ife is punctuated by unforeseen and unforeseeable shocks. Wars, banking and currency crises, political upheavals, pandemics, and natural catastrophes such as earthquakes and floods can all cause severe economic disruption. For example, if you want to make your hair stand on end, look at Table 26.1, which lists some of the greatest macroeconomic disasters in the past 100 years.
Major catastrophes such as those in Table 26.1 are, fortunately, rare. However, most companies are hit from time to time by potentially ruinous shocks. Good managers try to ensure that their companies are not overwhelmed by them. They check that their company has reserve borrowing power to tide them over difficult periods, they maintain sufficient liquid assets to protect the firm from a possible banking or currency crisis, and they ensure that the firm is not overly dependent on a single source of materials or a single outlet for its products.
Most of the time we take risk as God-given. A company’s cash flow is exposed to changes in demand, raw material costs, technology, and a seemingly endless list of other uncertainties. There’s nothing the manager can do about it other than to ensure that the business is not overwhelmed.
That’s not wholly true. The manager can avoid some risks. We have already come across one way to do so: Firms can use real options to provide flexibility. For example, a petrochemical plant that is designed to use either oil or natural gas as a feedstock reduces the risk of an unfavorable shift in the price of raw materials. As another example, think of a company that employs standard machine tools rather than custom machinery and thereby lowers the cost of bailing out if its products do not sell. In other words, the standard machinery provides the firm with a valuable abandonment option.
We covered real options in Chapter 22. This chapter explains how companies also use financial contracts to protect against various hazards. We discuss the pros and cons of corporate insurance policies that protect against specific risks, such as fire, floods, or environmental damage. We then describe forward and futures contracts, which can be used to lock in the future price of commodities such as oil, copper, or soybeans. Financial forward and futures contracts allow the firm to lock in the prices of financial assets such as interest rates or foreign exchange rates. We also describe swaps, which are packages of forward contracts.
Most of this chapter describes how financial contracts may be used to reduce business risks. But why bother? Why should shareholders care whether the company’s future profits are linked to future changes in interest rates, exchange rates, or commodity prices? We start the chapter with that question.
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