Risk Measurement

Risk measurement transforms that which is difficult to measure into quantifiable risks. The principal task initially is to model risk in order to measure its impact. Once the extent of the exposure has been determined, decisions about the appropriate course of action can be made. Typically, the procedure is to evaluate these risks using a cost–benefit approach (or, alternatively, the risk–reward trade-off) according to predetermined criteria. In principle the decision will depend on the costs and benefits involved in the different courses of action. There will be a tradeoff between the benefits of risk reduction and the costs to be incurred. Normally the risks are contingent, while the costs involve actual cash outlays (for instance, insurance premiums against damage to property from fire, floods, etc. that may never occur). Also, many risk-reducing measures may involve opportunity costs – eliminating the potential for loss may also eliminate the potential for gain. In practice, organisations will also have different views about the level and types of risk that are acceptable. Consequently, there is no hard and fast rule governing any particular course of action. Indeed, one aspect of risk measurement involves determining the organisation’s own risk-taking approach.

Risk Adjustment

Risk adjustment involves changing the nature of the risk from an undesirable level to an acceptable one. Three different approaches exist that include elements of risk pooling and risk transfer. The first involves insurance, where the risk is transferred to another party better able to accept the risk. Many kinds of standard risk can be insured at a price (known as a premium). The problem is that, as the risk to be insured becomes more specific to a particular organisation, insurers have the same problem as the insured! They will have the same difficulty quantifying the risk, and the price of such insurance will rise to reflect this uncertainty.

The second approach uses hedging. This is the principle of offsetting one risk with an opposite position in the same or similar risk. If the hedge works, the two risks should be self-cancelling. A decision can be made about how much of the total risk is to be hedged.

Organisations can undertake two different kinds of hedging. There is operational hedging (which shares some of the characteristics of the third approach discussed below), which involves the firm in changing sources of supply, the location of manufacturing and so on in order to reduce the impact of economic factors. The firm will also seek to match inflows and outflows in foreign currencies so as to become self-hedging.

The alternative is via financial hedging, which uses both on-balance-sheet and off-balance-sheet instruments.* Organisations using foreign-currency-denominated borrowings, for instance, seek to eliminate foreign exchange rate risk by using foreign currency income to service the foreign currency loan. This has the effect of creating new liabilities and hence increasing the size of the balance sheet. On the other hand, the great expansion in what were formerly off-balance-sheet instruments (largely through the use of derivatives) used to manage financial risk has greatly increased the organisation’s scope for such financial engineering. The advantage of these specialised instruments is that they are relatively low cost but can be rapidly adjusted to take account of changing economic circumstances. Onbalance-sheet hedging is less flexible in this regard and becomes very inflexible when real assets, such as property and plant, are involved.

The third approach involves accepting the risk but reducing some of the more undesirable aspects by changing behaviour. This typically involves strategic decisions by organisations that seek to minimise undesirable risks. For instance, in certain areas of the world, there is considerable country and political risk. To cope with such a position, firms might form consortia, to spread the risks, or joint ventures with local firms better able to understand local conditions. Another alternative involves breaking down and separating the component risks in any given situation and assuming only the acceptable risks. Such ‘cherry picking’ of risks is typically seen in certain kinds of capital or venture-type projects and is the normal practice in project finance, where the different parties connected with the undertaking accept different parts of the overall risks involved.

Although the above suggests a sequential approach, risk analysis and management is in fact a dynamic situation, as the perception of risks evolves over time. As with so many management tasks, risk assessment has to be kept under constant review as circumstances change. In addition, as organisations become more familiar with different risks, they are better able to assess these and to handle the consequences.