Unveiling a comprehensive framework for risk management, we delve into the intricacies of identifying, assessing, and mitigating potential threats. A strategic approach that empowers businesses to navigate uncertainty, ensuring resilience and sustainability in an ever-evolving corporate landscape.
Risk Management Framework to Guide Top-Level Managers
Without a clear set of risk-management goals, using derivatives can be dangerous
- There is no single, well-accepted set of principles that underlies their hedging programs. Financial managers will give different answers to even the most basic questions
- Should Dresser and Caterpillar have used derivatives to insulate their stock prices from shocks to energy prices and exchange rates? Should they have focused instead on stabilizing their near-term operating income, reported earnings, and return on equity, or on removing some of the volatility from their capital spending?
From Pharaoh to Modern Finance
Risk management is not a modern invention
- In the Middle Ages, hedging was made easier by the creation of futures markets
- More recently, large publicly held companies have emerged as the principal users of risk-management instruments
- Unlike individual risk management, corporate risk management doesn’t hurt, but it also doesn’t help
- Value is created on the left-hand side of the balance sheet when companies make good investments-in, say, plant and equipment, R&D, or market share-that ultimately increase operating cash flows
- How companies finance those investments is irrelevant
- They are purely financial transactions that have no consequence
Example 1:
If the dollar depreciates relative to the mark, it will become more expensive (in dollar terms) to build the plant in Germany.
- However, the marks it receives from selling cameras in Germany will also be worth more in dollars, so it would want to maintain its investment in Germany despite the dollar’s depreciation.
Why Hedge?
If exchange rates remain stable, Omega expects the dollar value of its cash flow from foreign and domestic operations to be $200 million. If the dollar appreciates substantially relative to the Japanese yen and the German mark, then Omega’s cash flow will fall to $100 million, since the weaker yen and mark mean that foreign cash flows are worth less in dollars.
- Conversely, a significant dollar depreciation would increase Omega’s cash flow to $300 million.
Example 2:
A depreciation in the dollar makes it less attractive to manufacture in Germany
- The company might want to scale back its investment or scrap the plant when the dollar depreciates
- This case is analogous to that of Omega Oil in that risk that hurts cash flows-namely, a depreciation of the dollar relative to the mark-also diminishes the appeal of investing
- If the company hasn’t committed to building the plant, it is less important to hedge the longer-term risks
- Companies should pay close attention to the hedging strategies of their competitors
- Futures and forwards are essentially linear contracts: for every dollar the company gains when the underlying variable moves in one direction by 10%, it loses a dollar when it moves in the other direction
When to Hedge-or Not
A proper risk-management strategy ensures that companies have the cash when they need it for investment, but it does not seek to insulate them completely.
- Omega Oil doesn’t need to hedge its oil-price risk as much as Omega Drug because it already has something of a built-in hedge.
Guidelines for Managers
Companies in the same industry should not necessarily adopt the same hedging strategy
- Even companies with conservative capital structures-no debt, lots of cash-can benefit from hedging
- To develop a coherent risk-management strategy, companies must carefully articulate the nature of both their cash flows and their investment opportunities
- Once they have done this, their efforts to align the supply of funds with the demand for funds will generate the right strategies for managing risk
