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Handbook of Integrated Risk Management in Global Supply Chains HANDBOOK OF INTEGRATED RISK MANAGEMENT IN GLOBAL SUPPLY CHAINS HANDBOOK OF INTEGRATED RISK MANAGEMENT IN GLOBAL SUPPLY CHAINS A JOHN WILEY & SONS, INC., PUBLICATION Copyright c 2010 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per- copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created ore extended by sales representatives or written sales materials. The advice and strategies contained herin may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services please contact our Customer Care Department with the U.S. at 877-762-2974, outside the U.S. at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print, however, may not be available in electronic format. Library of Congress Cataloging-in-Publication Data: Handbook of Integrated Risk Management in Global Supply Chains/co-edited by Panos Kouvelis, Onur Boyabatli, Lingxiu Dong, and Rong Li. Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 CONTENTS Acknowledgments ix 1 Risk Management and Operational Hedging: An Overview 1 Jan A. Van Mieghem 1.1 Introduction 1 1.2 Risk Management: Concept and Process 2 1.2.1 Defining hazards and risk 2 1.2.2 Financial versus operational risk 2 1.2.3 Risk management: concept and examples 3 1.2.4 Risk management as a process and integral part of operations strategy 5 1.3 Identification of Operational Hazards 6 1.3.1 Identifying operational risks using the competency view 7 1.3.2 Identifying operational risks using the process view 7 1.3.3 Identifying operational risks using the resource view 9 1.3.4 Surrounding background risks 9 v vi CONTENTS 1.3.5 Who should identify potential hazards? 10 1.4 Risk Assessment and Valuation 10 1.4.1 Qualitative risk assessment: the theory 10 1.4.2 Qualitative risk assessment: examples from practice 11 1.4.3 Quantitative risk assessment: risk metrics 12 1.4.4 Valuing risk with preferences and utility functions 14 1.4.5 Mean-variance frontiers 14 1.5 Tactical Risk Decisions and Crisis Management 16 1.5.1 Risk preparation 17 1.5.2 Risk discovery 17 1.5.3 Risk recovery 18 1.6 Strategic Risk Mitigation 19 1.6.1 The value-maximizing level of risk mitigation (risk-neutral) 19 1.6.2 Strategic risk-return trade-offs for risk-averse managers 20 1.6.3 Periodic updating and continuous risk management 21 1.7 Four Operational Hedging Strategies 22 1.7.1 Reserves and redundancy 23 1.7.2 Diversification and pooling 23 1.7.3 Risk sharing and transfer 24 1.7.4 Reducing or Eliminating Root Causes of Risk 24 1.8 Financial Hedging of Operational Risk 25 1.8.1 Hedging demand risk with options 25 1.8.2 Hedging demand risk with (weather) derivatives 26 1.8.3 Hedging currency risk with forward contracts and swaps 27 1.8.4 Differences between financial and operational hedging 29 1.9 Tailored Operational Hedging 30 1.9.1 Tailored natural hedging at Auto Co. 30 1.9.2 Tailored redundancy and dynamic pooling with allocation flexibility at Auto Co. 31 1.9.3 Tailored operational hedging: base demand, tail-pooling, and chaining 33 CONTENTS vii 1.9.4 Tailored redundancy and multi-sourcing for supply and project risk 34 1.10 Guidelines for Operational Risk Management 35 1.10.1 Implement an operational risk management process 35 1.10.2 Use a multi-faceted approach tailored to the type of risk and product life cycle 35 1.10.3 Use a portfolio approach 36 1.10.4 Realize that operational hedging may incur additional costs 36 1.10.5 Reducing risk is more powerful than mitigating exposure 36 ACKNOWLEDGMENTS The author is grateful for the thoughtful and constructive suggestions by the the three anonymous referees. ix CHAPTER 1 RISK MANAGEMENT AND OPERATIONAL HEDGING: AN OVERVIEW Jan A. Van Mieghem Kellogg School of Management Northwestern University, Evanston, Illinois 1.1 INTRODUCTION This chapter, which is based on Chapter 9 in (18), aims to give an introduc- tion and overview of risk management and of the techniques that operations managers can use to mitigate risks. We start the next section by describing the concept of risk management and viewing it as an ongoing 4-step process and integral part of operations strategy. We distinguish operational from financial risk. In section 3, we identify the various operational risks that com- panies are exposed to. Then we review methodologies to assess and value those risks both qualitatively (using subjective risk maps) and quantitatively (using risk preference functions and risk metrics). The goal of risk assessment is to improve how we react to risk and to proactively reduce our exposure to Handbook of Integrated Risk Management in Global Supply Chains. By Panos Kouvelis, 1 Onur Boyabatli, Lingxiu Dong, and Rong Li. Copyright c 2010 John Wiley & Sons, Inc. 2 RISK MANAGEMENT AND OPERATIONAL HEDGING: AN OVERVIEW it. In section 5, we review tactical risk decisions, including risk discovery and risk recovery. The remaining sections of the chapter illustrates strategic risk mitigation, i.e., how operations can be structured to mitigate specific risks. Hedging refers to any action taken to mitigate a particular risk exposure; operational hedging uses operational instruments. Section 7 posits that there are four generic strategies to mitigate risk using operational instruments: 1) reserves and redundancy; 2) diversification and pooling; 3) risk sharing and transfer; and 4) reducing or eliminating root causes of risk. Section 8 reviews financial hedging of operational risk using options and derivatives. Section 9 illustrates how operational hedging can be tailored to the specific operations strategy of the firm using techniques such as: tailored redundancy, dynamic pooling with allocation flexibility, chaining, and multi-sourcing. Section 10 finishes the chapter by summarizing some guidelines for operational risk man- agement. 1.2 RISK MANAGEMENT: CONCEPT AND PROCESS 1.2.1 Defining hazards and risk Before we can describe the concept of risk management, we must first define some terms. Hazards are potential sources of danger. In a business setting, danger can mean anything that may have a negative impact on the firm’s net present value. Hazards have a harmful impact, but they may or may not occur. In everyday language, risk refers to an exposure to a chance of loss or damage. (\We risked losing a lot of money in this venture"; \Why risk your life?") Risk thus arises from hazards and exposure: it does not exist if exposure to a hazard does not or will not occur (e.g., if you live on top of a mountain, you are not at risk of flooding). The interpretation of risk as an undesirable possible consequence of uncertainty suggests that risk is a combination of two factors: 1. The probability that an adverse event or hazard will occur. 2. The consequences of the adverse event. 1.2.2 Financial versus operational risk While it is intuitive to associate risk with a probability and an undesired out- come, there are other interpretations of risk. The 1997 Presidential-Congressional Commission on Risk Management defined risk as the probability that a sub- stance or situation will produce harm under specified conditions. In eco- nomics, \risk refers to situations in which we can list all possible outcomes and we know the likelihood that each outcome occurs."(11) In finance, risk is \the possibility that the actual outcome is likely to diverge [or deviate] from the expected value." (12) In finance, risk is equated with RISK MANAGEMENT: CONCEPT AND PROCESS 3 uncertainty in payoffs, which we will refer to as profit variability risk. Risk then implies the existence of some random variable whose standard deviation or variance can be used as a measure of risk. Notice that this view calls any uncertainty in outcomes, whether favorable or not, risk. The key distinction from the common interpretation of risk is the absence of \danger" or an \adverse event." For instance, people don't typically say that they are at risk of winning the lottery. Operational risks are risks that stem from operations, i.e. from activities and resources. Any potential source that generates a negative impact on the flow of information, goods, and cash in our operations is an operational risk.
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