Corporate risk refers to the liabilities and dangers that a corporation faces. Risk management is a set of procedures that minimizes risks and costs for businesses. The job of a corporate risk management department is to identify potential sources of trouble, analyze them, and take the necessary steps to prevent losses.
The term "risk management" once only applied to physical threats like theft, fire, employee injuries and car accidents. By the end of the 20th century, the term came to apply also to financial risks like interest rates, exchange rates, and e-Commerce. These financial risks are the most applicable type to corporations.
There are several steps in any risk management process. The department must identify and measure the exposure to loss, select alternatives to that loss, implement a solution, and monitor the results of their solution. The goal of a risk management team is to protect and ultimately enhance the value of a company.
For example, a business has locations in California that are subject to earthquakes, while ones in Florida will most likely encounter hurricanes. The risk management team identifies those physical risks and purchases the appropriate insurance for those situations. Insurance of any kind is truly managing the risk involved with varying scenarios.
With corporations, financial risks are the biggest concern. Just as with standard insurance policies for physical damage, some financial risks can be transferred to other parties. Derivatives are the primary way that corporate risk is transferred.
A derivative is a financial contract that has a value based on, or derived from, something else. These other things can be stocks and commodities, interest and exchange rates or even the weather when applicable. The three main types of derivatives that corporate risk managers use are futures, options, and swaps.
A future is an agreement to purchase an asset at a future date for a particular price. Options give the buyer the option, but not the obligation, to purchase that asset by a given date and price. Swaps are agreements to exchange cash flow before a particular date. All of these place value in the company and some provide backing in case of problems.
In 2008, credit swaps in particular received a great deal of scrutiny after the housing bubble of the previous years burst. During the housing bubble, subprime mortgage lenders were swapping the risk associated with their sub prime loans. The businesses who purchased the risk were then obligated to pay those lenders debts. Those companies holding the risk ended up paying out significantly more money than they ever thought possible. The calculated risk they took did not pay off, while the risk management teams of the original lenders played it safe.
Corporate risk is especially prominent during difficult times in the economy. Risk management teams will take less chances when the economy is less forgiving. They will do everything necessary to avoid additional risks, which in some cases can contribute to a decrease in credit availability and less overall spending.