How Companies Choose Their Risk Profile

Once a company's firm-wide risks are identified and measured, the question becomes "What is the bet risk profile for the firm?"

Active risk management can add value by helping a firm attain what it believes to be its appropriate risk profile, whether it takes the form of decreasing or increasing risk.

Companies should take risks that offer the greatest opportunities within their core competence, while shedding noncore risks. Even when risks are within their area of core competence, however, companies must manage concentration risk to minimize the chance of being devastated by a single event. Furthermore, there are strategic considerations for actively managing the volatility of earnings.

Core Operations

Specializing in core operations while shedding unnecessary risks can be a competitive advantage by allowing you to focus scarce resources on activities with the highest opportunities for return.

Examples

• A commercial bank may focus on generating fee revenue by underwriting home mortgages, without taking on the interest rate risk of these mortgages. Mortgages are pooled, securitized, and sold to other investors that specialize in managing the market risks of mortgage securities.
• An investment bank engaging in loan syndications will focus on generating underwriting fees instead of earning revenues by putting loans on its own balance sheet and taking interest rate and credit risk.
• An insurance company may focus on generating underwriting fees for insurance contracts, which it passes on to reinsurers.
• A market-neutral hedge fund may choose to eliminate all direct FX, interest rate, and equity risk, and instead focus on exploiting pricing discrepancies between comparable instruments.
• A manufacturer with global sales may decide to hedge FX exposures.

Concentration risk

In managing concentration risk, firms aim to reduce core business exposures to achieve a more balanced risk exposure and minimize the chance that temporary market fluctuations will seriously disrupt business.

Examples

Following are examples of companies shedding concentration risk:

• Commodity sensitive companies (for example, gold mines, oil producers, and wheat growers) may engage in a strategic hedging program to reduce price sensitivities by selling production forward.
• Regional banks may diversify credit concentration risk to a specific client base through credit derivatives.

Strategic considerations

Strategic considerations for corporate risk management include:

• Increasing the quality and predictability of earnings to maximize shareholder value
• Lowering the chance of financial distress
• Increasing debt capacity and decreasing the cost of funding through adding more tax-advantaged debt
• Preserving operating margins

This requires the firm to have an effective hedging program.