Introduction

Risk management is the process of adopting and implementing management decisions aimed at reducing the likelihood of an unfavorable outcome and minimizing potential project losses caused by its implementation. The purpose of risk management in the field of economics is to increase competitiveness of business entities by means of protecting them from sales of pure risk. Both financial and non-financial firms should use risk management methods to prevent risks or make use of them and build an effective strategy.

Modern economics sees the risk as a likely event the onset of which leads only to neutral or negative effects. If the event involves the presence of both positive and negative outcomes, it is known as speculative risk. These events have a dual nature, and can always be divided into “opportunity” (estimated event that could bring someone benefit or profit) and “risk” (the alleged event that could bring damage or loss). The dual events can be associated (implementation of chance might entail risk or vice versa), mutually exclusive (the game of toss) or independent (implementations of chance and risk are independent from each other, and represent defined circumstances and uncertainty). That is why, in order to create a coherent system of views regarding risk management, all risks should be recognized as clean, while dual events as “speculative” like a subject to re-analysis does.

Non-financial firms are the entities whose main function is the production of goods and provision of non-financial services. The current paper analyzes and evaluates the articles on the risk management techniques for non-financial firms that include the mean-variance model, the CAMP model, C-FAR, yield curve (the term structure of interest rates) and Value at Risk (VaR).

Risk Management Theories/Models/Techniques

There are several risk management models that non-financial companies prefer to use. Such models as C-FAR, VaR, yield curve or the CAMP models have similarities and differences as well as benefits and disadvantages. VaR includes methodologies for non-financial enterprises such as Methodology of CorporateMetrics ™ group RiskMetrics ™, Methodology of NERA (National Economic Research Associates) or methodology based on the use of regression analysis of risks (Laubsch & Ulmer 1999). However, one of the approaches known as Enterprise Risk Management unites frameworks aimed at managing risks for non-financial enterprises.

ERM (Enterprise risk management). ERM presupposes risk response strategy that may include avoidance, reduction, alternative actions, sharing, insuring or acceptance of the risk. ERM rise in popularity is largely explained by two reasons. Leaders of many companies have realized that the old methods of risk management do not meet today’s requirements and are not able to ensure the stability and predictability of the company’s development (Jorge & Augusto 2011). As a result, risk management in many companies has reached a qualitatively new level and has become an integral part of corporate strategy. Furthermore, risk management is becoming part of the corporate culture, which is the responsibility of every employee, not just top management or risk management specialists. There are institutions and organizations that use ERM to assess non-financial companies, for example, Standard & Poor’s (debt-rating agency) has chosen such strategy (Nocco & Stulz 2006). This has raised questions about risk management, while evaluating a certain company. This inquiry takes into account the debt rating that influences the interest rates, which lenders provide to companies for loans or bonds (Antikarov 2012).

Cash Flow at Risk (C-FAR). When one of the largest multinational companies in 2002 decided to introduce an integrated enterprise-wide dimension of financial risks, so-called cash-at-risk (Cash Flow at Risk, C-FAR) has been chosen as an aggregate risk measure. After measuring the total enterprise-wide risk, the company completely stopped all hedging programs, which had always been used before. The company preferred “strategy of portfolio diversification and correlation” of risks instead of a hedging strategy. Stein et al. (2001) analyze C-FAR for non-financial firms admitting that often C-FAR is compared to VAR. Giving the example of Dell, the article shows that the best method to be used by non-financial firms is the top-down method to look at C-FaR so that when it is high, this should be manifested in a high volatility of its historical cash flows (Stein et al. 2001). The major obstacle to this method is the lack of data. The benefits of estimating the accurate C-FAR for a non-financial company include better formulation of debt-equity tradeoffs together with capital structure policy; increased credibility for investors; correctly showing probability distribution of cash flows for risk management (Stein et al. 2001). According to Stein et al. (2001), “The greater are the unhedgeable background risks, as measured by C-FaR, the greater is the value of risk management” (p. 11)

Value-at-Risk (VaR). For the first time the concept of VaR (Value-at-Risk – VaR) was used by major banks in the late 1980s – early 1990s to measure the overall risk of trading portfolio (Kuester, Mittnik & Paolella 2006). It is believed that the idea of VaR belongs to Vezerstounu Dennis, who was the Chairman of the Board of Directors of the bank J.P. Morgan, who wanted to receive a report on the maximum losses for all trading positions in the bank expected in the following 24 hours and prepared every day at 16:15 (Kuester, Mittnik & Paolella 2006) The report was supposed to fit into one page, and be comprehensive for the Board of Directors. It was developed in the early 1990s, and became known as the “415 Report”. In 1993, the term “Value-at-Risk” first appeared in a report prepared by J.P. Morgan on request by (G30) “Group of Thirty”, a non-profit organization that brings together the largest financial institutions in the US (Kuester, Mittnik & Paolella 2006). In October 1994, the bank J.P. Morgan published RiskMetrics ™ system, based on which a software package for the calculation of VaR has been developed (Laubsch & Ulmer 1999). The methodology and the program quickly gained popularity with financial institutions. The impetus for the spread of VaR among non-financial corporations was the decision of the Securities and Exchange Commission of the US (Securities & Exchange Commission – SEC) (Stein et al. 2001). In 1997, the SEC established a regulation for all the companies accountable to the rules on mandatory disclosure of information about the market value of derivatives used and financial assets that are sensitive to fluctuations in the financial markets (Stein et al. 2001). As a result, there was a need to create a corporate version of VaR that would reflect the specific risks for the non-financial corporations.

VaR is the amount of loss, which is not exceeded with a probability equal to the level of confidence (e.g., 99%). Therefore, 1% of the magnitude of the loss is greater than VaR (Rowe 2013). The calculation of the value of VaR is carried out to reach the following conclusion: “We are confident for X% (with chance of X/100) that our losses will not exceed Y dollars over the next N days” (Rowe 2013). In this statement, the unknown quantity Y is VaR. There exists historical VaR when the distribution of revenues is taken from the time period when they have already been implemented, so that it is implicitly assumed that future profitability will behave similarly to what has been observed before. Another variant is parameter VaR when the calculations are made on the assumption that the form of the distribution of returns is known (most often it is assumed as normal one). VaR is characterized by three parameters. The first parameter is the time horizon, which depends on the present situation. According to the Basel documents, the time horizon is 10 days, but as described in Risk Metrics, it is one day. Most common is the evaluation with a time horizon of one day. Ten days are used to calculate the amount of capital covering potential losses. The second parameter is the confidence level that means the level of acceptable risk. Basel documents use the value of 99%, but RiskMetrics system uses 95%. The last parameter is the base currency by which the index is measured.

Alternative methods. In recent years, several alternative methods have been developed to measure risk in corporations, among which are the methods based on the use of regression analysis. Currently, there are three main alternative approaches to the calculation of value at risk metric for non-financial enterprises. The first one is methodology CorporateMetrics ™ of RiskMetrics ™ group. This method is suitable for measuring the risk of trading units that deal with liquid financial instruments; however, it is much less effective in the measurement of the risk in non-financial organizations. The next methodology is NERA (National Economic Research Associates). Finally, there is the methodology based on the use of regression analysis of risks. Nowadays, it is the most promising method of risk assessment.

Yield curve. The yield curve is the dependence (dependence curve) of yield of uniform financial instruments on their terms (duration); basic yield curve is based on government securities (G-curve, G-Curve) of different maturity (Stern n.d.). It is also possible to build one’s own yield curve for a particular organization based on the cost of funds and depending on the length (duration). Yield curve characterizes the state of the bond market and the economy in general and is used for interest rate risk assessment and decision-making by market participants of debt securities (Wooldridge 2001).

Financial derivatives. The use of derivatives differs depending on hedging goals, instruments or even corporate policies. The hedging can be natural for financial institutions (using financial derivative) (Poitras 2013). Bodnar and Gebhards (1999) compared German (Porsche and Volkswagen) and the US non-financial firms (Caterpillar and Kodak) in terms of the use of derivatives by them that best describes the differences between them . Glaum (2002) showed how German corporate policy regarding derivatives-based risk management differs from that of German non-financial companies. The same conclusion was made by Stulz (1996): “…larger companies reported greater use of derivatives than smaller firms.” However, the prioritizing of risk management in terms of price movements (in using derivatives method) for non-financial companies may bring about considerable losses. Stulz (1996) demonstrated this tendency on the example of Metallgesellschaft, its MGRM US subsidiary and Daimler-Benz.

In most cases, the use of derivatives such as foreign exchange, interest rate or commodity price is stipulated by derivative related losses (Poitras 2013). Interestingly, firms in different countries use managing cash flows and managing accounting results differently. One of the crucial goals of derivatives usage it to predict risks related to foreign exchange rates. The popularity of interest rates derivatives in interest risk management such as OTC Swaps, OTC Forwards, Futures, Exchange-traded Options, Structured Derivatives, OTC Options, and Hybrid Debt is different, making OTC Swaps the most attractive of all (Allayannis, Lel & Miller 2012).

CAPM. CAPM or the capital asset pricing model is the model used to determine the required level of profitability of the asset, which is expected to add to the already existing well-diversified portfolio, taking into account the market risk of the asset (Stern n.d.). The subject of portfolio theory is the profitability and risks of the securities. At the same time, the yield flows directly from the position of share. CAPM in its turn goes a little further and explores the market equilibrium, the equilibrium market rates, which are established if all market participants build efficient portfolios in line with portfolio theory (Stern n.d.). Pricing for one share affects the pricing for other shares. The equilibrium prices should in this case be achieved simultaneously and automatically. Equilibrium prices are important for determining the risk. When evaluating companies they serve to determine the capital cost. While determining the market price, objectivity is achieved through the risk. Risk management means the equilibrium price used to evaluate equity funds. This is common saying about the measurability of additional risk based on the average incremental yield.

The Relevant Economic and Finance Theories

There are specific and general economic and fiancé theories that provided the base for risk management models. The first general theory is stakeholder theory. Stakeholder theory states that to achieve the objectives, the organization should take into account the diverse interests of various interested parties (stakeholders), which represent a kind of informal coalition. The stakeholders can have various relationships that are not always characterized by the spirit of cooperation and convergence of interests, which makes them competitive (Antikarov 2012). However, all stakeholders can be seen as a contradictory entity, the resultant interest of which will determine the path of development for the organization and methods to be chosen.

The second theory is the modern portfolio theory. This component of the investment process stands for the periodic analysis of the functioning of the investment portfolio in terms of risk and return. In terms of risk, the best cash investment is the purchase of government bonds to ensure risk-free interest rate, so that the lack of risk affects the level of profitability, rarely covering losses associated with inflation processes. Despite this, the risk-free interest rate is the benchmark for assessing the effectiveness of any type of investment strategies. According to the CAPM model (Capital Asset Pricing Model), the Capital Market Line and the Security Market Line determine the relationship between risks and return measurement of financial assets; a key role here is played by a risk-free interest rate and the yield of the market index (Antikarov 2012). The main measures of risk investments in financial assets are the standard deviation and beta coefficient based on which CML and SML are built (Antikarov 2012). The data line is the yield of the benchmark portfolio, depending on the standard deviation and beta coefficient.

Lastly, the basis of the theory of risk management is the theory of probability and mathematical statistics. The quantitative risk assessment is carried out using the same concepts that are developed in these fields. Assigning a risk with a probability helps to evaluate the consequences of this risk. If to multiply the likelihood of risk and its negative effects, it becomes possible to evaluate the real danger of this risk. This is often referred to as the value of expected losses expressed by a formula Probability x Consequences = Cost of expected losses (Antikarov 2012).

The most elaborate economic theoretical background is given for VaR. To analyze it, for a given level of significance γ ∈ (0, 1) and the investment horizon Δt, the VaR risk measure is defined as: VaRγ = {u / P [R ≤ u] = γ, where R is income (yield) of portfolio securities, following continuous distribution law (Kuester, Mittnik & Paolella 2006). It is the division of wealth between the subjects of market relations. In addition, the distribution process is considered to be the final product transfer from producer to consumer. To solve the problem of constructing an optimal portfolio there are used different risk measures such as variance, VaR, CVaR, DaR, CDaR. There are various performances optimization problems where the risk measures are used to construct the objective functions, and to determine the set of feasible solutions (restrictions).

The Use of Models by Non-financial firms to Manage Their Risks

Interest in non-financial companies’ risk management originated because of different reasons. On the one hand, this is a logical transition to the new management methods and improvement of the quality of company management. On the other hand, there had taken place the events that caused problems in seemingly reliable and stable companies. According to Gentzoglanis (2006), the absence of effective risk management system has led to the onset of extremely adverse consequences for the large telecommunication companies, like WorldCom, Global Crossing, Adelphia Communications, Enron, Arthur Andersen, and others.

Every company identifies for itself the types of risk and risk management. In his work, Gentzoglanis (2006) defined such telecommunications industry risks as market, credit, liquidity, and operational and regulatory risks that have an impact on all departments of a non-financial company (p. 6). Additionally, there are increasing demands of the market regulators in terms of the effectiveness of control systems and risk management. In particular, the provision of the Sarbanes Oxley Act applies to the companies that participate in trading on the New York Stock Exchange (Gentzoglanis 2006). Despite recommendatory character, the COSO standards are widely used (Committee of Sponsoring Organizations of the Treadway Commission), describing the conceptual basis of the internal control and risk management across the enterprise. The terminology of risk management is presented in ISO / IEC 73 standards: 200 (GOST R 518 972 002) (Gentzoglanis 2006). The provisions of the Basel Committee on Banking Supervision determine risk management methodology for banks and non-financial companies and are used to classify risks, select assessment methods and manage market, credit and operational risks (Gentzoglanis 2006).

Gentzoglanis (2006) gives a bright example of TElUS Canada and the risk management process in this case has several stages. The first point is annual assessment of risk using COSCO-based survey and appropriate frameworks, review of audits and managers’ reports (Gentzoglanis 2006). The findings of the first point are used for internal audit (Liu 2012). The next step is quarterly assessment of risks and cooperation of the Audit Committee with key stakeholders (Liu 2012). Granular risk assessment is the last stage ending the risk evaluation from the greater annual timeframe to small risk initiatives.

Evaluation of the Reviewed Studies

Value at Risk (VaR) is value at risk measure. The common symbol “VaR” is used worldwide. It is the estimate of the quantity expressed in monetary units that do not exceed the expected value loss with a given probability for a given period of time. The most obvious difference between VAR and C-FAR is timeframe, which is greater for cash flow-at-risk. If to compare studies on both methods, both of them show that C-FAR for non-financial company lacks data but the precise C-FAR calculation helps to increase credibility and trustfulness for investors and presents the probability distribution of cash flows correctly, which is necessary for risk management.

Most non-financial firms are illiquid assets. For them, the main risk is the risk of reduction in operating cash flow. Therefore, a key value at risk metric is a cash-flow-at-risk. The time horizon for the calculation of C-FaR varies from one to twenty quarters. It is calculated with the help of not only basic financial risk factors but also specific factors affecting operating cash flows, such as changes in demand for the company’s products, the pricing policy of competitors, and industry results of R&D. When creating a C-FaR model operating cash flow, it should integrate with the model of the behavior of financial factors.

The importance of one more method of yield curve is that it shows how interest rates’ behavior will affect the course dynamics and comparable revenue for a non-financial company. The most common form of the yield curve is a gradually increasing curve. It shows that with the increasing time of repayment, the yield also increases, and customers who want to buy bonds with longer repayment period, and therefore act riskier, can count on a higher income. If the slope of the yield curves suddenly starts rising sharply, it is usually a sign of increasing inflation, with may result in interest rates increase. Sometimes the yield curve can be directed down and even take the form of an inverted curve. This situation occurs when the central bank raises short-term interest rates in an attempt to reduce inflation. As a rule, this is a sign that interest rates have peaked and will soon begin to fall. Information about the changes in the form and location of the yield curves helps to formulate the ideas about the behavior of interest rates in the future.

The derivatives are used to hedge commodity-price exposures in risk management in non-financial firms to mitigate the consequences of financial price fluctuations. The analysis of German and the US firms shows that the use of derivative depends on activities and company characteristics, and the pattern is similar for industry and enterprise size, however, the purpose of risk management including derivatives is different.

Therefore, the literature review showed that different companies prefer different risk management methods. However, they all try to identify the causes and main factors of risks, to analyze and assess them, to make a decision based on risk evaluation, generate control actions, reduce the risk to an acceptable level, monitor the implementation of the planned activities and evaluate the risk solutions.

Conclusion

The risk management is focused on search and organization of work to reduce the risk, as well as the art of obtaining and increasing income (winnings, profits) in an uncertain economic situation. The ultimate goal of risk management is to obtain the greatest profit at the optimum acceptable ratio of profit and risk. Risk management is a system of influencing risk and the economics, more precisely, the financial relations arising in the process of management. Risk management includes the management strategy and tactics. Consequently, strategy and tactics require certain techniques or methods to be applied.

The main methods that can be successfully used by non-financial firms in risk management are VaR (together with alternative methods), C-FAR, CAMP model, derivatives, yield curve and others. The most successful model nowadays is Value-at-Risk, however, firms with different risk management goals may use other methods and the next popular are C-FAR and derivatives. Risk management process includes systemic and thorough identification and evaluation of risks with their further re-evaluation. The main objective of any company, including non-financial one is to avoid, prevent or make use of risks of different categories and at different stages of company’s development.

The effectiveness of risk management depends largely on the speed of reaction to changes in market conditions, economic conditions, and the financial condition of the control object. Therefore, risk management must be grounded on knowledge of standard risk management techniques, the ability to quickly and accurately assess the specific economic situation and the ability to quickly find a good, if not the only way out of this situation.