Lund Institute of Economic Research
Working Paper Series
Enterprise Risk Budgeting
-Bringing risk management
into the financial planning process
2009/1
Alf Alviniussen
Håkan Jankensgård
Abstract
Enterprise Risk Management (ERM) is a holistic, integrated approach to managing a company’s risks, in contrast to the so-called “silo-approach” prevalent in many firms in which risks are managed independent of each other. Yet for all the risk exposures that are brought under the corporate umbrella in an ERM-approach, it may be inadequate for addressing the firm’s aggregate risk in terms of the probability of failing to meet important corporate objectives, such as implementing the business plan or protecting debt covenants. In this paper we present a quantitative approach to risk management in the non-financial firm that retains the integrative, enterprise-wide mindset, yet also equips Corporate Management with the ability to evaluate financial distress-probabilities by incorporating ideas related to the concept of a firm’s Economic Capital. We term such an effort Enterprise Risk Budgeting (ER-B). ER-B makes possible an ongoing re-assessment of the firm’s expected financial position and overall risk profile, and in particular of how these change as a result of corporate policy decisions, for example relating to capital expenditure, acquisitions, dividends, and hedging. The transparency created by such a tool increases the likelihood that Management makes sound proactive decisions with respect to its risk profile, rather than reacts to challenging circumstances once they occur. We illustrate using the experiences of Norwegian aluminium producer Norsk Hydro.
Keywords:Enterprise Risk Management, Risk Budgeting, Economic Capital, Risk Measures
Jel-codes: G30, G32
ISSN 1103-3010
Alf Alviniussen*, Senior Vice President, Norsk Hydro ASA, Oslo, Norway
Håkan Jankensgård* (corresponding author), Department of Business Administration, Lund University, P.O. Box 7080, 220 07 Lund, Sweden, Phone + 46-46-222 7830, [email protected]
* The authors wish to thank Stephan Mocek and Randi Birkeland of Norsk Hydro for useful comments.
1. Introduction
One of the most significant trends in corporate risk management over the last decade is the rise of Enterprise Risk Management (ERM). ERM is about taking a holistic, company-wide approach to managing a company’s risks, and aggregating information regarding various different risk exposures centrally in the organization.1
All relevant risks which have an impact on the future cash flow, the profitability and the continued existence of a company may be described as its inherent Risk Universe. The main objective of the ERM risk mapping process is to describe and structure the Risk Universe and to assess the importance of the risk factors in terms of likelihood and impact, as well as to define risk mitigating actions and risk owners.
Embracing ERM means leaving behind the so-called “silo” thinking (hereafter called Silo-Approach) related to risk management, where each category of risks is managed in isolation, normally by the respective departments responsible for that part of the business activity. In this regard one may argue that ERM traces some of its intellectual roots to Portfolio Theory, which expresses the idea that risks should be measured and managed on a portfolio basis, and that the risk of the portfolio should be balanced against potential rewards.2
The risk aggregation that takes place in ERM allows Management to assess inter-dependencies between its various risk exposures and to take this information into account when developing risk mitigation strategies. Furthermore, the proponents of ERM argue that it can enhance shareholder value by improving the way a company trades off risk and opportunity. By systematically mapping out its risks and opportunities a company is in a better position to decide which risks to retain and which to do something about.
Yet there is another key insight of financial theorists that has implications for the design of a corporate risk management programme, namely the insight that financial distress entails various costly consequences, and that any value from a risk management effort largely comes from avoiding such costs (“Corporate Risk Theory”).3
Corporate Management therefore has an incentive to assess the likelihood and severity of such outcomes. Following this line of thinking, we will use the term Total Risk to signify the risk that the firm fails to meet important corporate-level objectives, such as implementing the investment plan, protecting debt covenants and maintaining a certain credit rating, or that it experiences financial distress for example in terms of having to make asset sales in a depressed market (asset fire sales) or difficulties in raising external funding. We will argue below that, in spite of all the different exposures that are aggregated and monitored in the Risk Universe, this framework may not be capable of addressing or describing certain aspects of the Total Risk in the firm.
It is important to note that the Total Risk profile of a company is highly related to and a function of corporate policies and strategic decisions. Consider first a firm launching a share-buyback programme. Since this drains the firm of cash and reduces its equity, it should be intuitively understood that the risk in the firm will go up as the shares are bought and liquidity is reduced. Similarly, if the firm makes a large, debt-financed investment, the Total Risk of the company will normally increase, at least in the short to medium term. Indeed, the most important strategic decisions taken in a company are related to the level of growth and capital expenditure implied by its business plan. Normally high growth
1
See http://www.coso.org/documents/COSO_ERM_ExecutiveSummary.pdf for an introduction to the Enterprise Risk Management-framework.
2
Markowitz, H. (1952) “Portfolio Selection”, Journal of Finance, 7 (4), pp.77-91 3
In this literature, which is reviewed more extensively in section 3, prominent motivations for managing corporate risk include lowering the expected costs of bankruptcy and protecting the firm’s ability to invest optimally
ambitions reflected in high capital expenditure levels will expose the company to more risk. It is also intuitively understood that a sizeable hedge4
, if properly executed, will tend to decrease the overall level of risk in the firm. Management will normally like to have a better grasp of approximately how much the Total Risk is expected to go up or down due to corporate policy decisions.
The Risk Universe perspective is by and large inadequate for dealing with these questions due to the fact that it is essentially a static compilation of risk exposures and therefore lacks the suitable analytical structure. For one thing the identified risk exposures are not put together into a description of the uncertainty in the firm’s business performance (or its “volatility” in the jargon). Nor does one have the means to infer from the Risk Universe the firm’s capacity to carry that amount of uncertainty or volatility. In other words, the notion of a firm’s Economic Capital, i.e. a buffer that aims to ensure the firm’s survival in a worst-case scenario, is not very explicit in most ERM applications in non-financial firms. ERM initiatives would therefore, in our opinion, benefit from a quantitative risk modelling effort aimed at describing the firm’s Total Risk. However, ERM projects are all too often run as a separate, independent process in the company, related more to control and compliance than integrated with planning activities. In such case financial planning don’t benefit from the analytical consolidation of the financial consequences of risk that takes place in the ERM process.5
What is desirable is a framework which retains the holistic, enterprise wide-mindset of ERM, and its comprehensive mapping of risk exposures, yet also equips Corporate Management with the ability to evaluate the firm’s aggregate risk in terms of failing to meet important financial objectives that imply the realization of financial distress-related costs. We argue in this paper that the natural place for such an activity is the firm’s financial planning process, but that financial planning is often done in a rather static fashion that neglects important aspects of the firm’s risk profile. Simulation methodology offers a possibility to move beyond the traditional “optimistic-expected-pessimistic” triad of scenarios, and such methods can, correctly handled, greatly enrich the financial analysis of enterprise risk. The hallmark of a successful financial planning process, it is argued, is the ability to provide timely and accurate information on how a proposed corporate policy change affects the firm’s expected financial standing and overall risk profile.
Several authors have endorsed the use of simulation methodology in addressing risk analysis at the corporate level.6
Yet no paper of which we are aware presents an extensive and coherent treatment of how the non-financial firm’s financial planning process can be shaped in order to provide information relevant for managerial decision making related to the firm’s risk profile. The existing literature, therefore, falls short of providing an adequate account of how financial planning and risk management principles can be fused on the enterprise level.
Our aim in this paper is to present an approach in which risk management is brought more formally into the financial planning process, and becomes integrated with other issues high on the CFO agenda, such as business planning, balance sheet optimization, cash forecasting, and FX management. In particular, the suggested approach makes possible an ongoing re-assessment of the firm’s expected financial standing and risk profile to support
4
Throughout this paper we will use the term ‘hedge’ synonymous with the use of a financial derivative to reduce or eliminate a risk exposure
5
By financial planning we mean forecasting the firm’s liquidity (including possible funding needs), financial exposures, balance sheet, net income, and performance measures. Financial planning also includes analysis of how these forecasts change with variations of underlying assumptions.
6
See, for example, Hayt, G. and S. Song (1995) “Handle with sensitivity”, Risk, 8 (9), pp. 94-99, or Nocco, B. and R.M. Stulz (2006) “Enterprise Risk Management: Theory and Practice”, Journal of Applied Corporate
management decision-making. The kind of transparency created by such a tool increases management’s ability to make sound pro-active decisions with respect to its risk profile, rather than reacting to challenging circumstances once they occur. We will term such an effort Enterprise Risk Budgeting (ER-B).
The paper is outlined as follows. Section 2 outlines the basic principles and thinking behind Enterprise Risk Budgeting (ER-B). Section 3 explains ER-B in terms of the academic literature on risk management and also classifies different approaches to corporate risk management. Section 4 discusses some managerial challenges in relation to implementing ER-B. Section 5 illustrates an implementation of ER-B using the experiences of the Norwegian aluminium-producer Norsk Hydro ASA. Sections 6 and 7 deal, from an ER-B perspective, with two issues that are given high attention in the literature, namely hedging and foreign exchange risk management. Section 8 concludes the paper.
2. Enterprise Risk Budgeting
Enterprise Risk Budgeting (ER-B), in practical terms, implies the use of quantitative risk modelling in the firm's corporate-level financial planning process. Its main use is to create transparency about how corporate policies influence the firm's expected financial position and its Total Risk profile. At its most ambitious level, ER-B involves describing, in quantitative terms, the trade-off between the costs and benefits associated with a certain risk profile (i.e. "risk optimization").
A necessary first step in ER-B is to quantitatively model the firm’s cash flows, similar to some of the Cash-Flow-at-Risk approaches that have become popularized in recent years.7
The purpose of modelling the cash flows using Monte Carlo simulation methodology is to create an idea of how ‘risky’ the firm’s underlying business is in an overall sense, taking into consideration the combined impact on cash flow volatility from the variables identified in the Risk Universe. The probability-impact estimates included in the ERM Risk Universe mapping are thus the basic building blocks of a probability distribution of cash flow concerning some future point in time. This implies establishing, in a model format, the impact of volumes, prices, exchange rates, and various other risk factors on the aggregate cash flow of the company. This conceptual step is shown in Figure 1, illustrating how the information contained in the Risk Universe is used to create an estimate of the overall uncertainty in the firm’s cash flows.
The ER-B mindset also involves an analytical consolidation of enterprise risks that are often neglected in the financial planning process. Some assets and liabilities may not institutionally be a part of the firm, yet the firm bears the risk associated with those assets and liabilities. Pension plan asset and liabilities typically have huge risk exposures that could have implications for the financial standing of the company. Many companies also have substantial ownership in non-consolidated investments whose profitability may influence performance and cash flows (in the form of dividends or equity injections). In ER-B such risk exposures are comprehensively mapped out and made part of the financial analysis of enterprise risk.
7
Cash-Flow-at-Risk is a summary statistic of the risk inherent in the firm’s portfolio of cash flows. See, for example, Andren, N., H. Jankensgård, and L. Oxelheim (2005) “Exposure-based Cash-Flow-at-Risk: An Alternative to Value-at-Risk for Industrial Companies”, Journal of Applied Corporate Finance, 17 (3), pp. 76-87
Figure 1 From Risk Universe to simulated cash flow
It is important to acknowledge, however, that not all risks lend themselves easily to quantification. The probability and financial impact of, say, reputation risk, are fundamentally difficult to attach numbers to. Many risks lack a history of observations on which to base estimates. The cost involved in creating valid expertise assessments of such risks may sometimes vastly exceed the marginal benefit. So this step of the process is not about obsessively attaching probabilities to all risks that could possibly affect the firm’s future cash flows or performance. The firm should rather attempt to create a robust and meaningful description of the outcome distribution for its most important future cash flows, which in most cases will involve modelling the main commercial risks, such as product prices, the cost of raw materials, and exchange rates, and then adding other risk factors where valid probability-impact estimates are available at reasonable cost.
Once the exposures have been mapped out and aggregated into a corporate-level portfolio, one is compelled to ask: “What is the organization’s capacity to carry those risks?” A firm’s Risk Capacity could be thought of as the combined “weaponry” of resources which a firm possesses to manoeuvre in difficult times without having to make costly adjustments to its business activities. The firm’s financial resources, the quality of its assets and its management team, its reputation in the capital markets, are but some of the factors that will determine the company’s freedom to act and its overall ability to deal with challenging business conditions.
To narrow the concept a bit, however, and to make it operational for financial analysis, we think of Risk Capacity as a function of three things: 1) the amount of liquid assets (i.e. cash and cash equivalents), 2) spare debt capacity (i.e. its capacity to take on additional debt, e.g. as implied by current levels of key financial ratios) and 3) hedge positions (see Box 1)8. Taken together these elements determine the firm’s Risk Capacity,
8
A firm might be able to issue shares to raise new capital. However, issuing equity is typically viewed as costly, especially if the firm is forced to do so in a difficult situation. Having to resort to issuing shares in a stressed situation can therefore be viewed as a costly consequence of volatility, rather than an efficient risk management “tool”.
Probability
Impact Risk factor A
“The Risk Universe” “Simulated cash flow distribution”
X <=2543, 27 5% X <=3191, 97 95% 0 0 ,0 2 0 ,0 4 0 ,0 6 0 ,0 8 0 ,1 0 ,12 0 ,14 0 ,16 2 ,2 2 ,4 2 ,6 2 ,8 3 3 ,2 3 ,4 3
here defined as the amount of liquidity the firm is able to muster, on efficient terms, to support its cash commitments, including debt obligations and investment plans, in the event that the firm’s internally generated cash flow is insufficient to cover these commitments. Figure 2 illustrates how the firm’s portfolio of enterprise risks interacts with Risk Capacity to produce a certain risk profile.9
Assessing a firm’s Risk Capacity is about understanding how the company’s financial resources would develop in a wide range of possible scenarios for the future. The relevant question is how the firm can manage its commitments and implement value-creating investments in volatile markets across a large number of possible outcomes over the planning horizon. In particular, the focus is on how to deal with a situation in which things turn out for the worse, including tail-risk events (i.e. truly severe events that could threaten the viability of the company). This downside-risk perspective is in contrast to the practice of inferring a firm’s ‘financial capacity’ from today’s balance sheet, or from a forecast of that balance sheet based on a single set of assumptions.
Risk Capacity is similar in spirit to the idea of ‘Economic Capital’ that is often used to determine how well equipped financial institutions are to resist losses.10
It seeks to capture how much ‘financial backbone’ the firm has to support its growth and other risk taking activities. Yet these concepts are computed differently, mainly because spare debt capacity
9
Note that in Figure 2, for simplicity, the probability distribution of cash flow is fixed. Realistically the Total Risk profile of a company will depend on whether this volatility is “high” or “low”.
10
Economic Capital is usually defined as the amount of equity capital that a financial institution needs to have to survive a worst-case scenario, somehow defined. See Nocco and Stulz (2006), as quoted previously, for a discussion.
Box 1 Risk Capacity
Company Alpha is a copper producer facing several risk exposures which it has described in an enterprise cash flow model. The company now wonders how resilient it is to this volatility in terms of meeting its forecasted cash commitments. The company has $2mn in cash. It also has hedged some of its exposure to the copper price. This hedge would generate a cash inflow of $1mn if the copper price falls below a trigger level specified in the hedge contract. In this case the trigger level has been set to the price of copper at which the firm expects its operating cash flow to fall below its planned capital expenditure level. If the company still needs more liquidity the managers estimate that existing bond covenants would allow $6mn to be raised at acceptable terms if a bad scenario did occur. Company Alpha therefore estimates its Risk Capacity to be in the order of 2 + 1 + 6 = $9mn. This indicates the size of the shortfall of operating cash flow relative the firm’s cash commitment that the company could support with the current configuration of its balance sheet. Let’s assume that the firm needs to invest 20$mn. If the firm’s product prices, exchange rates, and other risks turn out to be such that operating cash flow (before hedges) is 18 there is a shortfall of 2, yet the firm can still invest 20 because it’s financial resources are sufficient. If operating cash flow turns out to be 10 (a “bad scenario”) the shortfall is 10, but financial resources will not be enough in that the hedge payoff, existing cash, and the maximum external borrowing allowed by the covenants are insufficient to cover this gap. The firm can’t invest according to plan without breaching the debt covenant. When the firm runs, say, 10,000 simulations of its cash flows a high Risk Capacity will manifest itself as a low number of outcomes in which this breach of a corporate objective happens
Enterprise risks Volume risk Price risk Exchange risk Legal risk Country risk Etc
Risk Capacity (balance sheet) Cash reserves
Spare debt capacity
Hedge positions
Does this volatility imply a risk of experiencing financial distress-related costs? Probability distribution for
cash flow Probability distribution M ean = 500,0007 X <=253 5% X <=746,66 95% 0 0,5 1 1,5 2 2,5 3 -200-1000 100200300400500600700800900100011001200 Re la ti ve f re quenc y Risk Capacity high Risk Capacity low Low probability of underinvesting, covenant breach, asset fire sales etc
High probability of underinvesting, covenant breach, asset fire sales etc Total Risk profile
does not have the same role in Economic Capital considerations. 11 For a non-financial firm, though, it is meaningful to consider how much debt can be used to bridge a temporary imbalance between cash in- and outflows.12
A temporary cash shortfall does not necessarily mean that the firm’s assets are impaired and that adding debt is imprudent, because its long-run prospects may well be viable. For this reason we think that Risk Capacity is a better mental model than Economic Capital, which has strong connotations to a banking environment and the risk of insolvency in such an institution.13 The reality for most industrial companies, we suspect, is a continuous stream of different types of policy decisions and changing circumstances to be evaluated, and a useful practical framework will provide feedback on the extent to which each of these affects the firm’s overall risk, where the default risk is only one of several possible aspects of this risk profile.
Figure 2 Risk Capacity and Total Risk
In practice, a firm’s Risk Capacity may not be independent of its general business model or corporate governance. A company usually determines a set of governing principles and general targets that it believes is most compatible with achieving the objective of creating shareholder value. For example, Management may be committed to maintaining a particular credit rating. Being committed to a rating implies that the overall risk profile of the company should be consistent with the targeted rating level, which to an extent constrains the firm’s risk taking and thereby growth. Financial targets, say in terms of the
11
Computing Risk Capacity is only rarely as straightforward as in the highly stylized example in Box 1, however, mainly due to the difficulty in treating a hedge instrument like a general buffer along the lines of cash and spare debt capacity. We will emphasize throughout this article that simulation methodology is very helpful in keeping track of how these elements influence the firm’s ability to meet cash commitments and make new investments.
12
Mello, A. and J. Parsons (1999) “Strategic hedging”, Journal of Applied Corporate Finance, 12 (3), pp.43-54 13
Conceptually there is nothing that prevents a non-financial firm from estimating fair values of its assets and liabilities to measure ‘solvency’ in different scenarios. It is an open question, however, how well this perspective can be practically implemented and anchored in the firm’s decision-making process.
ratio of Net Debt-to-Equity14, are then selected to be compatible with the desired rating. Certain companies also have to meet balance sheet ratios embedded in loan agreements in order not to default under the agreements. Such perspectives on Management targets may help in framing and conceptualizing the Risk Capacity of the company.
In ER-B the quantitative modelling of the firm’s portfolio of enterprise risks is extended to describe the elements making up the firm’s Risk Capacity. This typically involves modelling a complete set of dynamic financial statements over the planning horizon and defining key financial matrices and target levels on which to base risk assessments. Using such a model, a firm can get a sense of its Total Risk profile at some future point in time by interpreting a set of carefully defined risk measures. A Risk Measure is the probability that the company fails to meet a financial objective or experiences some form of financial distress, such as having to cut back on dividends or investments.15
Assume that a critical level for the Net Debt-to-Equity ratio has been defined by management, at which it considers it highly likely that it would be downgraded. Then the challenge is to quantify and measure the risk of exceeding this threshold level expressed as a probability. These Risk Measures are, as we discuss in Section 5, outputs in an ER-B financial planning tool and will therefore be sensitive to the corporate policies that are evaluated in such a model.
A risk report aimed at communicating the firm’s Total Risk profile may contain several such Risk Measures, and can be designed to answer questions like: How likely is it that a scenario materializes in which cash flows are so low so as to pose a problem for meeting existing cash commitments or taking on new investments? Are the financial resources sufficient to meet a low cash flow situation without incurring any negative consequences? How likely is it that existing loan covenants are breached? How likely is it that a situation implying financial distress will occur, say in terms of having to make asset sales in a depressed market? A high Risk Capacity will manifest itself as a low probability of experiencing such negative consequences. That is, generally speaking, the more cash, spare debt capacity and hedge positions a firm has, the more robust the firm will be in terms of avoiding costly adjustments to its business activities.
While carrying Risk Capacity creates benefits, it is important to acknowledge that keeping Risk Capacity also comes at a cost. Relying on equity financing, for example, means that the firm gives up the tax advantage that comes with debt financing. Equity financing also implies a higher required rate of return as investors in equity normally require a higher return than the cost of borrowing. Keeping piles of cash generates lower returns; may lead the firm’s managers to pursue value-destroying “pet projects”; and may prompt hostile take-over attempts. A hedge involves many disadvantages: it creates accounting noise; it may involve margin calls on liquidity; lost upside potential; spending money on put options could mean less funds available for investments; and so on. We think that the efficiency gains of avoiding excess cash and equity can, to some extent, be quantified (see Box 2). Also, the true costs of hedging need to be explicitly recognized (more on this in section 8).
14
Net Debt refers to the sum of short and long term interest bearing liabilities minus cash and cash equivalents.
15
A Risk Measure does not necessarily have to be a probability. There are other types of Risk Measures that take probability and magnitude of loss into account, and which may also apply some penalty to losses to reflect the risk tolerance of the decision-maker. The reader is referred to Harlow, W.V. (1991) “Asset Allocation in a Downside-risk Framework”, Financial Analysts Journal, 47 (5), pp.28-40.
At regular intervals, the firm’s managers (and board) will normally ask if the current risk profile is the desired one, and take appropriate actions to change the risk profile to a higher or lower level if this is not the case. Risk Optimization involves balancing the cots and benefits of a certain risk profile. Reducing excess Risk Capacity, for example by making a sizeable share buyback, is value-creating in that the firm trades a more efficient capital structure against a relatively small increase in Total Risk. If on the other hand the firm’s managers find that the risk of experiencing costly downside risk is too high, they can take appropriate actions to strengthen its Risk Capacity. The firm can, for example, increase Risk Capacity by entering into a hedge position or by boosting its cash by retaining a larger share of its net income. The main risk levers in this context typically are capital expenditure levels, acquisitions/asset sales, capital structure decisions, especially share-buybacks and dividends, and hedging programmes. Risk optimization is illustrated in Figure 3 as the firm moving from point Y to point Z, or from point X to point Z through appropriate policies adjusting Total Risk until reaching the equilibrium point between risk adjustment cost and benefits.
Figure 3 Risk optimization
Y X Risk Capacity Deficit Risk Capacity Surplus
Actions to increase risk (i.e. increase leverage, increase dividend, etc)
Actions to decrease risk (i.e. hedge, retain larger share of net income, etc.)
Optimal risk profile, i.e. costs = benefits Z
Box 2Costs and benefits of risk
Running a simulation of its operating cash flows and financial statements one year into the future, company Alpha finds that the probability of ending up in a financially distressed situation is 1%, and estimates that the cost if it did is $5mn (foregone investment opportunities, price discount in asset fire sale, etc). The company’s leverage over the one year time horizon is much lower than the industry average and its cash position is above the average. Considering its cost of equity, debt (after tax), and the interest rate it earns on cash deposits the company finds that by taking a new loan and returning cash to its shareholders through a dividend to bring leverage and cash in line with the industry average, the economic savings from a more efficient balance sheet is approximately $0,5mn on an annualised basis. Re-running the simulations under the new assumed policy Alpha finds that the probability of a financially weak situation has gone up to 3%, which implies an increase in the cost of risk of (3%-1%) * 5 = 0,1mn. The suggested policy is value-creating since the 0,5mn in economic savings over the planning horizon exceed the increase in the cost of risk (0,1mn).
A key benefit of an ER-B financial planning model is that it enables an on-going re-assessment of the expected financial situation and risk profile of a company (see Box 3). This means engaging in a continuous and pro-active financial planning process to provide feedback on how these would change as a result of a proposed policy change, and in which direction the company is heading in terms of its overall risk level. This makes it easier for management to make sound pro-active decisions with respect to the company’s risk profile.
3. Classification of Risk Management Approaches
In our opinion, ER-B is a response to two specific advances in financial theory that have strong implications for how one should go about implementing a corporate risk management programme:
•
The first is the insight of modern portfolio theory that risks should be measured and managed on a portfolio basis, and that the risk of the portfolio should be balanced against potential rewards (Portfolio Theory)16•
The second is the insight from financial theorists that financial distress entails various costly consequences, and that any value from a risk management effort largely comes from avoiding such costs (Corporate Risk Theory)
16
Markowitz, H. (1952), as quoted earlier
Box 3Ongoing re-assessment of risk profile
Company Alpha, a copper producing firm, operates an Enterprise Risk Budgeting model to monitor its expected financial position and risk. On 31/12/20X8 Management obtained the following report for a 12 month planning horizon:
Expected cash: $24mn
Expected Net Debt-to-Equity ratio: 0.87 Probability of breaching loan covenant: 4% Probability of net income showing a loss: 7%
On 1/1/20X9 the following events occurred: The production forecast for the year is revised down 5% due to new geological information at one of the key mines. Corporate Management proposes a 15% increase in the share buy-back programme and a 25% increase in capital expenditure. The company learns that it faces litigation for which it estimates a 10% chance of being fined $25mn USD. Re-running the model, the following was obtained:
Expected cash: $6mn
Expected Net Debt-to-Equity ratio: 1.26 Probability of breaching loan covenant: 47% Probability of net income showing a loss: 16%
Based on this information management concludes that the suggested policies are too risky and thus rejected in their current form, and that a modified proposal shall be evaluated as a next step.
Portfolio Theory is the intellectual foundation for much of Enterprise Risk Management. It maintains that it is the overall risk of a portfolio of assets that matters to its owner, and since the risks in a portfolio are typically not perfectly correlated there are diversification benefits that need to be recognized. When one price is down, another price risk in the portfolio may have a tendency to move up, which lowers the overall risk. Ironically, perhaps, financial theory would also have it that diversification at the investor level renders corporate risk management a meaningless activity. Yet over the last couple of decades researchers have assembled a number of independent justifications for risk management at the corporate level:
•
Lower the expected costs of bankruptcy17•
Reduce the risk premium demanded by risk-averse stakeholders18•
Avoid having to cut dividends19•
Increase the quantity of investment given contracting problems in the financial markets20
•
Avoid having to make asset fire sales21While volatility per se may be harmless from an investor perspective, the above arguments in favour of risk management show that there may be consequences on the downside of volatility that reduce the value of the company. So long as the company can manage and transfer risk at acceptable costs to reduce volatility, thereby lowering the probability of any of the above consequences, the value of the firm should increase.
Against this backdrop we can make a useful classification of approaches to corporate risk management. One way to classify firms’ approaches to risk is according to whether they aggregate risks or not at the corporate level (Portfolio Theory); another is whether they systematically analyse and measure the potential for negative consequences that may occur as a result of cash flow volatility (Corporate Risk Theory). In our view, the latter involves considering the firm’s Risk Capacity as previously described. Figure 4 shows a classification scheme for approaches to corporate risk management according to these two perspectives.
Figure 4 Classification of approaches to corporate risk management
17
Smith, C.W., and R.M. Stulz (1985) “The Determinants of Firms’ Hedging Policies”, Journal of Financial and
Quantitative Analysis, 20 (4), pp.391-405
18
Shapiro, A.C. and Titman, S. (1986) “An Integrated Approach to Corporate Risk Management”, in: J.M. Stern and D.H. Chew (eds.), The Revolution in Corporate Finance, Basil Blackwell, Oxford
19
Lessard, D. (1990) “Global Competition and Corporate Finance in the 1990s",
Continental Bank Journal of Applied Corporate Finance, 3, pp. 59-72
20
Froot, K.A., D.S. Scharfstein and J.C. Stein (1993) “Risk Management: Coordinating Corporate Investment and Financing Policies”, Journal of Finance, 48 (5), pp.1629-1658
21
Schleifer, A. and R.Vishny (1992) “Liquidation Values and Debt Capacity: A Market Equilibrium Approach”,
Journal of Finance, 47, pp. 1343-66
Silo-Approach Enterprise Risk Management (ERM) Enterprise Risk Budgeting
(ER-B) Silo Risk Budgeting
No Yes Risk Aggregation Risk Capacity considered No Yes
In the two columns in Figure 4 we distinguish between whether the firm chooses to aggregate its risks at the corporate level, or if risks are handled in a departmentalised way. The latter is the Silo-Approach, where little or no effort is made to take a holistic view of the risks facing the firm. In somewhat simplified terms, risks are managed by the department from whose activities they emanated, and the risk management activities of the different departments are not co-ordinated. The firm may, as a consequence, fail to acknowledge correlations across risk categories, and duplicate costly risk management activities.
While the Silo-Approach to a larger extent characterizes corporate practice, the trend in recent years has been towards integrating the risks under a common umbrella. One manifestation of this trend is the Enterprise Risk Management approach already discussed. While in part driven by a regulatory push (the Sarbanes Oxley act and Basel II come to mind) its proponents claim ERM has real benefits, including increased risk awareness; fewer surprises; enhanced risk response; a common risk ‘language’; and better risk-adjusted decisions.22
While risk aggregation has been a definite trend, few risk management programmes actually appear geared towards measuring the sort of consequences of volatility that Corporate Risk Theory prescribes a firm should manage. While ERM processes identify the risks facing a firm, only rarely is there an explicit effort made to say something about the firm’s overall capacity to carry those risks. In the lower left-hand corner of Figure 4 the approach taken is to consider potential consequences of volatility, but the firm focuses solely on one or a narrow set of risk factors. For lack of a better term we call this approach Silo Risk Budgeting. It could be the case if, say, a British oil exploration company focuses exclusively on the USD oil price risk when determining its exposure to financial distress-scenarios, but fails to take into account the impact of the pound/dollar exchange rate on these outcomes, or its volume risk. In Enterprise Risk Budgeting (ER-B), the firm undertakes a comprehensive modelling of not just firm’s portfolio of enterprise risks, but also a thorough assessment of the firm’s Risk Capacity, i.e. its ability to carry that amount of business risk. A distinguishing feature of ER-B is that the enterprise-wide process of consolidating information on the firm’s risk exposures, i.e. creating the Risk Universe, overlaps in a meaningful way with the process of generating quantitative feedback on the firm’s overall risk profile.
4. The Managerial Challenge
The managerial challenge is to put the firm on the path from a Silo-Approach to embracing ER-B. To make this effort successful, it is important to consider what sort of resources and commitment from Management that go into such an endeavour. First of all, involvement from Management is required in defining the framework needed to implement ER-B. Putting ER-B into practice requires being clear about how the firm’s business model and financial targets contribute to defining the framework within which the concepts of Risk Capacity and Total Risk can understood and how ER-B is used in a practical situation.
Management must also give support to using simulation methodology as a complement to sensitivity analysis and stress testing. In traditional financial planning the typical application is to evaluate the “pessimistic-expected-optimistic”-triad of scenarios. Such an approach, however, fails to recognize that certain scenarios are more likely to occur than others, and that some of the firm’s risk factors may be correlated with each other. Simulation methodology allows the firm to run several thousands of such scenarios, each weighted by its probability of occurrence and taking into account the way risk factors co-vary.
Management also needs to be willing to commit resources to developing a decision-support tool that in a number of ways improves on the traditional financial planning model. The
22
Again the reader is referred to http://www.coso.org/documents/COSO_ERM_ExecutiveSummary.pdf for an introductory list of perceived benefits of ERM.
traditional financial budgeting model is typically deterministic, and makes forecasts of a few selected performance indicators based on EBITDA forecasts provided by the business units. To implement ER-B, however, requires a comprehensive Enterprise Financial Planning and Risk model that contains a thorough and dynamic description of the firm’s cash flows and financial statements, designed in a way that a large number of simulations can be run to obtain probability distributions of key outputs, on which to base risk calculations. By using such a decision-support tool the risk considerations of the company stand a better chance of becoming an integrated part of the firm’s financial planning process.
Preferably Management should determine a limit for the maximum value of each Risk Measure, at which some pre-defined course of action is taken or at least evaluated. In this way a firm’s target setting is expanded to include a reference to its Total Risk profile. As we will discuss in Section 5, following such Risk Measures over time yields interesting insights into the “trend” in Risk, as well as rich possibilities for variance analysis: what factors are driving the risk profile in a certain direction?
As for many other new initiatives introduced in corporations, support from Management is essential for succeeding in implementing new methodology. For ER-B such support is even more important as ER-B to a large extent deals with core issues on the Corporate Management agenda.
5. Enterprise Risk Budgeting in practice
In this chapter we discuss some of the challenges a firm faces in going from a Silo-Approach to ER-B. We will illustrate what we see as the main issues using examples from the implementation of such an approach in Norsk Hydro ASA. Norsk Hydro is an integrated aluminium producer headquartered in Oslo, Norway. Its activities cover aluminium smelters in Norway, Germany, Australia and Canada, as well as downstream business activities in over 40 countries worldwide. Annual turnover was NOK 89bn in 2008. Its total number of employees in 2008 was approximately 23,000.
Risks in Norsk Hydro, like in any organization, have always been given high attention. However, in 2002 a project got underway in the Finance Department to establish a more formal approach to risk management. The goal was to create more accurate information about the risks the company was exposed to and how different corporate policies, such as hedging, affect the overall risk of the company. Central to developing the corporate thinking related to these issues has been the development of an integrated Enterprise Financial Planning and Risk model, which combines all relevant elements and variables in an efficient support tool for important business decisions. The development of the model has been a catalyst for more structured thinking related to risk and balance sheet management, as well as an arena for “theory meeting practice” in how to implement the most recent theoretical thinking on risk in a practical environment. The process of implementation has involved three steps, illustrated in Figure 5.
Figure 5 Enterprise Risk Budgeting step-by-step
The first step, Develop Enterprise Financial Planning and Risk model, involves the identification of relevant risk exposures, and putting this together into a model describing the factors that have the biggest impact on uncertainty related to the firm’s cash flows. It was clear from the outset that putting risk management into practice in a systematic way would require developing a risk model to complement and possibly replace existing decision-support tools. A considerable part of the effort in the risk management initiative has therefore gone into building a dynamic financial model with simulation capabilities. Detailed financial statement forecasts (including balance sheet, net income statement, and cash flow statement) are made for each quarter five years into the future. A ‘simulation engine’ allows generating, say, 10,000 scenarios for the risk factors to which Hydro has an exposure. This makes it possible to obtain a probability distribution for any item in the financial statements, for example the development of the cash position. The simulated outputs in the financial statement are, in turn, used to calculate Risk Measures, i.e. probabilities of breaching target ratios, funding needs, etc., in order to interpret the risk profile of the firm.
A key part of the model is a description of the firm’s value chain and the risk exposures in each of these steps. Purchases of raw materials that go into producing aluminium, such as alumina, coke and pitch, give rise to economic exposures. Production of aluminium is an energy-intense process, and energy is therefore a high contributor to cost volatility. Selling aluminium into the market leads to a price exposure that strongly contributes to cash flow volatility. A large part of Hydro’s aluminium production is not sold in the marketplace, but used in Hydro’s own downstream businesses that convert raw aluminium into highly specialised products. These products are in turn used in various industries, such as building construction and cars, which makes performance sensitive to the various stages of business cycles. Each step of the value chain introduces new exposures that contribute to the overall level of volatility, and the model has been designed to keep track of these relationships. The way these risks interact (i.e. “correlate”) is of course important to the estimate of how much cash flows are expected to vary when looking forward. The model also handles other categories of risks, such as credit risk and the risk of production interruptions, and incorporates this into the simulations.
Considerable effort has also been made to understand and model off-balance sheet risks, or “hidden risks”. A good example is the increase in the amount of business being conducted in legal entities which are not fully consolidated, although they are part of the company’s main business stream (“Equity Accounted Investments”, or EAI’s). Hydro is anticipating a large part of its growth taking place in such non-consolidated legal entities. For example, in early 2007 Hydro agreed to participate, with a 50% ownership share, in the building of a large aluminium-smelter
Develop Enterprise Financial Planning and Risk model
Define Risk Capacity based on key financial parameters
Evaluate and manage Total Risk (“Risk Optimization”)
in Qatar. The resulting economic exposures must somehow enter the risk assessment of Hydro. Hydro’s corporate risk model includes a modelling of these EAI’s as separate legal entities with appropriate links with the estimate of Hydro’s financial statements. Hydro’s share of debt in a EAI may, if considered appropriate, affect the calculation of Net Debt (and hence Hydro’s Risk Capacity, as discussed below).
The second step, Define Risk Capacity based on Key Financial Parameters, is largely the process of determining how Hydro’s Risk Capacity should be understood and put into practice. In Hydro’s case a key ambition is to uphold a particular rating (as of August 2008 the target rating from Standard & Poors is BBB). While the rating is ultimately a function of a number of issues, including Hydro’s competitive strength, evaluation of cost positions and management efficiency compared to peers, the Net Debt-to-Equity (D/E) and Funds From Operations-to-Net Debt (FFO/D) are the main financial indicators for determining how strained the rating is. At any point in time, the firm’s capacity to take on new risks is inferred partly by looking how far these ratios are from their targeted level. Many of the Risk Measures employed make reference to one of these steering parameters. In the financial model described in step 1 these financial ratios are simulated outputs. The cash balance is also modelled, as are any hedges that Hydro may have at any given point in time. By using simulations we can evaluate how these variables perform in a large number of scenarios, and, in particular, how they interact with our portfolio of business risks, together producing a risk profile of the company.
The third step, Evaluate and Manage Total Risk (“Risk Optimization”), has involved creating a set of Risk Measures, or risk statistics, that provide quantitative feedback on the firm’s risk profile. As mentioned, two main reference points for these Risk Measures are the key financial ratios D/E and FFO/D. For example, what is the probability that the critical level of one of these ratios is breached? Or what is the probability that both are breached for a sufficiently long period to possibly trigger a downgrade? Hydro’s risk model contains risk measures of this type, but also ones targeting other variables, for example relating to Net Income risk or the likelihood of funding needs, in order to get a broad picture of where the company currently is in the “risk landscape”. Several Risk Measures involve combinations of variables. For example, the model will report the probability that a major funding need is experienced at the same time that key financial steering parameters are on the wrong side of the target level. A high probability of such a situation would indicate that the firm’s Risk Capacity is too low, possibly requiring management attention. Put together, these Risk Measures provide a snapshot of the overall risk profile of the company. The following important question has then to be asked: “Is the current risk profile consistent with the company’s desired risk profile?” If the risk is too high, corrective actions such as hedging may be considered. If too low, this signals an inefficient balance sheet and that some action should be taken to move towards a more optimal risk profile.
Total Risk is evaluated as part of the business planning and strategy processes, and in connection with events that have a major impact on the firm’s financial condition. A typical application is to analyze the change in the firm’s financial standing and Total Risk profile that would result from a proposed share-buyback programme or an evaluated acquisition. If risk goes up, Hydro will have to decide if the benefits associated with the policies in question justify this increase in risk, and if some form of risk transfer, such as hedging, is warranted.
Having measured the risk profile regularly since early 2003 the risk department is able to study the trend in Total Risk. Is the company entering a phase of higher risk, or is risk on the decrease? What is more, an essential part of the evaluation process is to decompose the change in risk between two measurements into changes in variables in the model to explain why Total Risk has moved in one way or another. It is always possible to explain and decompose changes in risk by looking at changes in any of the different parts of the model. Variables that have a substantial impact on Total Risk include capital expenditure levels, capital structure decisions, especially share-buybacks and dividends, sales/cost expectations, and hedging programmes.
During the course of this project the benefits of a continuous, ongoing re-assessment of the firm’s financials and risk have become evident. When the pace of change is rapid, updating the model more frequently, say quarterly, with a new starting balance and fresh assumptions regarding model inputs is all the more important to stay informed about how the firm’s prospects are developing and to act accordingly.
A common thread in the evolution in this project has been that of integrating different forward-looking analytical functions that previously were handled more or less separately from each other. As Hydro has expanded the scope of the model, it has become much clearer how enterprise risk management, financial planning, cash flow-at-risk, hedging, cash forecasting and exchange rate risk management are highly related and that the right approach is to integrate these analyses. This has meant retiring several decision support tools that targeted some specific partial analysis, as many of the analytical challenges facing the modern finance function can be addressed with an integrated model. Whenever a piece of modelling is added, it is done in such a way that the cash flow, net income and balance sheet effects hang together from an accounting point of view, and that the balance sheet always balances, i.e. there is never an 'unexplained drift’ in the balance sheet plug. Insisting on this feature has been a great learning device as well as a quality control tool.
6. Hedging
As discussed, Total Risk will be sensitive to a large number of corporate policies, and one that has attracted a great deal of attention among academics as well as practitioners is hedging (or risk transfer more generally). A common view in practice is to regard a hedge as a tool to reduce the company’s exposure towards a certain risk or to secure a certain level of profit. In ER-B, however, a hedge is viewed as a conditional provider of cash to secure the fulfilment of various cash commitments at the corporate level, including capital expenditure and debt obligations, in case the case of a downturn (although the net effect of a hedge is of course the same regardless of which perspective is used.)23
As a rule of thumb, a hedge increases a firm’s Risk Capacity if its payoff boosts the firm’s liquidity in those scenarios in which the firm’s internally generated cash flow is expected to fall short of its cash commitments and desired investments.
Altering the firm’s risk profile through a large-scale hedge is a complex decision that has a lot of potential consequences, not all of which are desired. Hedging through forward contracts implies giving up upside potential, which may not be desirable from the investor’s point of view, and reflects poorly on the organization if prices go up. When hedging is done using options, cash is spent on option premiums which could have been put to other uses, such as investment. A hedge requires management attention and must be accounted for both externally and in internal analyses. Marking the hedge to market creates accounting noise that can make it harder for analysts to understand the company’s actual performance and financial standing. Margin calls on hedge positions make liquidity planning more difficult and may, if large enough, have disruptive effects.
If not all of aspects of the hedge are evaluated and accepted at the inception of the hedge then it can to some extent lead to unintended consequences, or “hidden risks”. One instance where a hedge might in fact involve the creation of a hidden risk is when the relationship between risks related to input and output factors is ignored. It may appear obvious that a sizeable hedge-programme should reduce the Total Risk in the firm, but it may actually increase it if not structured properly. An example of this is hedging of revenues when the price of the product is driven by the cost of raw materials. If sales prices are hedged but not cost of raw materials, the company may have a higher Total Risk compared to the pre-hedging situation (and compared to
23
Again, by a hedge we mean a financial derivative. In practice a firm’s managers will try to take maximum advantage of natural hedges, such as matching currency denomination of costs and revenues, before using hedge instruments.
its unhedged competitors) in the case of upward movements in raw material cost. Further limiting the usefulness of hedging is the fact that mitigating risks by use of derivatives may secure cash flows over a relatively short period of time, but normally does not function as a risk mitigating tool over the total lifetime of a project or the lifetime of a firm.
When there are multiple and hard-to-overview effects from a corporate policy such as hedging a comprehensive model of the kind described in this paper can prove very useful. A model can keep track of relationships that quickly overwhelm the individual, and help in illustrating different effects and scenarios. Hydro’s risk model has been equipped with a set of functions that allow the evaluation of how a particular hedge position affects the firm’s consolidated financial statements and the Risk Measures mentioned in section 5. This is not limited to the effects on cash flow, but also includes the simulated impact from marking these positions to market in each of the forecasted 20 quarters in the model.
While the above comments may reveal a rather negative view of hedging, it is acknowledged that a well-executed hedge can be a flexible tool for adjusting the firm’s risk profile in the short to medium term. What we would like to emphasize, however, is that the various negative consequences of a hedge, as described above, need to be clearly spelled out and communicated, and quantified where possible, when the hedge is evaluated. We also think it is important that the hedge is evaluated as part of the firm’s overall financial and business policy. That is the right context for determining if a hedge is lowering Total Risk in a meaningful way, or if the hedge is just adding to already unutilized Risk Capacity, implying additional costs related to keeping excess Risk Capacity as discussed in section 2. It may sometimes be the case that a hedging proposal originating from a business area is in conflict with the ER-B analysis made at the Corporate level in which Risk Capacity and Total Risk are considered. In a situation of a tension between a decentralised performance responsibility and a central ER-B perspective the corporate policy must be clear on what rules should apply. Such a conflict situation may be solved by internal hedging arrangements, which is applied in Hydro to a certain extent if and when needed.
7. Foreign exchange (FX) risk management
Another topic that usually attracts a good deal of attention is FX risk management. For Hydro with Norwegian Krone as the base reporting currency and a large exposure to USD-quoted product prices and a cost base tied mainly to Norway and Euroland, volatility in currency exchange rates are certainly important in influencing cash flows. Currency exposures also significantly impact key ratios and other performance matrices. The impact of changes in exchange rates along a number of dimensions has been integrated in Hydro’s risk model. Virtually all inputs in the model – sales, costs, depreciation, capital expenditure, debt, derivatives, payables and receivables, etc – are made split by local currency, which the model then translates into the base currency in each of the 20 forecasted quarters.
A key determinant of Hydro’s overall net exposure to exchange rates is the portfolio of financial positions – debt, forwards, swaps, etc. Calculating the effect of this portfolio on the company’s Net Income over the planning horizon is made challenging due to the fact that Hydro has legal units operating in a great number of currency regimes. It is further complicated by internal bank activities, i.e. when the parent company lends to or borrows from a subsidiary. The internal banking activity implies that internal payables/receivables may in fact lead to FX effects that need to be reported in the external accounts. This happens to the extent that the lending company may have a different base currency compared to the borrowing company. The model keeps track of these relationships in order to calculate the correct currency sensitivity in the consolidated company’s Net Income.
The philosophy guiding FX Management has developed over time. In earlier days FX exposures were mainly considered from the point of view of the parent company in Oslo. The focus was to a large degree on the exposures related to financial positions. Today the currency composition of these financial positions are looked at from the perspective of the consolidated group, and seen in relation to the other items in the accounts which are exposed to currency fluctuations and thereby influencing the Net Income, especially the operating cash flows. This implies that the function of the portfolio of finance positions can to a large extent be planned with the objective to counter-balance and mitigate the exposures that occur as a consequence of the firm’s ordinary business activities.
The scope of attention has also expanded in that currency exposure is measured and managed on several items that may normally not be in the focus when discussing FX management, yet can have rather large impacts on key metrics. For example, since Hydro’s growth to a considerable extent takes place outside Norway, changes in exchange rates have a substantial impact not only on operating cash flows but also the foreseeable cash commitments. Hydro also measures the net currency exposure on bottom lines like the FFO/D or the D/E-ratio, on which exchange rate volatility has effects through many channels including FX effects through Equity Accounted Investments and capital expenditure. Furthermore, book equity will be sensitive to exchange rates not only through Net Income, but also through the Currency Translation Adjustment in Other Reserves, which depends on the overall currency composition of assets and liabilities. This changing attitude towards currency exposures demonstrates how FX risk management has gone from being a classic silo-activity to being an integrated part of Enterprise Risk Budgeting.
8. Conclusions
In Enterprise Risk Management (ERM) a firm undertakes a comprehensive mapping of its risk exposures and aggregates them into a corporate-level portfolio of risks (its “Risk Universe”). It therefore breaks with the traditional Silo-Approach to risk management, in which each category of risks is managed in a departmentalised way, independent of other risks in the firm. For all its potential benefits, we think that ERM may not capture certain aspects related to the Total Risk in the firm. Total Risk, as we use the term, refers to the risk that the firm fails to meet important corporate-level objectives, such as implementing its investment plan, protecting debt covenants, or maintaining a certain credit rating. Total Risk also comprises situations of general financial distress, e.g. in terms of having to make asset fire sales or experiencing difficulties in raising senior debt or equity.
Despite all the risks that are aggregated in an ERM-programme, the framework is not very explicit about the firm’s ability to carry the amount of risk implied by its Risk Universe. To frame Total Risk, we have argued, a firm needs also to conceptualise and quantify its Risk Capacity, a concept related to the idea of a firm’s Economic Capital, i.e. a buffer that aims to ensure the firm’s survival in the event of a worst-case scenario. Although admittedly a simplification, in principle a firm’s Risk Capacity increases with 1) the amount of liquid assets (i.e. cash and cash equivalents), 2) spare debt capacity (i.e. its capacity to take on additional debt, e.g. as implied by current levels of key financial ratios) and 3) hedge positions (see Box 1). The lower the firm’s Risk Capacity, the higher the probability that the firm will incur negative consequences as a result of a low cash flow situation. We have also argued that it is important to note that corporate policy drives Total Risk, yet this dimension is not very explicit in most ERM-applications. For example, it is intuitive that a large share buyback will tend to increase the Total Risk of the firm, or that a hedge will tend to decrease it. The static nature of the Risk Universe-perspective does not allow for a rich analysis of the way corporate policy drives the firm’s risk profile.
We have suggested that ERM be complemented with a quantitative risk modelling effort aimed at addressing questions related to Total Risk. We have termed such an effort Enterprise Risk Budgeting (ER-B). ER-B at its most basic level refers to the use of quantitative risk modelling in the firm's corporate-level financial planning process. In ER-B one comprehensively models the firm’s underlying business, or cash flows, but also assesses and quantifies the firm’s Risk Capacity. At a more ambitious level, ER-B involves describing, in quantitative terms, the trade-off between the costs and benefits associated with a certain risk profile (i.e. "risk optimization"). Risk Capacity creates benefits in that it lowers the firm’s Total Risk, but keeping excess cash and equity are costly strategies. In addition, hedging also has many disadvantages that need to be recognized. That is, there are costs as well as benefits to maintaining a certain risk profile.
An ER-B financial planning model enables an ongoing re-assessment of the expected financial situation and risk profile of a company. This means engaging in a continuous and pro-active financial planning process to provide feedback on how these would change as a result of a proposed policy change and in which direction the company is heading in terms of its overall risk level. Adopting ER-B means that risk management principles are brought more formally into the financial planning process, and become integrated with traditional CFO challenges such as business performance planning, cash forecasting, balance sheet optimization, and FX management.
School of Economics and Management
Lund University
Working Paper Series
Editors: Hans Landström & Ulf Elg
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