<scp>Enterprise Risk Management Through Strategic Allocation of Capital</scp>

TLDR

The article proposes a conceptual framework to operationalize strategic enterprise risk management in a general firm. The framework uses a risk‑constrained optimization model that maximizes expected total return on capital subject to Value‑at‑Risk constraints, incorporating risk appetite, risk prioritization, default avoidance, and a multiperiod horizon, and is illustrated with a numerical example. The formulation enables more general ERM modeling within a consistent strategic framework, accommodating firm‑specific variations and diverse modeling assumptions. Managerial implications are discussed.

Abstract

Abstract This article presents a conceptual framework for operationalizing strategic enterprise risk management (ERM) in a general firm. We employ a risk‐constrained optimization approach to study the capital allocation decisions under ERM. Given the decision maker's risk appetite, the problem of holistically managing enterprise‐wide hazard, financial, operational, and real project risks is treated by maximizing the expected total return on capital, while trading off risks simultaneously in Value‐at‐Risk type of constraints. This approach explicitly quantifies the concepts of risk appetite and risk prioritization in light of the firm's default and financial distress avoidance reflected in its target credit rating. Our framework also allows the firm to consider a multiperiod planning horizon so that changing business environments can be accounted for. We illustrate the implementation of the framework through a numerical example. As an initial conceptual advancement, our formulation is capable of facilitating more general ERM modeling within a consistent strategic framework, where idiosyncratic variations of firms and different modeling assumptions can be accommodated. Managerial implications are also discussed.