The Value of Risk Management: A Frontier Analysis
39 Pages Posted: 25 Mar 2005
Date Written: March 2005
To address the value of risk management, we adopt a new perpspective. We characterize the relationships between operations management and real risk management activities by postulating a transformation possibility frontier for the cash flows of the firm. We show how external changes in the market parameters defining the price of risk can affect the optimal levels of the two types of real activities within the firm. The typical separation of operations management and real risk management is a potential source of organizational inefficiency. We show that the role of financial risk management is to create flexibility to alleviate this inefficiency problem. In so doing, it does contribute indirectly to the value of the firm. An important role of the CEO is then to properly coordinate operations and real risk management activities as well as financial risk management activites.
Keywords: Efficiency frontier, risk management, operations management, price of risk
JEL Classification: G22, G31, G34
Suggested Citation: Suggested Citation