To evaluate the effect of the toy company’s other major source of risk, exchange rates,
the managers must first determine how sales are related to exchange rates, and then explicitly link firm sales to exchange rates in their valuation model. Suppose that this
linkage results from the effect of the yen/dollar exchange rates on market prices in the
U.S., which in turn affect U.S. demand. A useful valuation model will specify how much
the U.S. market price will change for a given percentage movement in the yen/dollar
exchange rate, and then define how a shift in the market price will affect demand for the
product in the U.S. The toy company’s managers should also assess the probability of
large and small exchange rate movements, and whether or how exchange rate risk is
correlated to the expected life of the faddish toy. Challenges in Creating an Integrated Risk Management System
Corporate risk management is evolving rapidly, but the practice of risk aggregation is not
yet widespread. Instead, the institutional organization of the typical firm tends to isolate
and manage risks by type. The treasurer’s office will manage exchange-rate exposures,
and perhaps credit risk. Commodity traders, sometimes located within the purchasing
area, will focus on commodity price risk. Production and operations management will
consider risks associated with the production process. The insurance risk manager
focuses on property and casualty risks. Human resources may address employment risks.
So, as a practical matter, integrated risk management require the unification (at least for
the function of risk management) of previously separate institutional units. The firm,
rather than the type of risk, provides a frame of reference.