In this research paper about corporate risk management, Xun Li discusses various tactics used by corporate managers to ensure that their organizations handle their risks in a proper manner. Xun Li also outlines various definitions as given by different authors, such as Markowitz (1959, p.72), Merton’s (1973, p.55), Duffie and Pan (1997, p.61), and Li and Zhou (2006, p.74) concerning the topic of corporate risk management and its impact on quality management and smooth operation of the organization. The research is intended to address the concerns faced by managers in the corporate world when making investment decisions. The methods used in the research for risk management include the Value-at-risk method, the probability theory and the optimal control method.
Xun Li makes a good point starting the research paper with an outline on why corporate risk management is a critical issue in the business management. He also brings out the views of different authors concerning the issue. For example, Merton’s (1973, p.53) says that managers should view corporate business management as an integral part for business survival. Markowitz (1959, p.37), on the other hand argues that corporate risk management determines the preparedness of the organization in dealing with business risks.
Xun Li is right to refer to the mean-variance approach as the cornerstone of modern investment theory. This is because this approach helps in dealing with important investment tools such as derivative securities so as to ensure proper corporate risk management and efficient quality management. The term derivative, according to Stulz (2004, p.11), is used to describe that security whose market value is directly related to another traded security (underlying security). Examples of derivative securities include Option, futures, and forward. Stock warrants, swap agreements and other more exotic variations are also categorized as Derivative securities. A call option on a company’s stock is a simple example of a derivative. When pricing a derivative such as the option, the most significant factor is the price of the company’s shares on the open market.
The development of derivative securities has played a significant role in facilitating the market for risk associated with certain assets, apart from their actual ownership. An example worth considering is the incident where a farmer wishes to hold his farm produce until a later season because of better prices in that season. However, he is afraid of the uncertainty that comes with waiting for a long time, for example six months, before he can know the value his produce. Futures contracts would make it possible for the farmer to keep the produce until the desired season yet lock in the current prevailing prices. As a matter of fact, the contract would sell off the price uncertainty to another person in the market who is willing to hold it. The outcome in this case is that the farmer has hedged his risk of a price drop. On the other hand, the party accepting the risk is engaging in the practice of speculation. The need for such transaction was the causes that led to the evolution of first derivative securities markets (Wayne, 1999, p.17).
Although Xun Li points out the importance of downside risk management, such as being more accurate to measure uncertainty with respect to payoff distributions of projects, he does not mention the importance of options. Options are examples of derivative securities. They consist of call options and put options. Call options are securities that make it possible for a person to buy a stock at a specified price (exercise or strike price), on or before a certain date (expiration date). For example, LG call options at 100 would refer to a security that allows the buyers to get a share of LG stock for $100 any time on, or before, the day of expiry (Lo, 1999, p.54). As long as the price of LG is greater than $100, exercising the option would probably generate positive cash flow in case the option holder purchases the stock and then sales it to another investor. In case LG stock sells for less than $100 there is no obligation to exercise, hence the name option. Option premium is the amount of money paid to acquire the option.
Put option, on the other hand, is similar to call option except that it the buyer the right to sell stock at a specific price instead of buying it. Basing on the previous example, if LG stock is below $100 then the person buying the option could exercise the option and generate a positive cash flow. In this case, the stock is purchased for less than $100 then immediately disposed at the exercise value. It is important to note that, the buyers of the options are under no obligation to exercise.
The other important party in the transactions of an option is the person who agrees to sell either the call or put (Philippe, 1995, p. 36). This investor agrees to premium payments up front, and also agrees to the risk that the person buying will later exercise the option, which will force them to pay the buying party the amount of positive cash flow generated by the exercise. In the open market, the premium is determined as the value that equates sell orders with buy orders.
Xun Li is wrong in this research for pointing out that Value at Risk (VaR), the most popular continuous-time downside risk measure, is an ineffective risk management measure. This is wrong because this method is widely adapted by both nonfinancial institutions and financial institutions in their risk management practices (Ikeda. and Watanabe, 1989, p.27). These organizations prefer this technique because it is easier to imply operationally than other risk measures such as futures and forward contracts. Futures can be defined as contracts or agreements to sell or buy assets at some time in the future. The Original futures markets were for agricultural products such as wheat and corn, but currently items such as foreign exchange features, Treasury bond futures, and stock index futures trade much higher volumes than what agricultural futures trade.
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