Risk Management

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02-046
Copyright © 2002 Lisa K. Meulbroek
Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author.

Integrated Risk
Management for the
Firm: A Senior
Manager's Guide
Lisa K. Meulbroek
Harvard Business School
Soldiers Field Road
Boston,MA 02163
The author gratefully acknowledges the financial support of Harvard Business School's Division of Research. Email: Lmeulbroek@hbs.edu
Abstract
This paper is intended as a risk management primer for senior managers. It discusses the integrated risk management framework, emphasizing the connections between the three fundamental ways a company can implement its risk management objectives: modifying the firm's operations, adjusting its capital structure, and employing targeted financial instruments. "Integration" refers both to the combination of these three risk management techniques, and to the aggregation of all risks faced by the firm. The paper offers a functional analysis of integrated risk management using a wide set of illustrative situations to show how the risk management process influences, and is influenced by, the overall business activities and the strategy of the firm. Finally, the paper provides a risk management framework for formulating and designing a risk management system for the firm, concluding with a perspective on the future evolution of risk management. 2

Introduction
Managers have always attempted to measure and control the risks within their companies. The enormous growth and development in financial and electronic technologies, however, have enriched the palette of risk management techniques available to managers, offering an important new opportunity for increasing shareholder value. "Integrated risk management" is the identification and assessment of the collective risks that affect firm value, and the implementation of a firm-wide strategy to manage those risks. For some managers, "risk management" immediately evokes thoughts of "derivatives," and strategies that magnify, not reduce, risk. Derivatives, as a risk management tool, are only a small part of the integrated risk management process. Moreover, a proper risk management strategy does not involve speculation, or betting on the future price of oil, corn, currencies, or interest rates, and indeed is antithetical to such speculation. Instead, the goal of integrated risk management is to maximize value by shaping the firm's risk profile, shedding some risks, while retaining others.

Companies have three fundamental ways of implementing risk management objectives: modifying the firm's operations, adjusting its capital structure, and employing targeted financial instruments (including derivatives). "Integration" refers both to the combination of these three risk management techniques, and to the aggregation of all the risks faced by the firm. While managers have always practiced some form of risk management, implicit or explicit, in the past, risk management was rarely undertaken in a systematic and integrated fashion across the firm. Integrated risk management has only recently become a practical possibility, because of the enormous improvements in computer and other communications technologies, and because of the wide-ranging set of financial instruments and markets that have evolved over the past decade. A sophisticated and globally-tested legal and accounting infrastructure is now in place to support the use of such contractual agreements on large scale and at low cost. Equal in importance to this evolution in capital markets is the cumulative experience and success in applying modern finance theory to the practice of risk management. Today, managers can analyze and control various risks as part of a unified, or integrated, risk management policy. 3

Integrated risk management is by its nature "strategic,"...
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