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A Framework For RiskManagement

by Kenneth A. Froot, David S. Scharfstein and Jeremy C. Stein

Reprint 94604

Harvard Business Review

This document is authorized for use only in Gest?o de Riscos e Derivativos_273 by Paulo Beltr?o Fraletti at FGV - EAESP from July 2014 to January 2015.

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NOVEMBER-DECEMBER 1994

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CHRISTOPHER A. BARTLETT CHANGING THE ROLE OF TOP MANAGEMENT: 94601AND SUMANTRA GHOSHAL BEYOND STRATEGY TO PURPOSE

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K.A. FROOT, D.S. SCHARFSTEIN, A FRAMEWORK FOR RISK MANAGEMENT 94604AND J.C. STEIN

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In recent years, managers have become increas-ingly aware of how their organizations can be buf-feted by risks beyond their control. In many cases,fluctuations in economic and financial variablessuch as exchange rates, interest rates, and commod-ity prices have had destabilizing effects on corpo-rate strategies and performance. Consider the fol-lowing examples:M In the first half of 1986, world oil prices plummet-ed by 50%; overall, energy prices fell by 24%. Whilethis was a boon to the economy as a whole, it wasdisastrous for oil producers as well as for companies

like Dresser Industries, which supplies ma-chinery and

Kenneth A. Froot is a professor at the Harvard BusinessSchool in Boston, Massachusetts. David S. Scharfstein isthe Dai-Ichi Kangyo Bank Professor and Jeremy C. Steinthe J.C. Penney Professor, at the Massachusetts Instituteof Technology’s Sloan School of Management in Cam-bridge, Massachusetts.

A Framework forRisk Management

by Kenneth A. Froot, David S. Scharfstein, and Jeremy C. Stein
equip-ment to ener-gy producers. As do-mestic oil production collapsed, so did demand forDresser’s equipment. The company’s operatingprofits dropped from $292 million in 1985 to $139million in 1986; its stock price fell from $24 to $14;and its capital spending decreased from $122 mil-lion to $71 million.M During the first half of the 1980s, the U.S. dollarappreciated by 50% in real terms, only to fall backto its starting point by 1988. The stronger dollarforced many U.S. exporters to cut prices drasticallyto remain competitive in global markets, reducingshort-term profits and long-term competitiveness.Caterpillar, the world’s largest manufacturer ofearthmoving equipment, saw its real-dollar salesdecline by 45% between 1981 and 1985 before in-creasing by 35% as the dollar weakened. Mean-while, the company’s capital expenditures fell from$713 million to $229 million before jumping to$793 million in 1988. But by that time, Caterpillarhad lost ground to foreign competitors such asJapan’s Komatsu.
In principle, both Dresser and Caterpillar couldhave insulated themselves from energy-price andexchange-rate risks by using the derivatives mar-kets. Today more and more companies are doing

HARVARD BUSINESS REVIEW November-December 1994 Copyrigh

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just that. The General Accounting Office reportsthat between 1989 and 1992 the use of derivatives–among them forwards, futures, options, and swaps–grew by 145%. Much of that growth came from corporations: one recent study shows a more thanfourfold increase between 1987 and 1991 in theiruse of some types of derivatives.1

In large part, the growth of derivatives is due toinnovations by financial theorists who, during the1970s, developed new methods – such as the Black-Scholes option-pricing formula–to value these com-plex instruments. Such improvements in the tech-nology of financial engineering have helped spawna new arsenal of risk-management weapons.

Unfortunately, the insights of the financial engi-neers do not give managers any

guidance on how to de-ploy the new

weapons most effectively. Al-though many com-panies are heavily in-volved in risk management, it’s safe to say that there is no single, well-acceptedset of principles that underlies their hedging pro-grams. Financial managers will give different an-swers to even the most basic questions: What isthe goal of risk management? Should Dresser andCaterpillar have used derivatives to insulate theirstock prices from shocks to energy prices and ex-change rates? Or should they have focused insteadon stabilizing their near-term operating income,reported earnings, and return on equity, or on re-moving some of the volatility from their capitalspending?

Without a clear set of risk-management goals, us-ing derivatives can be dangerous. That has been

t © by the President and Fellows of Harvard College. All rights reserved.

3 by Paulo Beltr?o Fraletti at FGV - EAESP from July 2014 to January 2015.

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made abundantly clear by the numerous cases ofderivatives trades that have backfired in the lastcouple of years. Procter & Gamble’s losses in cus-tomized interest-rate derivatives and Metallge-sellschaft’s losses in oil futures are two of the mostprominent examples. The important point is notthat these companies lost money in derivatives, be-cause even the best risk-management programswill incur losses on some trades. What’s importantis that both companies lost substantialsums of money – in the case of Met-allgesellschaft, more than $1 bil-lion – because they took posi-tions in derivatives that didnot fit well with their corpo-rate strategies.

Our goal in this articleis to present a frameworkto guide top-level man-agers in developing a co-herent risk-managementstrategy – in particular, tomake sensible use of therisk-management fire-power available to themthrough financial deriva-tives.2 Contrary to what seniormanagers may assume, a com-pany’s risk-management strategycannot be delegated to the corporatetreasurer– let alone to a hotshot financial en-gineer. Ultimately, a company’s risk-managementstrategy needs to be integrated with its overall cor-porate strategy.

Our risk-management paradigm rests on threebasic premises:M The key to creating corporate value is makinggood investments.M The key to making good investments is generat-ing enough cash internally to fund those invest-

ments; when companies don’t generate enoughcash, they tend to cut investment more drasticallythan their competitors do. M Cash flow–so crucial to the investment process–can often be disrupted by movements in externalfactors such as exchange rates, commodity prices,

Without a clear set of risk-management goals, usingderivatives can be dangero

92This document is authorized for use only in Gest?o de Riscos e Derivativos_27

and interest rates, potentially compromising a com-pany’s ability to invest.

A risk-management program, therefore, shouldhave a single overarching goal: to ensure that acompany has the cash available to make value-en-hancing investments.

By recognizing and accepting this goal, manag-ers will be better equipped to address the most basic questions of risk management: Which risks

should be hedged and which should beleft unhedged? What kinds of instru-

ments and trading strategies areappropriate? How should a

company’s risk-managementstrategy be affected by itscompetitors’ strategies?

From Pharaoh toModern Finance

Risk management isnot a modern invention.The Old Testament tells

the story of the EgyptianPharaoh who dreamed that

seven healthy cattle weredevoured by seven sickly cat-

tle and that seven healthy earsof corn were devoured by seven

sickly ears of corn. Puzzled by thedream, Pharaoh called on Joseph to interpret

it. According to Joseph, the dream foretold sevenyears of plenty followed by seven years of famine.To hedge against that risk, Pharaoh bought andstored large quantities of corn. Egypt prospered dur-ing the famine, Joseph became the second mostpowerful man in Egypt, the Hebrews followed himthere, and the rest is history.

In the Middle Ages, hedging was made easier bythe creation of futures markets. Rather than buying

and storing crops, consumers couldensure the availability and price of a crop by buying it for delivery at apredetermined price and date. Andfarmers could hedge the risk that theprice of their crops would fall by sell-ing them for later delivery at a pre-determined price.

It is easy to see why Pharaoh, theconsumer, and the farmer would want to hedge.The farmer’s income, for example, is tied closely tothe price he can get for his crop. So any risk-aversefarmer would want to insure his income againstfluctuations in crop prices just as many workingpeople protect their incomes with disability insur-

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ance. It’s not surprising, then, that the first futuresmarkets were developed to enable farmers to insurethemselves more easily.

More recently, large publicly held companieshave emerged as the principal users of risk-manage-ment instruments. Indeed, most new financialproducts are designed to enable corporations tohedge more effectively. But, unlikethe farmer, the consumer, andPharaoh, it is not so clear why a cor-poration would want to hedge. Afterall, corporations are generally ownedby many small investors, each ofwhom bears only a small part of therisk. In fact, Adolf A. Berle, Jr., andGardiner C. Means argue in theirclassic book, The Modern Corporation and PrivateProperty, that the modern corporate form of organi-zation was developed precisely to enable entrepre-neurs to disperse risk among many small investors.If that is true, it’s hard to see why corporationsthemselves also need to reduce risk – investors canmanage risk on their own.

Until the 1970s, finance specialists accepted thislogic. The standard view was that if an investordoes not want to be exposed to, say, theoil-price risk inherent in owningDresser Industries, he can hedgefor himself. For example, he canoffset any loss on his DresserIndustries stock that mightcome from a decline in oilprices by also holding thestocks of companies thatgenerally benefit fromoil-price declines, suchas petrochemical firms.There is thus no reasonfor the corporation tohedge on behalf of the in-vestor. Or, put somewhatdifferently, hedging trans-actions at the corporate lev-el sometimes lose money andsometimes make money, but on av-erage they break even: companies can’tsystematically make money by hedging. Un-like individual risk management, corporate riskmanagement doesn’t hurt, but it also doesn’t help.

Corporate finance specialists will recognize thislogic as a variant of the Modigliani and Miller theo-rem, which was developed in the 1950s and becamethe foundation of “modern finance.” The key in-sight of Franco Modigliani and Merton Miller, eachof whom won a Nobel Prize for his work in this

invca

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area, is that value is created on the left-hand side ofthe balance sheet when companies make good in-vestments – in, say, plant and equipment, R&D, ormarket share – that ultimately increase operatingcash flows. How companies finance those invest-ments on the right-hand side of the balance sheet –whether through debt, equity, or retained earnings–

is largely irrelevant. These decisions about finan-cial policy can affect only how the value created bya company’s real investments is divided among itsinvestors. But in an efficient and well-functioningcapital market, they cannot affect the overall valueof those investments.

If one accepts the view of Modigliani and Miller,it follows almost as a corollary that risk-manage-ment strategies are also of no consequence. They

are purely financial transactions thatdon’t affect the value of a company’s

operating assets. Indeed, once thetransaction costs associated

with hedging instrumentsare factored in, a hard-lineModigliani-Miller disciplewould argue against do-ing any risk manage-ment at all.

Over the past twodecades, however, a dif-ferent view of financialpolicy has emerged that

allows a more integralrole for risk management.

This “postmodern” para-digm accepts as gospel the

key insight of Modigliani andMiller – that value is created only

when companies make good invest-ments that ultimately increase their operat-

ing cash flows. But it goes further by treating finan-cial policy as critical in enabling companies tomake valuable investments. And it recognizes thatcompanies face real trade-offs in how they financetheir investments.3

For example, suppose a company wants to add anew plant that would expand its production capaci-ty. If the company has enough retained earnings to

The key to making goodstments is generating theh to fund them internally.


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n

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pay for the cost of the plant, it will use those fundsto build it. But if the company doesn’t have thecash, it will need to raise capital from one of twosources: the debt market (perhaps through a bankloan or a bond issue) or the equity market.

It is unlikely that the company would decide toissue equity. Indeed, on average, less than 2% of allcorporate financing comes from the external equitymarket.4 Why the aversion to equity? The problemis that it’s difficult for stock market investors to

know the real value of a company’s assets. Theymay get it right on average, but sometimes theyprice the stock too high and sometimes they price ittoo low. Naturally, companies will be reluctant toraise funds by selling stock when they think theirequity is undervalued. And if they do issue equity,it will send a strong signal to the stock market thatthey think their shares are overvalued. In fact,when companies issue equity, the stock price tendsto fall by about 3%.5 The result: most companiesperceive equity to be a costly source of financingand tend to avoid it.

The information problems that limit the appealof equity are of much less concern when it comes to debt: most debt issues – particularly those of in-vestment-grade companies – are easy to value evenwithout precise knowledge of the company’s assets.As a result, companies are usually less worriedabout paying too high an interest rate on their bor-rowings than about getting too low a price for theirequity. It’s therefore not surprising that the bulk ofall external funding is from the debt market.

However, debt financing is not without cost: tak-ing on too much debt limits a company’s ability toraise funds later. No one wants to lend to a compa-ny with a large debt burden, because the companymay use some of the new funds not to invest in productive assets but to pay off the old debt. In theextreme, high debt levels can trigger distress, de-faults, and even bankruptcy. So while companiesoften borrow to finance their investments, there arelimits to how much they can or will borrow.

The bottom line is that financial markets do notwork as smoothly as Modigliani and Miller envi-

The role of risk managemeensure that a company hasthe cash available to makevalue-enhancing investme


sioned. The costs we have outlined make externalfinancing of any form – be it debt or equity – moreexpensive than internally generated funds. Giventhose costs, companies prefer to fund investmentswith retained earnings if they can. In fact, there is afinancial pecking order in which companies relyfirst on retained earnings, then on debt, and, as alast resort, on outside equity.

What is even more striking is that companies seeexternal financing as so costly that they actually

cut investment spending when theydon’t have the internally generatedcash flow to finance all their invest-ment projects. Indeed, one studyfound that companies reduced theircapital expenditures by roughly 35cents for each $1 reduction in cashflow.6 These financial frictions thusdetermine not only how companiesfinance their investments but alsowhether they are able to undertake

those investments in the first place. Internally gen-erated cash is therefore a competitive weapon thateffectively reduces a company’s cost of capital andfacilitates investment.

This is the most critical implication of the post-modern paradigm, and it forms the theoreticalfoundation of the view stated earlier – that the roleof risk management is to ensure that companieshave the cash available to make value-enhancinginvestments. Although the practical implicationsof this idea may seem vague, we will demonstratehow it can help to develop a coherent risk-manage-ment strategy.

Why Hedge?Let’s start with the case of a hypothetical multi-

national pharmaceutical company, Omega Drug.Omega’s headquarters, production facilities, and re-search labs are in the United States, but roughlyhalf of its sales come from abroad, mainly Japan andGermany. Omega has several products that are stillprotected by patents, and it does not expect to in-troduce any new products this year. Omega’s mainuncertainty is the revenue it will receive from for-eign sales. The company can forecast its foreignsales volume very accurately, but the dollar value ofthose sales is hard to pin down because of the un-certainty inherent in exchange rates. If exchangerates remain stable, Omega expects the dollar valueof its cash flow from foreign and domestic opera-tions to be $200 million. If, however, the dollar ap-preciates substantially relative to the Japanese yenand the German mark, then Omega’s cash flow will

t is to

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from Omega &D Investment

rs

Discounted Cash Flows*

160

290

360

Net Present Value*

60

90

60

fall to $100 million, since the weaker yen and markmean that foreign cash flows are worth less in dol-lars. Conversely, a significant dollar depreciationwould increase Omega’s cash flow to $300 million.Each of these scenarios is equally likely.

Like most multinational corporations, Omegafrequently receives calls from investment bankerstrying to persuade the company to hedge its foreign-exchange risk. The bankers typically present an im-pressive set of calculations showing how Omegacan reduce the risk in its earnings, cash flow, stockprice, and return on equity simply by trading on for-eign-exchange markets. So far, Omega has resistedthose overtures and has chosen not to engage in anysubstantial foreign-exchange hedging. “After all,”Omega’s top-level officers haveargued, “we’re a pharmaceuticalcompany, not a bank.”

Omega has one thing going forit: a healthy skepticism of bank-ers trying to sell their financialservices. But the bankers alsohave something going for them:the skills to insulate companiesfrom financial risk. What neitherthe company nor the bankershave is a well-articulated view ofthe role of risk management.

The starting point for our anal-ysis is understanding the link be-tween Omega’s cash flows and its strategic investments, princi-pally its R&D program. R&D is the key to suc-cess in the pharmaceutical business, and its impor-tance has grown dramatically during the last twodecades. Twenty years ago, Omega was spending8% of sales on R&D; now it is spending 12% ofsales on R&D.

Last year, Omega’s R&D budget was $180 mil-lion. In the coming year, the company would like tospend $200 million. Omega arrived at this figure byfirst forecasting the increase in patentable productsthat would result from a particular level of R&D.As a second step, managers valued the increasedcash flows through a discounted-cash-flow analy-sis. Such an approach could generate only rough es-timates of the value of R&D because of the uncer-tainty inherent in the R&D process, but it was thebest Omega could do. Specifically, the company’scalculations indicated that an R&D budget of $200million would generate a net present value of $90million, compared with $60 million for R&D bud-gets of $100 million and $300 million. (See the table“Payoffs from Omega Drug’s R&D Investment.”)The company took comfort in the knowledge that

PayoffsDrug’s R

*in millions of dolla

R&D Level*

100

200

300


the $200 million budget was, on a relative basis,roughly in line with the budgets of its principalcompetitors.

Given its comparatively high leverage and limit-ed collateral, Omega is not in a position to borrowany funds to finance its R&D program. It is also re-luctant to issue equity. That leaves internally gen-erated cash as the only funding source that Omega’smanagers are prepared to tap for the R&D program.Therefore, fluctuations in the dollar’s exchangerate can be critical. If the dollar appreciates, Omegawill have a cash flow of only $100 million to allo-cate to its R&D program – well below the desired$200 million budget. A stable dollar will generateenough cash flow for the program, while a depreci-

ating dollar will generate an excess of $100 million.(See the table “The Effect of Hedging on OmegaDrug’s R&D Investment and Value.”)

Will Omega be better off if it hedges? SupposeOmega tells its bankers to trade on its behalf so thatthe company’s cash flows are completely insulatedfrom foreign-exchange risk. If the dollar appreci-ates, the trades will generate a $100 million gain; ifthe dollar depreciates, they’ll post a $100 millionloss. The trades will generate no gain or loss if thedollar remains at its current level. Effectively, thehedging program locks in net cash flows of $200million for Omega – the cash flows that the com-pany would receive at prevailing exchange rates.Whatever the exchange rate turns out to be, Omegawill have $200 million available for R&D – just theright amount.

If Omega doesn’t hedge, it will be able to investonly $100 million in R&D if the dollar appreciates.By hedging, Omega is able to add $100 million ofR&D in this scenario, increasing discounted futurecash flows by $130 million (from $160 million to$290 million). On the other hand, if the dollar de-


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*in millions of dollars

100

200

300

100

200

200

+100

0

–100

100

0

0

+130

0

–100

The Dollar

Appreciation

Stable

Depreciation

The Effect of Hedging on Omega Drug’s R&D Investment and Value

Internal Funds*

R&D Without Hedging*

Hedge Proceeds*

Additional R&D from Hedging*

Value from Hedging*

en

preciates, Omega will lose $100 million on its for-eign-exchange transactions. However, the $130million gain clearly outweighs the $100 millionloss. Overall, Omega is better off if it hedges.

Although this example is highly stylized, it illus-trates a basic principle. In general, the supply of in-ternally generated funds does not equal the invest-ment demand for funds. Sometimes there is anexcess supply; sometimes there is a shortage. Be-cause external financing is costly, this imbalanceshifts investment away from the optimal level.Risk management can reduce this imbalance andthe resulting investment distortion. It enables com-panies to better align their demand for funds withtheir internal supply of funds. That is, risk manage-ment lets companies transfer funds from situationsin which they have an excess supply to situationsin which they have a shortage. In essence, it allowscompanies to borrow from themselves.

Here’s another way to look at what happens. As the dollar depreciates, the internal supply offunds – Omega’s cash flow – increases. The demand

for funds – the desired level of investment – is fixedand independent of the exchange rate. When thecompany doesn’t hedge, demand and supply areequal only if the dollar remains stable. If the dollardepreciates, however, supply exceeds demand; if itappreciates, supply falls short of demand. By hedg-

Risk management enablescompanies to become bettaligning the demand for fuwith the internal supply of


ing, the company reduces supply when there is ex-cess supply and increases supply when there is ashortage. This aligns the internal supply of fundswith the demand for funds. Of course, the averagesupply of funds doesn’t change with hedging, be-cause hedging is a zero-net-present-value invest-ment: it does not create value by itself. But it en-sures that the company has the funds preciselywhen it needs them. Because value is ultimatelycreated by making sure the company undertakesthe right investments, risk management adds realvalue. (See the graph “Omega Drug: Hedging withFixed R&D Investment.”)

When to Hedge–or NotThe basic principle outlined above is just a first

step. The real challenge of risk management is toapply it to developing strategies that deal with thevariety of risks faced by different companies.

What we have argued so far is that companiesshould use risk management to align their internal

supply of funds with their demandfor funds. In the case of Omega Drug,that means hedging all the exchange-rate risk. Since we have assumedthat the demand for funds – the de-sired amount of investment – isn’t affected by exchange rates, Omegashould stabilize its supply by in-sulating its cash flows from anychanges in exchange rates. This as-sumption may be reasonable in the

case of Omega because it is unlikely that the val-ue of investing in R&D in pharmaceuticals woulddepend very much on exchange rates. But there are many instances in which exchange rates, com-modity prices, or interest rates do affect the valueof a company’s investment opportunities. Under-

r atds

funds.


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standing the connection between a company’s in-vestment opportunities and those key economicvariables is critical to developing a coherent risk-management strategy.

Take the case of an oil company. The main risk itfaces is changes in the price of oil. When oil pricesfall, cash flows decline because existing oil proper-ties produce less revenue. Therefore, the company’ssupply of internal funds is exposed to oil-price riskin much the same way that a multinational drugcompany’s cash flows are exposed to foreign-ex-change risk.

However, while the value of pharmaceuticalR&D investment is unaffected by exchange rates,the value of investing in the oil business falls whenoil prices drop. When prices are low, it’s less attrac-tive to explore for and develop new oil reserves. Sowhen the supply of funds is low, so is the demandfor funds. On the flip side, when oil prices rise, cashflows rise and the value of investing rises. Supplyand demand are both high. For an oil company,much more than for a pharmaceutical company,the supply of funds tends to match the demand forfunds even if the company does not actively man-age risk. As a result, there is less reason for an oilcompany to hedge than there is for a multinationalpharmaceutical company.

Omega Drug: Hedging with Fixed R&D Investment

Supply of Internal Funds (cash flow from operations)

Stable Dollar

Hedging

Hedging Demand for Funds (desired R&D investment)

Appreciating Dollar

Depreciating Dollar

To illustrate the differencemore clearly, let’s change someof the numbers in our OmegaDrug example and rename thecompany Omega Oil. Let’s sup-pose there are three possible oilprices – low, medium, and high –which generate cash flows of$100 million, $200 million, and$300 million, respectively. Thehigher the oil price, the more revenue Omega Oil generates onits existing reserves.

So far, the example is exactlythe same as before. Where it dif-fers is on the investment side.The optimal amount of invest-ment in the low-oil-price regimeis $150 million; in the medium-oil-price regime, it’s $200 mil-lion; and in the high-oil-priceregime, it’s $250 million. Thus,higher oil prices make exploringfor and developing oil reservesmore attractive. In this example,the supply of funds is not too faroff from the demand for fundseven if Omega Oil doesn’t hedge.


Omega Oil sometimes has an excess demand of $50million and sometimes an excess supply of $50 mil-lion; with Omega Drug, the excess demand and ex-cess supply were $100 million. Omega Oil, there-fore, doesn’t need to hedge its oil-price risk as muchas Omega Drug needed to hedge its foreign-ex-change risk. Roughly speaking, the optimal hedgefor Omega Oil is only half that for Omega Drug.

Here the demand for funds increases with theprice of oil. (See the graph “Omega Oil: Hedgingwith Oil-Price-Sensitive Investment.”) The differ-ence between supply and demand is smaller in theexample of the oil company than it is when the in-vestment level is fixed, as it was with Omega Drug.To align supply with demand, Omega Oil doesn’tneed to hedge as much as Omega Drug did. Essen-tially, Omega Oil already has something of abuilt-in hedge.

An important point emerges from this example:A proper risk-management strategy ensures thatcompanies have the cash when they need it for in-vestment, but it does not seek to insulate themcompletely from risks of all kinds.

If Omega Oil follows our recommended strategyand hedges oil-price risk only partially, then itsstock price, earnings, return on equity, and anynumber of other performance measures will fluc-


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tuate with the price of oil. When oil prices are low, Omega is worth less: the company’s existingproperties are less valuable, and it will invest less.It’s simply less profitable to be in the oil business,and this will be reflected in Omega’s performancemeasures. But there’s nothing a risk-managementprogram can do to improve the underlying bad economics of low oil prices. The goal of risk man-agement is not to insure investors and corporatemanagers against oil-price risk per se. It is to en-sure that companies have the cash they need to create value by making good investments.

In fact, attempting to insulate investors com-pletely from oil-price risk could actually destroyvalue. For example, if Omega Oil were to hedge ful-ly, it would actually have an excess supply of fundswhen oil prices fall: its cash flow would be stabi-lized at $200 million, and its investment needswould be only $150 million. But when oil prices arehigh, just the opposite would be true: the companywould lose so much money on its hedging positionthat it would have a shortage of funds for invest-ment. Its net cash flows would still be only $200million, but its investment needs would rise to$250 million. In this case, hedging fully would pre-vent the company from making value-enhancinginvestments.

98

Supply of Internal Funds(cash flow from operatio

Current Oil Price

Demand for Fund(desired investme

Lower Oil Price O

Hedging

He

Omega Oil: Hedging with Oil-Price-Sensitive Investment

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This approach helps managers address two keyissues. First, it helps them identify what is worthhedging and what isn’t. Worrying about stock-pricevolatility in and of itself isn’t worthwhile; suchvolatility can be better managed by individual in-vestors through their portfolio strategies. By con-trast, excessive investment volatility can threatena company’s ability to meet its strategic objectivesand, as a result, is worth controlling through riskmanagement.

Second, this approach helps managers figure outhow much hedging is necessary. If changes in ex-change rates, commodity prices, and interest rateslead to large imbalances in the supply and demandfor funds, then the company should hedge aggres-sively; if not, the company has a natural hedge, andit does not need to hedge as much.

Managers who adopt our approach should askthemselves two questions: How sensitive are cashflows to risk variables such as exchange rates, com-modity prices, and interest rates? and How sensi-tive are investment opportunities to those risk vari-ables? The answers will help managers understandwhether the supply of funds and the demand forfunds are naturally aligned or whether they can bebetter aligned through risk management.

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by Paulo Beltr?o Fraletti

Guidelines for ManagersWhat follow are some guide-

lines for how managers can thinkabout risk-management issues.Although these are by no meansthe only issues to consider, oursuggestions should provide man-agers with useful direction.M Companies in the same indus-try should not necessarily adoptthe same hedging strategy. To un-derstand why, take the case of oil.Even though all oil companies areexposed to oil-price risk, somemay be exposed more than othersin both their cash flows and theirinvestment opportunities. Let’scompare Omega Oil with EpsilonOil. Omega has existing reservesin Saudi Arabia that are a rela-tively cheap source of oil, where-as Epsilon gets its oil from theNorth Sea, which is a relativelyexpensive source. If the price ofoil falls dramatically, Epsilonmay be forced to shut down thosereserves altogether, wiping out an

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Demystifying Derivatives

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At first glance, the list of derivative products looksbewilderingly long. Forwards, futures, options, swaps,caps, and floors are just some of the more commonlyused derivatives, and new ones are being designed allthe time. However, all these products are derived fromjust two basic building blocks: forwards and options.Understanding how these two instruments work goesa long way toward demystifying derivatives.

Forward-Based Contracts:Forwards, Swaps, and Futures

Perhaps the most basic type of derivative is the for-ward contract. With a forward, the user promises tobuy or sell an asset –say, oil, Treasury bills, or yen–at aspecified price on a specified date. For example, a longforward position of 1,000 barrels of oil at a price of $20per barrel, with a one-year maturity, obligates the userto buy 1,000 barrels of oil one year hence for $20,000.A short forward position obligates the user to deliver1,000 barrels of oil (or its cash equivalent) for $20,000.Long positions enable hedgers to protect themselvesagainst price increases in the underlying asset; shortpositions protect hedgers against price decreases.

Forward contracts have four important features:Linearity. Forward contracts are linear: the gain

when the value of the underlying asset moves in onedirection is equal to the loss when the value of the as-set moves by the same amount in the opposite direc-tion. In the long forward position described above, theuser makes a $1,000 profit when the oil price rises by$1 and loses $1,000 when it falls by $1.

No Money Down. When a forward contract is initi-ated, no money changes hands.

Settlement at Maturity. Forward contracts are notsettled until their maturity date. In the case of the oilforward, no money changes hands for a year. Whilethis feature may be convenient to hedgers, it comeswith a price: there is a risk –known as “counterparty”risk – that the other party will be unable to meet itsobligations on the maturity date.

Customization. Since forwards are privately ar-ranged (traded over the counter) and not traded on anexchange, the terms of the forward – for example, thematurity date and the characteristics of the underly-ing asset–can be customized for the users.

Swaps are packages of forward contracts and shareall the same basic features. They can be used to createhedges that extend over several time periods. A com-pany that issues ten-year floating-rate debt requir-ing annual interest payments, for instance, can use aswap to convert its floating-rate liability to a fixed-rate obligation, thereby hedging against interest-rateincreases. Such a swap is just a bundle of interest-rateforward contracts: one with a one-year maturity, anoth-er with a two-year maturity, and so on, up to ten years.

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Futures contracts are also closely related to for-wards. However, they are marked to market on a dailybasis. In other words, cash is paid in by the user to cov-er any losses on the transaction, and it is paid out tothe user to reflect any profits. The advantage of mark-ing to market is that it greatly reduces counterpartyrisk. This feature enables futures to be traded anony-mously on large exchanges, thereby generating bothmore liquidity and more competitive pricing.

Option-Based Contracts: Options, Caps, and Floors

The other building-block financial instrument isthe option contract. It differs from a forward in thatthe holder of an option can choose to buy or sell theunderlying asset at a specified price on a specified datebut is not obligated to do so. For example, a call optionon oil might grant the user the right to buy 1,000 bar-rels of oil at a price of $20 per barrel anytime betweennow and one year hence. Conversely, with a put op-tion, the user would have the right to sell the oil at theagreed-upon price. Like long forward positions, calloptions protect hedgers against increases in the priceof the underlying asset; like short forward positions,put options protect hedgers against price decreases.

Option-based contracts can be analyzed along thesame four dimensions as forward-based contracts:

Nonlinearity. The fact that one is not obligated toexercise an option means that its payoffs are nonlin-ear, or asymmetrical, with respect to gains and losses.The holder of a call option on oil can profit a great dealif oil prices rise; if oil prices fall, however, the option issimply not exercised and the holder can walk awaywithout taking any losses.

Money Down. Unlike forward-based contracts, op-tions require an initial investment when the positionis established. The user pays an option premium upfront in exchange for the right to walk away later on.

Settlement at Exercise. While forwards are settledwhen they mature, options are settled when they areexercised, which may occur before the maturity date.They are typically not marked to market, so beyondthe initial premium no further money changes handsuntil they are exercised.

Customization. Options are available both on ex-changes and over the counter. The over-the-countermarket offers greater opportunity for customization.

Caps and floors are to option contracts what swapsare to forward contracts: a cap is simply a package ofcall options, and a floor a package of put options. Forexample, if a company issues ten-year floating-ratedebt that requires annual interest payments, it mightsimultaneously purchase a cap that ensures that its to-tal interest costs do not exceed some target level. Sucha cap would simply be a series of call options on theunderlying interest rate.


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RISK MANAGEMENT

important source of its cash flow. Omega wouldcontinue to operate its reserves because the cost oftaking the oil out of the ground is still less than theoil price. Therefore, Epsilon’s cash flows are moresensitive to the price of oil. Hedging is more valu-able for Epsilon than it is for Omega because Ep-silon’s supply of funds is less in sync with its de-mand for funds.

Similar logic applies when the two oil companiesdiffer in their investment opportunities.Suppose instead that Omega and Ep-silon both have essentially thesame cash-flow streams fromtheir existing oil properties,but Epsilon is trying to de-velop new reserves in theNorth Sea, and Omega inSaudi Arabia. When theprice of oil drops, it mayno longer be worthwhileto try to develop re-serves in the North Sea,since it is an expensivesource of oil, but it maybe worthwhile to do so in Saudi Arabia. Thus, thedrop in the oil price affectsboth companies’ cash flowsequally, but Epsilon’s investmentopportunities fall more than Omega’sdo. Because Epsilon’s demand for funds ismore in line with its supply of funds, Epsilon hasless incentive to hedge than Omega does.

Again, a simple message emerges: To develop acoherent risk-management strategy, companiesmust carefully articulate the nature of both theircash flows and their investment opportunities.Once they have done this, their efforts to align thesupply of funds with the demand for funds will gen-erate the right strategies for managing risk. M Companies may benefit from risk managementeven if they have no major investments in plantand equipment. We define investment very broadlyto include not just conventional investments suchas capital expenditures but also investments in in-tangible assets such as a well-trained workforce,brand-name recognition, and market share.

In fact, companies that make these sorts of in-vestments may need to be even more active aboutmanaging risk. After all, a capital-intensive compa-ny can use its newly purchased plant and equip-ment as collateral to secure a loan. “Softer” invest-ments are harder to collateralize. It may not be soeasy for a company to raise capital from a bank tofund, say, short-term losses that result from a poli-


cy of pricing low to build market share. For compa-nies that make such investments, internally gener-ated funds are especially important. As a result,there may be an even greater need to align the sup-ply of funds with the demand for funds through riskmanagement.M Even companies with conservative capital struc-tures – no debt, lots of cash – can benefit from hedg-ing. At first glance, it might appear that a company

with a very conservative capital structureshould be less interested in risk man-

agement. After all, such a compa-ny could adjust rather easily to

a large drop in cash flow byborrowing at relatively lowcost. It wouldn’t need tocurtail investment, andcorporate value wouldnot suffer much. The ba-sic objective of risk man-agement – aligning thesupply of internal fundswith the demand for in-

vestment funding – hasless urgency in this type of

situation because managerscan easily adjust to a supply

shortfall by borrowing. To besure, hedging wouldn’t hurt, but it

might not help much either.But managers in this position should ask

themselves why they have chosen such a conserva-tive capital structure. If the answer is, The world isa risky place, and you never know what can happento exchange rates or interest rates, they have morethinking to do. What they have done is use lowleverage instead of, say, the derivatives markets toprotect against the risk in those economic vari-ables. An alternative strategy would be to take onmore debt and then hedge those risks directly in thederivatives markets. In fact, there’s something to besaid for the second approach: it’s no more risky interms of the ability to make good investments thanthe low-debt/no-hedging strategy, but, in manycountries, the added debt made possible by hedgingallows a company to take advantage of the tax de-ductibility of interest payments. M Multinational companies must recognize thatforeign-exchange risk affects not only cash flowsbut also investment opportunities. A number ofcomplex issues arise with multinationals, butmany of them can be illustrated with two exam-ples. In each example, a company is planning tobuild a plant in Germany to manufacture cameras.In Example 1 it will sell the cameras in Germany,


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while in Example 2 it will sell them in the UnitedStates. In both cases, most of the company’s cashflows come from its other businesses in the UnitedStates. How aggressively should it hedge the dol-lar/mark exchange rate?

Example 1. If the dollar depreciates relative to themark, it will become more expensive (in dollarterms) to build the plant in Germany. But this doesnot mean that the company will want to build asmaller plant – or scrap the plant altogether – be-cause the marks it receives from selling cameras inGermany will also be worth more in dollars. In oth-er words, because the plant’s costs and revenues areboth mark-denominated, as long as the plant is eco-nomically attractive today, it will still be attractiveif the dollar/mark rate changes. Therefore, just asOmega Drug wants to maintain its R&D despitethe dollar’s appreciation, this company would wantto maintain its investment in Germany despite thedollar’s depreciation. This calls for fairly aggressivehedging against a depreciation in the dollar to en-sure that the company has enough marks to buildthe plant.

Example 2. The answer here is a bit more com-plex. Since the company is now manufacturingcameras for export back to the United States, a de-preciation in the dollar makes it less attractive tomanufacture in Germany. Dollar-denominated la-bor costs are simply higher when the mark is morevaluable. Thus, any depreciation in the dollar raisesthe dollar cost of building the plant. But it also re-duces the dollar income the company would re-ceive from the plant. As a result, the companymight want to scale back its investment or scrapthe plant when the dollar depreci-ates. The value of investing falls, sothere’s less reason to hedge than inExample 1. This case is analogous tothat of Omega Oil in that risk thathurts cash flows – namely, a depre-ciation of the dollar relative to themark – also diminishes the appeal ofinvesting. As a result, there is lessreason to hedge the risk.

Of course, this assumes that thecompany hasn’t yet committed to building theplant. If it has, then it would make sense to hedgethe short-term risk of a dollar depreciation to en-sure that the funds are available to continue theproject. But if it hasn’t committed, it is less impor-tant to hedge the longer-term risks.M Companies should pay close attention to thehedging strategies of their competitors. It is tempt-ing for managers to think that if the competitiondoesn’t hedge, then their company doesn’t need to,

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either. However, there are some situations inwhich a company may have even greater reason tohedge if its competitors don’t. Let’s continue withthe example of the camera company that is consid-ering building capacity to manufacture and sellcameras in Germany. Suppose now that its com-petitors – other camera companies with revenuesmostly in dollars – are also considering building ca-pacity in Germany.

If its competitors choose not to hedge, they won’tbe in a strong position to add capacity if the dollardepreciates: they will find themselves short ofmarks. But that is precisely the situation in whichthe company wants to build its plant – when itscompetitors’ weakness reduces the likelihood of industry overcapacity; this makes its investment inGermany more attractive. Therefore, the companyshould hedge to make sure it has enough cash forthis investment.

This is just another example of how clearly artic-ulating the nature of investment opportunities caninform a company’s risk-management strategy; inthis case, the investment opportunities depend onthe overall structure of the industry and on the fi-nancial strength of its competitors. Thus, the sameelements that go into formulating a competitivestrategy should also be used to formulate a risk-management strategy. M The choice of specific derivatives cannot simplybe delegated to the financial specialists in the com-pany. It’s true that many of the more technical as-pects of derivatives trading are best left to the tech-nical finance staff. But senior managers need tounderstand how the choices of financial instru-

ments link up with the broader issues of risk-man-agement strategy that we have been exploring.

There are two key features of derivatives that acompany must keep in mind when evaluatingwhich ones to use. The first is the cash-flow impli-cations of the instruments. For example, futurescontracts are traded on an exchange and require acompany to mark to market on a daily basis – thatis, to put up money to compensate for any short-term losses. These expenditures can cut into the

The choice of specificvatives should not simply elegated to the company’s

financial specialists.


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RISK MANAGEMENT

1. The study, reported in Derivatives: Practices and Principles, was con-ducted by the Group of Thirty, an independent study group in Washing-ton, D.C., made up of economists, bankers, and policymakers.

2. A more technical article on this subject, “Risk Management: Coordinat-ing Corporate Investment and Financing Policies,” was published by the au-thors in the Journal of Finance, vol. 48, 1993, p. 1629.

3. This view has been advanced in an influential series of papers by Stew-art C. Myers of MIT’s Sloan School of Management: “The Determinantsof Corporate Borrowing,” Journal of Financial Economics, vol. 4, 1977, p. 147; “Corporate Financing and Investment Decisions When Firms HaveInformation That Investors Do Not Have,” coauthored with NicholasMajluf, Journal of Financial Economics, vol. 13, 1984, p. 187; and “TheCapital Structure Puzzle,” Journal of Finance, vol. 39, 1984, p. 575.

4. See, for example, Jeffrey MacKie-Mason, “Do Firms Care Who ProvidesTheir Financing?” in Asymmetric Information, Corporate Finance, andInvestment, ed. R. Glenn Hubbard (Chicago: University of Chicago Press,1990), p. 63.

5. Paul Asquith and David Mullins, “Equity Issues and Offering Dilu-tion,” Journal of Financial Economics, vol. 15, 1986, p. 61.

6. See, for example, Steven Fazzari, R. Glenn Hubbard, and Bruce Petersen, “Financing Constraints and Corporate Investment,” BrookingsPapers on Economic Activity, no. 1, 1988, p. 141.

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cash a company needs to finance current invest-ments. In contrast, over-the-counter forward con-tracts–which are customized transactions arrangedwith derivatives dealers–do not have this drawbackbecause they do not have to be settled until the con-tract matures. However, this advantage will proba-bly come at some cost: when a dealer writes thecompany a forward, he will charge a premium forthe risk that he bears by not extracting any pay-ments until the contract matures.

The second feature of derivatives that should bekept in mind is the “linearity” or “nonlinearity” ofthe contracts. Futures and forwards are essentiallylinear contracts: for every dollar the company gainswhen the underlying variable moves in one direc-tion by 10%, it loses a dollar when the underlyingvariable moves in the other direction by 10%. Bycontrast, options are nonlinear in that they allowthe company to put a floor on its losses withouthaving to give up the potential for gains. If there is a minimum amount of investment a company needsto maintain, options can allow it to lock in the nec-essary cash. At the same time, they provide theflexibility to increase investment in good times.

Again, the decision of which contract to useshould be driven by the objective of aligning the de-mand for funds with the supply of internal funds. Askillful financial engineer may be good at pricingintricate financial contracts, but this alone does notindicate which types of contracts fit best with acompany’s risk-management strategy.

An important corollary to this point is that itprobably makes good sense to stay away from themost exotic, customized hedging instruments un-less there is a very clear investment-side justifica-tion for their use. Dealers make more profit sellingcutting-edge instruments, for which competition isless intense. And each additional dollar of profit go-ing to the dealer is a dollar less of value available to


shareholders. So unless a company can explain whyan exotic instrument protects its investment op-portunities better than a plain-vanilla one, it’s bet-ter to go with plain vanilla.

Where do managers go from here? The first step–which may be the hardest – is to realize that theycannot ignore risk management. Some managersmay be tempted to do so in order to avoid high-pro-file blunders like those of Procter & Gamble andMetallgesellschaft. But, as the Dresser Industriesand Caterpillar examples show, this head-in-the-sand approach has costs as well. Nor can risk man-agement simply be handed off to the financial staff.That approach can lead to poor coordination withoverall corporate strategy and a patchwork of de-rivatives trades that may, when taken together, re-duce overall corporate value. Instead, it’s critical for a company to devise a risk-management strate-gy that is based on good investments and is alignedwith its broader corporate objectives.


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