Enterprise Risk Management Through Strategic Allocation of Capital |
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Authors: | Jing Ai Patrick L. Brockett William W. Cooper Linda L. Golden |
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Affiliation: | 1. Jing Ai is in the Department of Financial Economics and Institutions, Shidler College of Business, The University of Hawaii at Manoa;2. Patrick L. Brocket and William W. Cooper are in the Department of Information, Risk, and Operations Management, Global Fellow IC2 Institute, The University of Texas at Austin;3. Linda L. Golden is in the Department of Marketing, Global Fellow IC2 Institute, The University of Texas at Austin. |
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Abstract: | 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 multiperiod 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. |
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