Fall 2024 Chapter 4

Enterprise Risk Management and

Related Topics

Dr. Dina Qamar

First Topic: Financial Risk Management.
1. Commodity price risk.
2. Interest rate risk.
3. Currency exchange rate risk.
4. Managing Financial Risks.
• Contractual Provisions.
• Capital Market Instruments.
5. The Changing Scope of Risk Management.
• Integrated Risk Management Program.
• The chief risk officer.
• A double-trigger option.
Second Topic: Enterprise Risk Management.
1. ERM program.
Third Topic: Loss Forecasting.
1. Probability Risk Analysis.
• Individual Event
• Dependent Event
• Independent Event
• Mutually Exclusive
• Not Mutually Exclusive
2. Regression Analysis.
3. Forecasting Based on Loss Distribution.
Fourth Topic: Analyzing Insurance coverage bids.
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First Topic: Financial Risk Management:
Business firms face a number of speculative financial risks. Financial risk
management refers to the identification, analysis, and treatment of speculative financial
risks. These risks include the following:
1. Commodity price risk
2. Interest rate risk
3. Currency exchange rate risk
Commodity Price Risk:
Commodity Price Risk is the losing of money if the price of commodity changes.
Producers and users of commodities face commodity price risk.
Ex: consider an agricultural operation that will have thousands of bushels
of grain at harvest time. At harvest, the price of the commodity may have
increased or decreased, depending on the supply and demand for grain. If little
storage is available for the crop, the grain must be sold at the current market
price, even if the price is low.
Hedging a Commodity Price Risk Using Futures Contracts:
For example: a corn grower estimates in May that his production will total
20,000 bushels of corn, with the harvest completed by December. If the price of
futures contracts, is $4.90 per bushel. The futures contracts are traded in 5,000
bushel units. If the price of corn in December has dropped to $4.50 per bushel
or $ 5.
Profit= original future price – spot price at maturity
Case1: Profit = 4.90$ - 4.50$=0.40$
= 0.40$ × 20000= 8000$
Case 2: Profit = 4.90$ - 5$= - 0.10$
= 0.10$ × 20000= 2000$

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Interest Rate Risk:
Financial institutions are especially susceptible to interest rate risk. Interest
rate risk is the risk of loss caused by adverse interest rate movements. For example,
consider a bank that has loaned money at fixed interest rates to home purchasers
with 15- and 30-year mortgages. If interest rates increase, the bank must pay
higher interest rates on deposits while the mortgages are locked in at lower
interest rates.
Similarly, a corporation might issue bonds at a time when interest rates
are high. For the bonds to sell at their face value when issued, the coupon interest
rate must equal the investor-required rate of return. If interest rates later decline,
the company must still pay the higher coupon interest rate on the bonds.
Currency Exchange Rate Risk:
Currency Exchange Rate is the value for which one nation’s currency may be
converted to another nation’s currency.
Currency Exchange Rate Risk is the risk of loss of value caused by changes in the
rate at which one nation’s currency may be converted to another nation’s currency. Ex: a
U.S. company faces currency exchange rate risk when it agrees to accept a
specified amount of foreign currency in the future as payment for goods sold or
work [Link] illustrate, if
Managing Financial Risks:
Pure risks were handled by the risk manager through risk retention, risk
transfer, and risk control. Speculative risks were handled by the finance division
through contractual provisions and capital market instruments.
Examples of contractual provisions that address financial risks include
callable bonds that permit bonds with high coupon rates to be retired early and
adjustable interest rate provisions on mortgages through which the interest rate

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varies with interest rates in the general economy. A variety of capital market
approaches (derivatives market) are also employed, including options contracts,
forward contracts, and futures contracts.
Using options in Hedging:
• Options on stocks can be used to protect against adverse stock price
movements.
• Call Option: gives its holder the right to buy an asset for a strike price on
or before the expiration date.
• Put Option: gives its holder the right to sell an asset for a strike price on or
before the expiration date.

If number of stocks (N) = 100. In case of (In the money) Profit =100 × 3.50
= 350, while in case of (Out the money) Loss = 100 × 1.50 = 150, which is profit
for the writer and loss for the buyer.
• Exercise value = Exercise price (strike) - Stock price
• Net profit = Exercise value – Premium.
Note that, there is no negative exercise value, because if the immediate exercise
of the option results in a loss, the holder (buyer of the option) will not exercise
it. It was just written as (3) in previous table to make it clear for you.
• Strike Price: the price at which the holder of call option can buy, or the
holder of put option can sell.
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 • Premium: the purchase price of the option. It is the money initially paid
by the buyer to the writer. It is not refundable.
• In the Money: strike price > stock price at expiration date (put)
• Out of the Money: strike price < stock price at expiration date (put).
The Changing Scope of Risk Management:
✓ Integrated Risk Management Program is a risk treatment technique that
combines coverage for pure and speculative risks in the same contract.
✓ Some organizations have created a Chief Risk Officer (CRO) position
✓ The chief risk officer is responsible for the treatment of pure and speculative risks
faced by the organization.
✓ A double-trigger option is a provision that provides for payment only if two
specified losses occur. EX: payments would be made only if a large property
claim and a large financial loss occurred. The cost of such an arrangement is
less than the cost of treating each risk separately.
Second Topic: Enterprise Risk Management.
(ERM) a comprehensive risk management program that addresses all risks
faced by organization pure risks, speculative financial risks, strategic risks,
operational risks, and other risks.
• Strategic risk refers to uncertainty regarding an organization’s goals and
objectives, and the organization’s strengths, weaknesses, opportunities,
and threats.
• Operational risks develop out of business operations, including the supply
chain, the manufacture and distribution of products, providing services to
customers, and cyber-security.
• Other risks: reputational risk.

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As noted by the Risk and Insurance Management Society (RIMS), an ERM program
does the following:
• Prioritizes and manages those exposures as an interrelated risk portfolio
rather than as individual risks
• Evaluates the risk portfolio in the context of all significant internal and
external environments, systems, circumstances, and stakeholders
• Recognizes that individual risks across the organization are interrelated
and can create a combined exposure that differs from the sum of the
individual risks.
• Provides a structured process for the management of all risks, whether
those risks are primarily quantitative or qualitative in nature
• Views the effective management of risk as a competitive advantage
• Seeks to embed risk management as a component in all critical decisions
through the organization
The ERM Process is similar to the risk management process discussed in the
previous chapter: risk identification, risk analysis, selection combinations of
techniques for treating the loss exposures, and implementation and monitoring
the program and taking corrective actions. As with traditional risk management
programs, enterprise risk management is a continuous process. ERM Program
includes new loss exposures such as terrorism risk- Climate Change Risk- Cyber-
security Risk.
Third Topic: Loss Forecasting:
Although loss history provides valuable information, there is no guarantee
that future losses will follow past loss trends. Risk managers can employ a
number of techniques to assist in predicting loss levels, including the following:
1. Probability Risk Analysis.

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 2. Regression analysis.
3. Forecasting based on loss distribution.
Probability Risk Analysis include individual event, dependent event,
independent event, mutually exclusive, and not mutually exclusive.
1. Individual Event:
Chance of loss is the possibility that an adverse event will occur. The
probability (P) of such an event is equal to the number of events likely to occur
(X) divided by the number of exposure units (N).
𝒙
𝑷=
𝑵
EX: if a vehicle fleet has 500 cars and on average 100 vehicles suffer
physical damage each year, the probability that a fleet vehicle will be damaged
in any given year is:
𝟏𝟎𝟎
𝑷𝒑𝒉𝒚𝒔𝒊𝒄𝒂𝒍 𝒅𝒂𝒎𝒂𝒈𝒆 = = 𝟐𝟎%
𝟓𝟎𝟎
2. Independent Event:
If the occurrence of one event does not affect the occurrence of the other event.
Ex: Suppose the probability of a fire at plant A is 4% and the probability of a fire
at plant B is 5%.

𝑷𝒇𝒊𝒓𝒆 𝒂𝒕 𝒃𝒐𝒕𝒉 𝒑𝒍𝒂𝒏𝒕𝒔 = 𝑷(𝒇𝒊𝒓𝒆 𝒂𝒕 𝒑𝒍𝒂𝒏𝒕 𝑨) × 𝑷(𝒇𝒊𝒓𝒆 𝒂𝒕 𝒑𝒍𝒂𝒏𝒕 𝑩)

𝑷𝒇𝒊𝒓𝒆 𝒂𝒕 𝒃𝒐𝒕𝒉 𝒑𝒍𝒂𝒏𝒕𝒔 = 𝟎. 𝟎𝟓 × 𝟎. 𝟎𝟒 = 𝟎. 𝟎𝟎𝟐 𝒐𝒓 𝟎. 𝟐%
3. Dependent Event:
If the occurrence of one event affects the occurrence of the other. If two
buildings are located close together, and one building catches on fire, the
probability that the other building will burn is increased.

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 For example, suppose that the individual probability of a fire loss at each
building is 3%. The probability that the second building will have a fire given
that the first building has a fire 40%
𝑷𝒃𝒐𝒕𝒉 𝒃𝒖𝒓𝒏 = 𝑷(𝒇𝒊𝒓𝒆 𝒂𝒕 𝒐𝒏𝒆 𝒃𝒍𝒅𝒈) × 𝑷(𝒇𝒊𝒓𝒆 𝒂𝒕 𝒔𝒆𝒄𝒐𝒏𝒅 𝒃𝒍𝒅𝒈 𝒈𝒊𝒗𝒆𝒏 𝒇𝒊𝒓𝒆 𝒂𝒕 𝒇𝒊𝒓𝒔𝒕 𝒃𝒍𝒅𝒈)

P= 0.03 × 0.40 =1.20%

4. Mutually Exclusive:
If the occurrence of one event precludes the occurrence of the second event.
EX: Suppose the probability a plant is destroyed by a fire is 2% and the
probability a plant is destroyed by a flood is 1%. What is the probability that the
plant will be destroyed by flood or fire?
𝑷(𝒇𝒊𝒓𝒆 𝒐𝒓 𝒇𝒍𝒐𝒐𝒅 𝒅𝒆𝒔𝒕𝒓𝒐𝒚𝒔 𝒑𝒍𝒂𝒏𝒕) = 𝑷(𝒇𝒊𝒓𝒆 𝒅𝒆𝒔𝒕𝒓𝒐𝒚𝒔 𝒑𝒍𝒂𝒏𝒕) + 𝑷(𝒇𝒍𝒐𝒐𝒅 𝒅𝒆𝒔𝒕𝒓𝒐𝒚𝒔 𝒑𝒍𝒂𝒏𝒕)

𝑷(𝒇𝒊𝒓𝒆 𝒐𝒓 𝒇𝒍𝒐𝒐𝒅 𝒅𝒆𝒔𝒕𝒓𝒐𝒚𝒔 𝒑𝒍𝒂𝒏𝒕) = 0.02+0.01 =0.03 or 3%

5. Not Mutually Exclusive:
If the independent events are not mutually exclusive, then more than one
event could occur.
Ex: if the probability of minor fire damage is 4 % and the probability of minor
flood damage is 3 %, then the probability of at least one of these events occurring
is:
𝑷(𝒂𝒕 𝒍𝒆𝒂𝒔𝒕 𝒐𝒏𝒆 𝒆𝒗𝒆𝒏𝒕) = 𝑷(𝒎𝒊𝒏𝒐𝒓 𝒇𝒊𝒓𝒆) + 𝑷(𝒎𝒊𝒏𝒐𝒓 𝒇𝒍𝒐𝒐𝒅) − 𝑷(𝒎𝒊𝒏𝒐𝒓 𝒇𝒊𝒓𝒆 𝒂𝒏𝒅 𝒇𝒍𝒐𝒐𝒅)

0.04 + 0.03 - (0.04 × 0.03) =0.0688 or 6.88%

Regression analysis:
RA characterizes the relationship between two or more variables and then
uses this characterization to predict values of a variable. One variable— the
dependent variable—is hypothesized to be a function of one or more
independent variables.
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 For example, consider workers compensation claims. It is logical to
hypothesize that the number of workers compensation claims should be
positively related to some variable representing employment (such as the)
number of employees, payroll, or hours worked.

𝒀=𝜶+𝜷𝑿
Y is the dependent variable, X is the independent variable, α and β are
parameters. Y refers to claims, and X refers to payroll in thousand.
Consider the claims, dependent variable, are affected by two independent
variables, number of employees, and hours worked. The regression model will
be written as follow;

𝒀 = 𝜶 + 𝜷 𝑿𝟏 + 𝜷 𝑿𝟐
Where, 𝑿𝟏 refers to number of employees, and 𝑿𝟐 refers to hours worked.

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 The coefficient of determination, R-square, ranges from 0 to 1 and measures
the model fit. An R-square value close to 1 indicates that the model does a good
job of predicting Y values.
Forecasting Based on Loss Distribution:
A loss distribution is a probability distribution of losses that could occur
• Useful for forecasting if the history of losses tends to follow a specified
distribution, and the sample size is large.
• The risk manager needs to know the parameters of the loss distribution,
such as the mean and standard deviation.
• The normal distribution is widely used for loss forecasting.
Fourth Topic: Analyzing Insurance Coverage Bids:
Assume that a risk manager would like to purchase property insurance on
a building. She is analyzing two insurance coverage bids, the coverages are
identical, and the policy limits are the same. The premiums and deductibles,
however, differ.

The risk manager wonders whether the additional $55,000 in premiums is

warranted to obtain the lower deductible.
Assume that premiums are paid at the start of the year, losses and
deductibles are paid at the end of the year, and 5 % is the appropriate discount
rate.

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 𝑭𝑽
𝑷𝑽 =
(𝟏 + 𝒊 )𝒏
Comparison:
Company A
• Premium: 90000
• 5000 for 20 loss
• Deductible: 5000* 20= 100000
𝟏𝟎𝟎𝟎𝟎𝟎
• 𝑷𝑽 = = 𝟗𝟓, 𝟐𝟑𝟖
𝟏+𝟎.𝟎𝟓

• 95238 + 90000= 185238

Company B
• Premium: 35000
• 7500 for 20 loss
• Deductible: 7500 * 20 = 150000
𝟏𝟓𝟎𝟎𝟎𝟎
• 𝑷𝑽 = = 𝟏𝟒𝟐, 𝟖𝟓𝟕
𝟏+𝟎.𝟎𝟓

• 𝟏𝟒𝟐, 𝟖𝟓𝟕 + 35000= 177,857

So, the risk manager should choose company B.

Assignment:

1. A beans grower estimates in September that his production will total

50,000 bushels of beans, with the harvest completed by November. If the
price of futures contracts, is $3.50 per bushel. If the price of beans in
November becomes $3.80, calculate his profit or loss?
2. Compare between currency exchange rate risk and interest rate, support
your answer by giving examples?

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Questions for Practice:

1. XYZ Company has factories in Spain and France. The probability that in
any given year a fire will damage the factory in Spain is 7% percent. The
probability that in any given year a fire will damage the France factory is
8%. What is the probability that both factories will be damaged by fire in
any given year?
2. If a car fleet has 400 cars and on average 50 cars suffer physical damage
each year, the probability that a fleet car will be damaged in any given
year is?

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