Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 4. Risk and Risk Management

CHRISTOPHER L. CULP

Senior Advisor, Lexecon

Senior Fellow in Financial Regulation, Competitive Enterprise Institute Adjunct Professor of Finance, Graduate School of Business, University of Chicago

Abstract: Despite fundamental similarities, the once-separate worlds of financial and nonfinancial risk and risk management have finally begun to converge. Financial risk is the risk that unexpected losses to a firm may arise from its financial activities, including financial market positions and counterparty credit exposures. Nonfinancial risks (including perils, hazards, and accidents) arise instead from a firm's nonfinancial exposures, including property, liability, and the like. For both types of risk, a firm can choose to retain the risk, neutralize it, or transfer it to another firm. Risk retentions occur both because the risks in question are central or "core" to the operation of the business—and its potential profitability—or because the other alternatives are simply too expensive. A risk that is retained by a firm may be "funded" or "unfunded"—that is, funds may be earmarked to cover losses arising from retained risks so that the firm need not take the hit to its per-period cash flows at the time the loss occurs. Funded risk retentions, in turn, can be managed using a range of preloss and postloss products now collectively known as "risk finance." Alternatively, risk can be transferred to other firms using the usual methods of (re)insurance, derivatives, ...