Many riskscan hehedged inexpensivelywithderivativescontracts.Examples include
exposurestochangesinexchange rates,interest rates,and commoditiesprices. Rather than face the risk that unexpected cashshortfallsdue to these exposures might negativelyaffect theabilityof thefirm tocarry outitsstrategicplan, thefirmshould hedgetheseexposures.
Other riskscannot be inexpensivelyhedged.Theseareriskswherethe firm’smanagement
either hasaninformationaladvantageoveroutsidersor theabilityto manage dieoutcome
ofthe risk-takingactivity.Acounterpartytoatransactionthat hedgessuch riskswould requireveryhighcompensadon tobewillingto takeonthe transferred risks.The firm's businessrisksfallintothiscategory.
The guiding principleindecidingwhether toretain orlayoffrisks isdie comparative advantagein riskhearing.Acompanyhasa comparativeadvantagein bearingitsstrategic and businessrisks,becauseitknowsmoreabout these risksthan outsiders do.Becauseof this informadonaladvantage,die firm cannottransfer these riskscosteffectively. Moreover, thefirmis in the businessofmanagingdiese“core"risks.On the otherhand, thefirmhas nocomparativeadvantagein forecastingmarket variablessuchasexchangerates,interest races,orcommodities prices. These“noncore” riskscan be laidoff. By reducingnoncore exposures, the firm reduces thelikelihoodofdisruptions toitsability tofundstrategic
investmentsandincreases itsabilityto takeonbusiness risks.
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Topic40 CrossReferencetoGARPAssigned Reading—Nocoo&Stulz
KEY CONCEPTS
AIM 40.1
Enterprise riskmanagement (ERM) isdie process of managingallacorporation'srisks withinanintegrated framework.
AIM40.2
Themacro benefitofERM is thathedgingcorporatediversifiahleriskimproves
management’s abilitytoinvest invalue-creating projectsinatimelymannerand improves thefirm'sabilitytocarryout thestrategicplan.
Themicro benefitofERM requiresdecentralizingrisk management toensure thateach project's total riskisadequatelyassessedbyproject planners during dieinidalevaluation of theproject.The two maincomponentsofdecentralizingthe risk-return tradeoff areconsideration of themarginal impact of each projectonthe firm’s totalriskanda
performanceevaluationsystem thatconsiders unitcontributions to total risk.
AIM40.3
Thegoalof riskmanagementis tooptimize (not eliminate) total risk bytrading off the expectedreturnsfromtakingrisks widi theexpectedcostsof financial distress. Financial distressin thiscaseisdefinedoscircumstanceswhere thefirm isforced toforego positive NPVprojects.
AIM40.4
Theconceptualframeworkof ERMisafour-step process:
* Determinedie firm's risk appedte.
• Estimatetheamountofcapital needed tosupportthedesired levelof risk.
• Determinedieoptimalcombinadonofcapitaland riskthatachievesdie targetcredit
rating.
* Decentralize themanagementofri.sk.
AIM40.5
Economicvalue and accoundng valuearelikelytodiffer. Managementmustdecide which valueismostrepresentativeof the firm’s riskexposure,anddesign dieir riskmanagement
program accordingly.
AIM40.6
Duetodiversificationeffects of aggregating market, credit,andoperationalrisk,firm-wide VaRwill beless than thesumof the VaRs from each riskcategory.Thissuggeststhat the correlation amongrisksis somevalue less thanone.
Topic-40
CrossReferencetoGASPAssigned Reading—Nocco&Stulz
AIM40.7
Regulatorycapitalrequirements maydiffersignificantlyfrom thecapital required toachieve ormaintain agiven credit rating(economiccapital).
Becauseregulatorycapitalrequirementsaretypically basedcm accounting capital, rather than economiccapital,afirm wi theconomicvalues inexcessofaccountingvaluesmaybe penalized, andmayhavetomaintain higheramountsinliquidassets to cover the shortfall.
AIM40.8
Theeconomiccapitalof thefirm musthe puttoproductive use.Ifafirmaccumulates excesseconomiccapital that is notemployed productively,investors will reducethe valueof the firm.
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Topic40 CrossReferencetoGARPAssignedReading—Nocco&Stulz
CONCEPT CHECKERS
Reducingdiversiliable riskcreates value:
A. onlywhen marketsareperfect.
B. becauseit iscostlyforshareholderstoeliminatediversifiahleriskthrough their
ownactions.
C. becausereducingdiversifiahleriskmitigates the underinvestment problem that.
can occurwheninvestorshaveimperfectinformationahout the firm's projects.
D. onlywhenitresultsina permanent reduction incash flow.
Elective enterpriseriskmanagementincludesall of thefollowingexcept:
A. centralizedevaluationofevery projects risk.
B. aprojectisonlyaccepted ifits returnisadequateafterconsideringthecostof theproject'scontribution tototal firm risk,
C. the project’splanners perform theinitial evaluation ofprojectrisk.
D. periodic evaluationsof theperformanceofhusiness unitsconsidereach units contributiontototal risk.
1.
2.
Thegoalof enterprise riskmanagement(ERM) can bestbedescribedasmaximizing firm valueby:
A. eliminatingthe total riskof the firm.
B. minimizing the total risk of thefirm.
C. optimizing thetotalriskof die firm.
D. eliminating the probability of financialdistress.
Indeterminingdierelativeimportance ofeconomicvaluecomparedtoaccounting performancein itsenterprise riskmanagement program,afirmshould:
A. relyonaccounting performance becauseitwill bemore accurate.
B. relyoneconomicvalue becauseitwill bemoreaccurate.
C. baseitsdecisionon theinput ofproject-levelmanagers.
D. baseitsdecisionon theobjectiveof theERM program.
Which riskisleastlikelytohe beneficialforacompanytolayoff?
A. Currencyexchangeraterisk.
B. Businessrisk
C. Commodities price risk.
D. Interestraterisk.
Foradditional Book 3, Topic40practice questionssee:
3.
4.
5.
PastFRM Exam Questions:#16-17(page282)
Topic40
CrossReferencetoGASPAssigned Reading-Nocco& Stuiz:
CONCEPT CHECKER ANSWERS
1. C Whenmarketsarcnotperfect(i,c.,investors’information about project vafucsis
incomplete), thefirmmaynothe able toraisefendson (airterms. Forafirmlaced withan
unexpected dropinoperating cash flow,thiscanleadtotheunderinvestment prohlcm,where thecompany passesupvaluablestrategicinvestmentsrather thanraiseequityon onerous
terms.Theinabilitytofundstrategicinvestmentscan resultina permanentreductionin shareholdervalueevenifthe cash shortfallis temporary.Hedgingdiversifiablc risk mitigates theunderinvestmentproblemandcreatesvalue,eventhoughshareholderscaneliminate divcrsifiahlc riskatlowcost bydiversifyingtheirportfolios.
2. A CentraltoERM isthe idea thatadece?ttmlised approachtotheevaluationofprojectrisks focusesmanagersthroughoutthefirmontheimportanceofproperly consideringthe risk and returnimplicationsof projects.
3. C Thegoalof ERMistooptimize thetotalriskof the firm. Eliminating total riskisnot
possible.Minimizingtotal riskwould precludeacceptingriskyprojectsthat would allow the firmtoexpandandmaximizevalue. These riskyprojectswillincreasetheprobabilityof financialdistress.Thegoalof ERM istooptimize the risk of distress relativetothe potential
returnsfrom the risky projects,
4. D Therearccertain situationswherecither accounting valuesoreconomic valueswill more accuratelyreflect the firmssituation,Thedeterminingfactorinchoosingbetween economic values and accounting valuesistheobjectiveof the program. Forexample, iftheobjectiveis maintainingarating,hased inlatgcpartonaccounting numbers, then accounting numbers willassume morerelative importance.
5. B Acompany hasacomparativeadvantagein bearingitsstrategicandbusiness risksbecause it knowsmoreaboutthese risks than outsiders do. The firm isinthe businessof managing these“core” risks. Thefirmhasnocomparative advantageinforecastingmarket variables suchasexchangerates,interestrates,orcommodities prices. These‘’noncotc” riskscanbe laidoff.
Page 104 ©2013Kaplan,Inc.
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