Integrated Risk Management: Techniques and Strategies for Reducing Risk

Integrated Risk Management: Techniques and Strategies for Reducing Risk, by Neil A. Doherty (New York: McGraw-Hill, 2000).

Reviewer: Nicos A. Scordis, The College of Insurance, New York City

Neil Doherty's book Integrated Risk Management begins by answering the question of why risk management programs add value to firms. Cash-flow smoothing cannot justify corporate risk management programs. The rate of return shareholders require from a firm depends on the covariance of the firm's cash-flow with broad market movement, not its overall cash-flow volatility, or variance. In general, risk managers reduce cash-flow volatility by insuring and hedging perils shareholders can eliminate themselves at lower cost by holding diversified portfolios of assets. The cashflow volatility shareholders cannot diversify is the unavoidable trapping of a business venture promising its shareholders a rate of return above the "risk-free" rate of government bonds. When risk managers reduce volatility associated with this nondiversifiable or systematic part of cash flow, they change the covariance of the firm's cash flow to broad market movements. Any reduction in systematic risk, however, is accompanied by reductions in the shareholder's return, according to traditional financial theory.

If shareholders value a risk management program, it is because it mitigates the frictional costs created by cash-flow volatility. One frictional cost is management's unwillingness or inability...