A science or an art?
Strategies for identifying and measuring risk can help treasury personnel develop a sound diversification policy
Before a risk profile can be managed it must be identified. What is considered high risk by one entity may be considered the normal course of business by another entity. Appetite for risk-taking will vary not only between industries but also between management styles.
Once risk parameters have been identified a measurement system must be introduced.
"A man who travels a lot was concerned about the possibility of a bomb on board his plane. He determined the probability of this, found it to be low, but not low enough for him; so now, he always travels with a bomb in his suitcase. He reasons that the probability of two bombs being on board would be infinitesimal."
Quote by John Paulos.
The man has taken a strategic approach to risk management: He has identified the risk(s), their nature, location and probability.
Likewise, a business or financial institution must balance its risk profile between financial risk and business risk. Senior management must decide how much business risk it can absorb and how much financial risk is appropriate. Senior management also has the responsibility of selecting the best mix between financial risk and business risk.
Business risk can be defined as risk arising from uncertainty about outlays and operating cash flows, without regard to how investments are financed. Financial risk is inherent in the movement of interest and foreign-exchange rates. It also includes the risk of liquidity or the inability to refinance debt.
Corporations will always absorb some incidental exposure. It occurs in the light of competitive pressure. An example would be sales contracts denominated in, say, exotic currencies, which are difficult to hedge and often fluctuate wildly. Another more dynamic situation is the challenge of designing a pricing structure to shift some risk from the...