The Two Headed Coin

CHAPTER 1Strategy and Risk: Two Sides of the Same Coin

Strategy and risk are two sides of the same coin. Both aspire to create profits in an uncertain future.¹ The classic strategy question is: What business is the organization in? This starting point determines the organization's purpose, that is, what problem it is solving for its targeted market, and should make clear what inherent risks it will face. For example, if you are a detergent maker in 2020, it is important that your product not only cleans safely but also is environmentally friendly and childproof. Because a major goal of the firm is to create economic value, not just accounting profits, risk management with the calculation of economic capital is fundamental to the strategy process. Both strategy and risk management confront important cash flow, income statement, and balance sheet issues. Strategy and risk meet in pricing and capital because these are the two tools to deal with expected losses (ELs) and unexpected losses (ULs) arising from the risks that an organization takes in creating and claiming value.² Because we will say more about economic capital later, for now, let us provide a simple definition. Economic capital is the capital required to support the economics of the business including the necessary infrastructure (critical assets for operations) and risks. This means if the unexpected happens, you have a reserve that enables you to survive for a length of time calculated by probability and market conditions. ...