Enterprise Risk Management Through Strategic Allocation of Capital
University of Hawaii at Manoa - Shidler College of Business
Patrick L. Brockett
University of Texas at Austin - Department of Information, Risk and Operations Management
William W. Cooper
University of Texas at Austin - McCombs School of Business
Linda L. Golden
University of Texas at Austin - Red McCombs School of Business
January 1, 2011
Journal of Risk and Insurance, Forthcoming
This article presents a conceptual framework for operationalizing strategic enterprise risk management (ERM) in a general firm. We employ a risk-constrained optimization approach to study the capital allocation decisions under ERM. Given the decision maker’s risk appetite, the problem of holistically managing enterprise-wide hazard, financial, operational, and real project risks is treated by maximizing the expected total return on capital, while trading off risks simultaneously in Value-at-Risk type of constraints. This approach explicitly quantifies the concepts of risk appetite and risk prioritization in light of the firm’s default and financial distress avoidance reflected in its target credit rating. Our framework also allows the firm to consider a multi-period planning horizon so that changing business environments can be accounted for. We illustrate the implementation of the framework through a numerical example. As an initial conceptual advancement, our formulation is capable of facilitating more general ERM modeling within a consistent strategic framework, where idiosyncratic variations of firms and different modeling assumptions can be accommodated. Managerial implications are also discussed.
Number of Pages in PDF File: 35Accepted Paper Series
Date posted: May 15, 2011 ; Last revised: May 24, 2011
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