42313
FINANCIAL
MANAGEMENT
OF RISKS
Steven P. Feinstein
For better or worse, the business environment is fraught with risks. Uncer-
tainty is a fact of life. Profits are never certain, input and output prices change,
competitors emerge and disappear, customers’ tastes constantly evolve, techno-
logical progress creates instability, interest rates and foreign-currency values
and asset prices f luctuate. Nonetheless, managers must continue to make deci-
sions. Businesses must cope with risk in order to operate. Managers and firms
are often evaluated on overall performance, even though performance may be
affected by risky factors beyond their control. The goal of risk management
is to maximize the value of the firm by reducing the negative potential impact
of forces beyond the control of management.
There are essentially four basic approaches to risk management: risk
avoidance, risk retention, loss prevention and control, and risk transfer.^1 Sup-
pose after a firm has analyzed a risky business venture and weighed both the
costs and benefits of exposure to risk, management chooses not to embark on
the project. They determine that the potential rewards are not worth the risks.
Such a strategy would be an example of risk avoidance. Risk avoidance means
choosing not to engage in a risky activity because of the risks. Choosing not to
f ly in a commercial airliner because of the risk that the plane might crash is an
example of risk avoidance.
Risk retention is another simple strategy, in which the firm chooses to en-
gage in the project and do nothing about the identified risks. After weighing
the costs and benefits, the firm chooses to proceed. It is the “damn the torpe-
does” approach to risk management. For many firms, risk retention is the opti-
mal strategy for all risks. Investors expect the company’s stock to be risky, and
they do not reward managers for reducing risks. Investors cope with business