Risk Management & Operational Hedging
Operational hedging is integral part of ops strategy
each market has its own risks & opportunities that need to be understood
assets & processes determine the outcomes under all scenarios
Risk
variance
2 types of risk
Risk management
undesirable consequences of uncertainty
Hedging
operational risk
financial risk
about the undesirable variability of realised profit flows
the threat that an asset or processes will fail to perform as intended
the risk of a mismatch between supply & demand, which reduces expected profit flows
controlling likelihood or consequences
means mitigating reducing (the negative consequences) of these risks:
operational hedging are constructions (large upfront commitments) in the operating system (As + Ps) to reduce operational risks
financial hedging are constructions with financial instruments to reduce the variance of profits
ops hedging may increase expected profits as well as reduce their variance
4 Steps of Risk Management
- Assess risk level of all hazards
- Make tactical risk decisions
- Implement strategic risk mitigation or hedging
- identify all potential hazards
one perspective of ops risk
inputs
transformation:
ops is the design & management of the As + Ps involved in acquiring supply, transforming inputs into outputs, and fulfilling customer demand
outputs
operational risk is the threat that an asset/ a process will fail to perform as intended
a broader perspective
supply
demand
operational risk is significant threats to cost-effective supply-demand balance
Ops mandate:
match supply & demand in efficient manner
risks e.g.,
cost risk
availability risk
delay risk
quality risk
volume risk
timing risk
location risk
operational risks from the asset view
tangible assets
(PPE asset risks, people risks)
intangible assets
(cultural risks, policy risks, IP risks)
environmental & background risks
natural risks
political risks
competitive risks
operational risks from the process view
innovation risk
marketing & sales commercial risk
demand risk & supply risk
production risk & distribution risk
service risk
coordination & information risk
Subjective risk map
(a matrix - classify as high/ low)
Effect (aggregate loss severity $)
probability (frequency of occurrence)
how to value risk
quantitative or qualitative
best
qualitative understanding
quantitative assessment of probability & impact
key risk events are well understood
directionally correct
qualitative (High, Medium, Low)
can't isolate risk
judgemental/ opinionated
analytically precise
quantitative
time consuming
statistics less understood
lost in data
mean-variance frontiers
other crucial dimensions
probability
mean value (return) of portfolio vs. variance (risk) of portfolio value
mean-var. analysis
Depending on one’s risk aversion, different capacity plans may be considered optimal
impact
detectability (see FMEA in Six Sigma)
urgency
this requires
- risk discovery (event warning)
monitoring
detection/discovery that hazard is likely to occur/ has occurred
- risk recovery
acting when risk has occurred
- risk preparedness
fire drills, power loss, what-if contingency plans
speed in disruption discovery & recovery is key!
proactively develop a plan for
anticipatory decisions when risk level is elevated
reactive decisions after hazard has occurred
resilient operations
4 generic operational hedging strategies
Financial Hedging
Why are organisations bad at RM?
we don't take action for the risks we are aware of
3) Risk-sharing & Transfer
2) Diversification & Pooling
4) Reducing or eliminating root cause of risk
1) Reserves & Redundancy
what should we do about risk
beyond tactical risk decisions
key questions
what is the cost of hedging the risk?
protect against risks
exploit risk (or "opportunities")
do nothing: pass to investors
is there significant benefit in terms of higher cash flows or lower discount rate?
get some extra, just in case
portfolios, integration: it can't all go wrong at the same time
if we build some flexibility, we can adjust
let others take on & manage the risk (through contracts); like outsourcing
(prevention vs mitigation)
e.g., Backup generator for the Philips plant (fire was caused by the lack of power for a cooling fan)
a form of risk transfer
Good option for risk-averse managers, maybe not for shareholders
we may not be around when the trouble starts
risk management needs to become a management discipline
there is no glory nor reward for prevented risks
leaders can expect a little credit for the prevention of predictable surprises - fixing the problem would incur significant costs in the present, while the benefits of action would be delayed & ambiguous
"good managers welcome problems" so that they can solve them & look good
people tend to discount the future very strongly (more than financial models)
we don't communicate the risks we see
messenger can't win - why speak up?
we don't see the risks
people are overconfident (they underestimate the probability and impact of adverse advents): “it’s not going to happen” or “it won’t be that bad”
People are not very good at dealing with low-probability high-impact risks