Essay Sample: The Objectives of Risk Management

Risk management is the practice of pointing out potential risks earlier, examining them, and taking necessary steps to curb or reduce the risk. The steps or actions taken may either minimize the expected losses or lose variability. An action gets considered if the benefit associated with it surpasses the cost. Risk aversion enables an individual or organization to minimize loss variability. Risk-averse persons plan first before deciding on the risk management action since they understand that a loss hurts much than the benefit of again. Risk-averse seek for additional anticipated return for them to make riskier investments. They end up paying more premium loadings to an insurance company to eliminate or minimize the risk.

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In business, managing risk requires shareholder diversification. Diversification is a strategy that incorporates any kind of investment in a portfolio. A portfolio is made up of various types of products that are believed to yield more significant returns and low risk. When firms have diversified portfolios, they need to minimize the anticipated wealth to buy insurance by premium loading. Buying insurance using premium loading would only decrease the due wealth without reducing any risk. The main objective of risk management for any firm is to ensure it maximizes shareholder value by ensuring it mitigates the risk early enough. Equity value gets increased by reducing the risk as long as the shareholders can diversify on their own. When a more significant risk management strategy is applied, the cash flows and operating margins increase. When risk exposure gets reduced in periods of high growth, the anticipated growth rate makes the investors more comfortable while taking the risk. Market risk affects the equity cost directly as well as the total cost of capital. Equity funding is determined by approximating the mean return of investment, which is anticipated based on the broader market's generated returns.

The cost of capital refers to the company's return on its projects to enable it to maintain its market value. It has various components, which include preferred stock, common stock, and debt. The risk of cash flows should be reflected by the premium risk. Premium risk refers to the excess return of the risk-free return rate, which a given investment is anticipated to yield. Nevertheless, investors can vary their products to expand or spread the risk. They can achieve that via partitioning the risk of cash flow into two constituents: the diversifiable and non-diversifiable risk, also termed systematic risk. Systematic or diversifiable risk is the risk inherent in the whole market, whereas diversifiable risk results from an event that affects the industry rather than the market.

The premium risk depends only on the non-diversifiable risk. The cash flow risk is affected by both the systematic and diversifiable risks. Systematic risk affects the cost of capital by raising it, while diversifiable risk does not affect capital cost. Insurance and hedging also fail to affect capital cost; instead, they only minimize the diversifiable risk. Insurance and hedging, which minimizes systematic risk are said to decrease the cost of capital. An individual bears systematic risk. Any counterparty who takes the additional risk should compensate for having to bear it, resulting in a cash flow decrease.

In that regard, they are shifting non-diversifiable risk results to both lowering the cost of capital and anticipated cash flows. If the parties acknowledge the bearing cost of systematic risk, the two effects will not affect its value. Risk and risk management costs the individual and businesses, thus a need for trade-offs. Managers of any company can maximize their shareholders' value by offering them compensation contracts and allowing major creditors and large stakes shareholders to monitor; however, when managers use compensation contracts, it may result in corporate market control. When shareholders get given the mandate to control, they may bring lawsuits against managers and directors since they operate under credit rating agencies. For a given firm to maximize its risk cost, it should aim to maximize the business's value.

There are various elements of cost of risk which include: the expected losses that lead to direct and indirect losses, loss control cost which results in a rise in precautions and reduced activities, loss financing cost which results in self-insurance and retention, hedging, insurance among other transfer risks, risk of internal reduction cost that result in information investment and diversification and lastly the residual uncertainty cost which affects the shareholders and stakeholders. Indirect losses are caused by large losses like clean-up costs, raising capital costs, bankruptcy costs, lost profits, and foregone opportunities investment. Indirect losses are vital in minimizing the large losses probability may reduce the anticipated indirect losses.

Diversification helps a firm minimize the anticipated indirect losses but does not affect direct losses. Segregating assets, which is the separation of assets or creating a separate account for a specific group of assets, fails to alter the anticipated direct losses. However, a diversification that can minimize high loss probability is said to reduce the expected indirect losses. The main reason motivating a firm to opt for hedging or insurance is the increased likelihood of raising costly external capital to pay off losses when a risk occurs. Insurance minimizes that risk plus reduces the possibility of a firm going bankrupt, which brings about financial distress.

When a firm is experiencing financial distress, it may experience an underinvestment problem due to a new project's lack of funds. Decreasing the financial distress likelihood may result in minimizing the underinvestment and overinvestment problems. In that regard, firms may manage risk due to the following: it aids them in reducing the cost of acquiring services, minimizing the external financing cost likelihood, and financial distress reduction, which aids in improving claimants' contractual terms and minimizes the anticipated tax payments.