is
responsible when the risk is materializing and should therefore act.
Major learning outcomes
Get familiar with risk and uncertainty concepts.
• Identify different types of risks.
• Explain the fundamentals of corporate risk management.
o Describe the evolution of risk management.
o Gain insight in the enterprise risk management (ERM) framework.
• Produce an overview of current major risks.
Getting started exercise
Risks involved: growing costs might be related to commodity risk (risk on input side), this increase will
cause an increase in consumer prices which has an effect on the demand (demand risk). Products
which are more high end will suffer less from the increase in prices, while beers where prices are low
and the brand does not matter that much to the customer will suffer more heavily.
3
,Risks involved: political risks related to BREXIT, will also affect overall economic growth. Because
living standards will go down, you could expect the demand to go down.
Risks involved: cyber risk. This is about an open source code that has been used quite a lot by firms in
order to log the activities within their network. But apparently there was a bug, which hackers have
identified. This opened the discussion of whether these open source code is something you have to
pursue.
Risks involved: COVID.
Introduction to risk and uncertainty
Uncertainty
= a state of not knowing whether a proposition is true or false. All future events have some intrinsic
uncertainty.
Types of uncertainty:
“As we know, there are known knowns. There are things we know are known.
We also know there are known unknowns. That is to say we know there are some
things we do not know. But there are also unknown unknowns, The ones we
don’t known we don’t know” (Donald Rumsfeld, 2012)
When you have a good idea of the consequences and the probability you have established
uncertainty,… No idea about probabilities: imaginable uncertainty,…
4
, Risk
= no universal definition, despite its importance.
Formal approach:
Enterprise risk management perspective:
COSO : “risk is the possibility that events will occur and affect the achievement of objectives”
ISO: “the effect of uncertainty on objectives”
Risk measure: mathematical method for computing risk.
Risk measurement: summary number that captures risk which is obtained by applying data to a risk
measure.
Defining risk…
5
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