What to do with risk?
Classification, transfer, downside measures, management systems and ESG
Rolandas Rakštys · Lecturer · Vytautas Magnus University, Agriculture Academy · Faculty of Bioeconomy Development, Department of Business and Rural Development · [email protected] · ORCID 0000-0003-0299-9930
Chapter 3 “Business risk and profitability”, section 3.1.2 (part 2 of 2) · English translation of chapter v1.15.1 (2026-10-31) · set v1.2 · 21 slides, ≈ 32 min
Rakštys, R. (2026). Chapter 3. Business risk and profitability (English translation of v1.15.1, 2026-10-31). Verslo planavimas ir vertinimas [Business planning and evaluation]. Vytautas Magnus University, Agriculture Academy. https://rakstys.eu/studijos/verslo-planavimas-ir-vertinimas/en/skyriai/ch03/ · CC BY-NC-ND 4.0
Hedge or retain?
In practice – the risk management question most often asked.
The answer is not self-evident.
Risk by source of origin
“Effective risk management begins with structured identification. Without a systematic classification, risks are either ignored or analysed unsystematically.”
A small open economy
A small open economy – particularly sensitive to fluctuations in external demand.
2022
The energy crisis that followed Russia’s invasion of Ukraine raised production costs and caused a wave of double-digit inflation.
2021
China’s trade blockade, prompted by the opening of a Taiwanese representative office, showed how geopolitical decisions can directly affect export markets.
Christensen (1997), The Innovator’s Dilemma
Firms follow the needs of their most profitable customers and keep improving the existing technology, so they undervalue cheaper and simpler disruptive innovations until those take over the market.
Risk by scope for management
Risk that can be avoided entirely
Compliance breaches, fraud
Prevention, internal control
The probability or the impact can be reduced
Operational errors, supply disruptions
Process optimisation, redundancy, natural hedging
Transferred to another party
Fire, natural disasters, credit risk
Insurance, financial hedging, factoring
Deliberately assumed
Market risk, strategic risk
Self-insurance, capital reserves, a risk premium
The third and fourth rows lead to the question most often asked in practice: hedge the risk or retain it?
Two types of hedging
Hedging – the management of risk through a transaction or an operational decision whose result moves in the opposite direction to the position being protected.
Natural hedging
Transfers risk to no one – it reduces risk through the structure of the business itself.
A firm exports to the United States and buys its raw materials there: revenue and costs in dollars, and the currency position is essentially closed.
An open currency position – how is it covered?
Natural – no premium, but it costs operational flexibility and forgone opportunities. Financial – applied without changing operations, but it has a cost: the option premium, or transaction costs and the profit given up if the price moves in the firm’s favour.
Why should a firm hedge at all?
The logic of Modigliani and Miller (1958): if capital markets are perfect, the shareholder can hedge on their own.
The firm’s hedging then creates nothing: it merely repeats what the investor can already do in their own portfolio, and pays a commission for doing so.
The same argument that is used against corporate diversification (part 1, slide 7; Chapter 5), only applied to the transfer of risk.
The way out is not to reject the argument but to notice its condition: markets are not perfect.
The same imperfections explain in Chapter 11 why capital structure matters.
When hedging creates value
Three channels of value creation as the determinants of hedging policy.
1. The costs of financial distress
Hedging by the shareholder does not reduce the probability that the firm itself will become insolvent. Bankruptcy is irreversible: customers lost, employees gone, assets sold under duress.
Hedging that reduces the volatility of cash flows also reduces the probability of entering that zone.
2. Tax asymmetry
Profit is taxed, whereas a loss is not always recovered, and not immediately.
Two volatile years pay more tax than two stable ones with the same total.
3. Underinvestment
When cash flow falls, even value-creating investments are abandoned – external financing is then at its most expensive.
Froot, Scharfstein and Stein (1993): the purpose is to ensure that internal funds suffice for investment at the moment when investment is most valuable.
A requirement for the business plan
A hedging decision must be justified by one of these three reasons, and not by a reference to the fact that “the risk is large”.
If none of the reasons applies, the cost of hedging is a pure leakage of value.
Self-insurance and the exploitation of risk
Self-insurance – insurance cover is deliberately not bought; a liquid reserve is created to cover the losses instead.
A commercial insurance premium is usually larger than the expected loss. The exception is subsidised insurance.
Frequent, small, predictable
Self-insurance is cheaper – the firm pays no margin for a risk it can forecast itself.
Rare, large, exceeding the limit
Never worth retaining – what matters is whether the firm would survive a single realisation.
The average loss ↔ the worst case – operationalised in Chapter 4 through VaR and CVaR (slide 13).
A fifth possibility – the exploitation of risk. By deferring a decision one acquires the right to invest only when the assumptions are confirmed. The logic of real options – Chapter 14.
Three ever more relevant categories
The taxonomy of risks by source of origin is worth supplementing with three categories.
Reputational risk (Benn, Abratt & Kleyn, 2016)
The loss of trust, legitimacy and social capital arising from a failure to meet the expectations of stakeholders. Insidious, because it often arises as a secondary consequence of other risks.
Systemic digital risk (Curran, 2020)
A local disruption – a cyber attack, the failure of a cloud service – may become a failure of the whole system.
Lu et al. (2024) – a cascading model for large construction projects. Langley (2013) – stress testing for low-probability, high-impact events.
Maps of causal chains, rather than risk registers alone.
Losses matter more than profits
The standard deviation treats positive and negative deviations symmetrically.
In business, losses are asymmetrically more important: bankruptcy is irreversible, whereas “too much” profit is not a problem.
The Sortino ratio
Analogous to the Sharpe ratio (formula (3.8)), but with only the downside standard deviation in the denominator: deviations below a minimum acceptable level of return.
Value at Risk and Conditional Value at Risk
Value at Risk (VaR)
A quantile of the loss distribution: the threshold which, over a chosen period and at a given confidence level, the actual loss should not exceed.
“A one-day 99 % VaR of EUR 50 000” – on 99 days out of 100 the loss will not exceed EUR 50 000.
Conditional Value at Risk (CVaR, ES)
The average loss given that it exceeds the VaR threshold.
CVaR is a coherent measure: the CVaR of a portfolio is always less than or equal to the sum of the CVaRs of the individual assets; VaR does not have this property (Artzner et al., 1999). The question is not “what loss is expected” but “what loss is possible in the worst case”.
ISO 31000: a process, not a procedure
ISO 31000:2018 – a universal yet systematic risk management process for organisations of any type.
Dotted – not stages: they take place continuously and in parallel with all the others.
It is precisely this difference that is most often simplified in practice – risk management is turned into a procedure carried out once a year rather than a continuous process.
COSO ERM: where in the organisation risk lives
The COSO (Committee of Sponsoring Organizations of the Treadway Commission) enterprise risk management (ERM) framework (2017) integrates risk management with strategy and objective-setting.
ISO describes how risk is managed, COSO where in the organisation that management lives.
Without the support of governance and culture it remains a procedure that can be performed as a formality.
Crawford & Jabbour (2024): ERM is an integrating lens; risk cuts across the whole chain of value creation.
The costs of implementation are high, so for smaller Lithuanian firms the principle of ISO 31000 is often enough: what matters is systematic thinking, not the size of the system (ISO, 2018; COSO, 2017). The methods – in Chapter 4.
ESG – a new dimension of risk
Environmental, social and governance (ESG) risks – an independent category affecting all the layers of business value.
The physical hazards of climate change; transition risk; the reputational risk of greenwashing.
Breaches of labour rights in the supply chain; resistance from communities; employee health and safety incidents.
A lack of independence on the board of directors; the misalignment of executive remuneration with results; corruption.
Friede, Busch & Bassen (2015)
More than 2 200 empirical studies: roughly 90 % show no negative relationship between ESG and financial return.
Causality remains debatable
Well-managed businesses may simply invest more both in ESG and in other measures of efficiency.
ESG works in two directions
ESG performance reduces risk
Liu & Song (2025)
It eases financing constraints, improves reputation and lowers the probability of sanctions – particularly under conditions of environmental uncertainty.
ESG exposure increases risk
Galdos-Urbizu, Ortas & Alvarez-Etxeberria (2025)
A high ESG risk exposure strengthens the influence of market volatility and increases firm-specific risk; the effect is non-linear and grows stronger among already volatile stocks.
An instrument for reducing risk when a firm actively manages ESG, and an additional source of risk when ESG factors act on it from outside. More in Chapter 1 (intangible capital) and Chapter 10 (the evaluation of investment decisions).
Five layers of value – five risk profiles
Risk is not a homogeneous dimension – every layer has its own profile and requires different instruments of management and measurement.
What does it harm?
ISO 31000 defines risk as the
effect of uncertainty on objectives
ISO (2018)
The standard deviation measures fluctuation without asking what the firm is aiming at; ISO requires the objective to be named first and only then measured.
Convenient for a business plan: the objectives are already formulated, so risk becomes not a separate section but a question attached to every assumption.
The definition includes a positive deviation as well – and in that it differs from a purely loss-based ontology.
The owner’s risk toolbox
Origin and scope for management; plus reputational risk, systemic digital risk and cascading.
Avoid, reduce, transfer or accept; hedging – with one of the three reasons; self-insurance – for frequent and small losses.
The Sortino ratio, Value at Risk and Conditional Value at Risk.
The ISO 31000 process, COSO ERM; ESG – in both directions.
For discussion · question 3.13. A company can hedge against significant fluctuations in the price of a raw material, but the hedging transaction has costs. Why, under conditions of a perfect market, would such a decision not in itself increase the value of the firm? Choose one of the channels of value creation discussed in this section and explain in what circumstances of the firm the benefit of hedging could exceed its costs.
References
Artzner, P., Delbaen, F., Eber, J.-M., & Heath, D. (1999). Coherent measures of risk. Mathematical Finance, 9(3), 203–228.
Benn, S., Abratt, R., & Kleyn, N. (2016). Reducing reputational risk: Evaluating stakeholder salience and prioritising stakeholder claims. Marketing Intelligence & Planning, 34(6), 828–842. https://doi.org/10.1108/MIP-10-2015-0191
Christensen, C. M. (1997). The Innovator's Dilemma: When New Technologies Cause Great Firms to Fail. Harvard Business School Press.
COSO. (2017). Enterprise Risk Management – Integrating with Strategy and Performance. Committee of Sponsoring Organizations of the Treadway Commission.
Crawford, J., & Jabbour, M. (2024). The relationship between enterprise risk management and managerial judgement in decision-making: A systematic literature review. International Journal of Management Reviews, 26(1), 110–136. https://doi.org/10.1111/ijmr.12337
Curran, D. (2020). Connecting risk: Systemic risk from finance to the digital. Economy and Society, 49(2), 239–264. https://doi.org/10.1080/03085147.2020.1718912
Friede, G., Busch, T., & Bassen, A. (2015). ESG and financial performance: Aggregated evidence from more than 2000 empirical studies. Journal of Sustainable Finance & Investment, 5(4), 210–233. https://doi.org/10.1080/20430795.2015.1118917
Froot, K. A., Scharfstein, D. S., & Stein, J. C. (1993). Risk management: Coordinating corporate investment and financing policies. The Journal of Finance, 48(5), 1629–1658. https://doi.org/10.1111/j.1540-6261.1993.tb05123.x
Galdos-Urbizu, L., Ortas, E., & Alvarez-Etxeberria, I. (2025). ESG risk exposure, management and firm risk: New evidence from a panel quantile regression approach. Cogent Business & Management, 12(1), 2585542. https://doi.org/10.1080/23311975.2025.2585542
ISO. (2018). ISO 31000:2018 Risk management – Guidelines. International Organization for Standardization.
Langley, P. (2013). Anticipating uncertainty, reviving risk? On the stress testing of finance in crisis. Economy and Society, 42(1), 51–73. https://doi.org/10.1080/03085147.2012.686719
Liu, E. X., & Song, Y. (2025). ESG performance, environmental uncertainty, and firm risk. Journal of International Financial Management & Accounting, 36(2), 292–322. https://doi.org/10.1111/jifm.12227
Lu, Y., Liu, J., & Yu, W. (2024). Social risk analysis for mega construction projects based on structural equation model and Bayesian network: A risk evolution perspective. Engineering, Construction and Architectural Management, 31(7), 2604–2629. https://doi.org/10.1108/ECAM-04-2022-0319
Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48(3), 261–297.
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Rakštys, R. (2026). Chapter 3. Business risk and profitability (English translation of v1.15.1, 2026-10-31). Verslo planavimas ir vertinimas [Business planning and evaluation]. Vytautas Magnus University, Agriculture Academy. https://rakstys.eu/studijos/verslo-planavimas-ir-vertinimas/en/skyriai/ch03/ · CC BY-NC-ND 4.0
These slides are based on the textbook Verslo planavimas ir vertinimas [Business planning and evaluation]. The text was translated, structured and visually laid out with the help of artificial intelligence tools (Claude), following the protocol for working with AI and the verification procedures set by the author.