Investor risk is perceived as fear or underperformance, notably in losing the value of the original investment. Substantial benchmarking occurs, notably in the comparison of returns against inflation, stock-market and other industrial yardsticks. Similar executive peer-group pressure and benchmarking lead them to see who gained the highest award from the remuneration committee. Not all CEOs are intent on removing value from the company, a fine minority contribute by increasing investor wealth whether in share price or earnings per share.
The hazard remains that many CEOs are executive recruitment failures. They create negative shareholder return and blacken the name of the company. Reputational risk emerges as one of the more obscure risks, while being costly too. An incompetent executive seems to be excusable in the markets, certainly if we believe the newspaper accounts; being crooked is not. Either way, CEO tenure is usually short term, so CEOs may adopt the attitude: “Better clean up the company assets before they boot me out.”
We have seen that the Board of Directors is not always an adequate counter to the ego of the CEO and the wish for more M&A and self-aggrandisement. Non-executive directors, who are enlisted in a cabal to add to the existing yes-men on the Board, can never serve to deter the company from embarking on an unacceptably risky course. We need an essential set of conditions for successful corporate guidance.
An appropriate range of multidisciplinary skills
Power to ensure effective implementation of decisions
Ability to undertake effective assessments of the soundness of decisions associated with projects
Suitably qualified and dedicated support staff for the collection and analysis of data
Otherwise, we are condemned with the dire corporate leadership that has steered so many companies on the rocks.
An incompetent or crooked CEO underperforms colleagues and rivals. The bottom line is either the profit level or the share price. They fail on both scores. Failure should destroy their reputation in the industry. While the CEO can inflict great damage upon the company, reputational risk decrees that the executive can be punished with the embarrassment of being summarily ejected. By then it may be too late. There are two subrisks operating here – stemming from:
an inept executive;
a crooked executive.
What to do? Risk management becomes an empirical business study in corporate control.
We have seen how risk comprises:
hazard;
catalyst;
result.
We come back to the risk of a shark attack described in previous posts. The shark has a large dorsal fin that alerts us to its impending attack. We have already detailed an AEW warning system to alert us to the adverse CEO choice.
There are various risk management techniques to shed light upon a dark corporate operational area. These can include more effective interviewing to bring unsuitable executive candidates under the spotlight. Another is to undertake a management review of the control structure for recruiting key staff. Redesign the audit processes to block potential fraudulent financial statements passing the accounting process.
Compare this risk management arsenal against the risk of a fraudulent CEO. Fraud needs conditions:
1. motivation;
2. opportunity;
3. rationalisation.
We deploy risk countermeasures:
1. Anti-fraud motivation measures – better training of staff and recruitment, screening and interviewing of new applicants, monitor HR performance at work plus instigate an effective ethics programmes.
2. Anti-fraud opportunity measures – better staff monitoring, accounts screening, external audits, limit IT systems access and raise security physical access limits.
3. Anti-fraud rationalisation measures – raise chances of detection, raise punishment levels to act as deterrent, lower expectations of profit.
Risk management is really about a logical sequence of tasks to protect the business investment. The enterprise risk management strategy or life-cycle could be outlined as the series of tasks.
I. Risk detection.
II. Risk countermeasures.
III. Risk monitoring.

As derivative markets develop, options (and even some other types of derivatives) have begun to emerge on such underlyings as electricity, various sources of energy, and even weather. These instruments are almost exclusively customized over-the-counter instruments. Perhaps the most notable feature of these instruments is how the underlyings are often instruments that cannot actually be held. For example, electricity is not considered a storable asset because it is produced and almost immediately consumed, but it is nonetheless an asset and certainly has a volatile price. Consequently, it is ideally suited for options and other derivatives trading.
Consider weather. It is hardly an asset at all but simply a random factor that exerts an enormous influence on economic activity. The need to hedge against and speculate on the weather has created a market in which measures of weather activity, such as economic losses from storms or average temperature or rainfall, are structured into a derivative instrument. Option versions of these derivatives are growing in importance and use. For example, consider a company that generates considerable revenue from outdoor summer activities, provided that it does not rain. Obviously a certain amount of rain will occur, but the more rain, the greater the losses for the company. It could buy a call option on the amount of rainfall with the exercise price stated as a quantity of rainfall. If actual rainfall exceeds the exercise price, the company exercises the option and receives an amount of money related to the excess of the rainfall amount over the exercise price.
Another type of option, which is not at all new but is increasingly recognized in practice, is the real option. A real option is an option associated with the flexibility inherent in capital investment projects. For example, companies may invest in new projects that have the option to defer the full investment, expand or contract the project at a later date, or even terminate the project. In fact, most capital investment projects have numerous elements of flexibility that can be viewed as options. Of course, these options do not trade in markets the same way as financial and commodity options, and they must be evaluated much more carefully. They are, nonetheless, options and thus have the potential for generating enormous value. Again, our emphasis is on financial options, but readers should be aware of the growing role of these other types of options in our economy. Investors who buy shares in companies that have real options are, in effect, buying real options. In addition, commodity and other types of options are sometimes found in investment portfolios in the form of “alternative investments” and can provide significant diversification benefits. To this point, we have examined characteristics of options markets and contracts. Now we move forward to the all-important topic of how options are priced.