Why Manage Risk?

Financial transactions undertaken solely to reduce risk do not add value in perfect and effi­cient markets. Why not? There are two basic reasons.

• Reason 1: Hedging is a zero-sum game. A corporation that insures or hedges a risk does not eliminate it. It simply passes the risk to someone else. For example, suppose that a heating-oil distributor contracts with a refiner to buy all of next winter’s heating-oil deliveries at a fixed price. This contract is a zero-sum game because the refiner loses what the distributor gains, and vice versa.² If next winter’s price of heating oil turns out to be unusually high, the distributor wins from having locked in a below-market price, but the refiner is forced to sell below the market. Conversely, if the price of heating oil is unusually low, the refiner wins because the distributor is forced to buy at the high fixed price. Of course, neither party knows next winter’s price at the time that the deal is struck, but they consider the range of possible prices, and in an efficient market they negotiate terms that are fair (zero-NPV) on both sides of the bargain.

• Reason 2: Investors’ do-it-yourself alternative. Corporations cannot increase the value of their shares by undertaking transactions that investors can easily do on their own. When the shareholders in the heating-oil distributor made their investment, they were presum­ably aware of the risks of the business. If they did not want to be exposed to the ups and downs of energy prices, they could have protected themselves in several ways. Perhaps they bought shares in both the distributor and refiner, and do not care whether one wins next winter at the other’s expense.

Of course, shareholders can adjust their exposure only when companies keep investors fully informed of the transactions that they have made. For example, when a group of Euro­pean central banks announced in 1999 that they would limit their sales of gold, the gold price immediately shot up. Investors in gold-mining shares rubbed their hands at the prospect of rising profits. But when they discovered that some mining companies had protected themselves against price fluctuations and would not benefit from the price rise, the hand­rubbing by investors turned to hand-wringing.

Some stockholders of these gold-mining companies wanted to make a bet on rising gold prices; others didn’t. But all of them gave the same message to management. The first group said, “Don’t hedge! I’m happy to bear the risk of fluctuating gold prices, because I think gold prices will increase.” The second group said, “Don’t hedge! I’d rather do it myself.” We have seen this do-it-yourself principle before. Think of other ways that the firm could reduce risk. It could do so by diversifying, for example, by acquiring another firm in an unrelated industry. But we know that investors can diversify on their own, and so diversification by corporations is redundant.^[2]

Corporations can also lessen risk by borrowing less. But we showed in Chapter 17 that just reducing financial leverage does not make shareholders any better or worse off, because they can instead reduce financial risk by borrowing less (or lending more) in their personal accounts. Modigliani and Miller (MM) proved that a corporation’s debt policy is irrelevant in perfect financial markets. We could extend their proof to say that risk management is also irrelevant in perfect financial markets.

Of course, in Chapter 18, we decided that debt policy is relevant, not because MM were wrong, but because of other things, such as taxes, agency problems, and costs of financial distress. The same line of argument applies here. If risk management affects the value of the firm, it must be because of “other things,” not because risk shifting is inherently valuable.

Let’s review the reasons that risk-reducing transactions can make sense in practice.^[3]

1. Reducing the Risk of Cash Shortfalls or Financial Distress

Transactions that reduce risk make financial planning simpler and reduce the odds of an embarrassing cash shortfall. This shortfall might mean only an unexpected trip to the bank, but a financial manager’s worst nightmare is landing in a financial pickle and having to pass up a valuable investment opportunity for lack of funds. In extreme cases an unhedged setback could trigger financial distress or even bankruptcy.

Banks and bondholders recognize these dangers. They try to keep track of the firm’s risks, and before lending, they may require the firm to carry insurance or to implement hedging programs. Risk management and conservative financing are therefore substitutes, not comple­ments. Thus, a firm might hedge part of its risk in order to operate safely at a higher debt ratio.

Smart financial managers make sure that cash (or ready financing) will be available if investment opportunities expand. That happy match of cash and investment opportunities does not necessarily require hedging, however. Let’s contrast two examples.

Cirrus Oil produces from several oil fields and also invests to find and develop new fields. Should it lock in future revenues from its existing fields by hedging oil prices? Probably not, because its investment opportunities expand when oil prices rise and contract when they fall. Locking in oil prices could leave it with too much cash when oil prices fall and too little, relative to its investment opportunities, when prices rise.

Cumulus Pharmaceuticals sells worldwide and half of its revenues are received in foreign currencies. Most of its R&D is done in the United States. Should it hedge at least some of its foreign exchange exposure? Probably yes, because pharmaceutical R&D programs are very expensive, long-term investments. Cumulus can’t turn its R&D program on or off depending on a particular year’s earnings, so it may wish to stabilize cash flows by hedging against fluc­tuations in exchange rates.

2. Agency Costs May Be Mitigated by Risk Management

In some cases, hedging can make it easier to monitor and motivate managers. Suppose your confectionery division delivers a 60% profit increase in a year when cocoa prices fall by 12%. Does the division manager deserve a stern lecture or a pat on the back? How much of the profit increase is due to good management and how much to lower cocoa prices? If the cocoa prices were hedged, it’s probably good management. If they were not hedged, you will have to sort things out with hindsight, probably by asking, “What would profits have been if cocoa prices had been hedged?”

The fluctuations in cocoa prices are outside the manager’s control. But she will surely worry about cocoa prices if her bottom line and bonus depend on them. Hedging prices ties her bonus more closely to risks that she can control and allows her to spend worrying time on these risks.

Hedging external risks that would affect individual managers does not necessarily mean that the firm ends up hedging. Some large firms allow their operating divisions to hedge away risks in an internal “market.” The internal market operates with real (external) market prices, transferring risks from the division to the central treasurer’s office. The treasurer then decides whether to hedge the firm’s aggregate exposure.

This sort of internal market makes sense for two reasons. First, divisional risks may cancel out. For example, your refining division may benefit from an increase in heating-oil prices at the same time that your distribution division suffers. Second, because operating managers do not trade actual financial contracts, there is no danger that the managers will cause the firm to take speculative positions. For example, suppose that profits are down late in the year, and hope for end-year bonuses is fading. Could you be tempted to make up the shortfall with a quick score in the cocoa futures market? Well . . . not you, of course, but you can probably think of some acquaintances who would try just one speculative fling.

The dangers of permitting operating managers to make real speculative trades should be obvious. The manager of your confectionery division is an amateur in the cocoa futures market. If she were a skilled professional trader, she would probably not be running chocolate factories.^[4]

Risk management requires some degree of centralization. These days many companies appoint a chief risk officer to develop a risk strategy for the company as a whole. The risk manager needs to come up with answers to the following questions:

1. What are the major risks that the company is facing and what are the possible consequences? Some risks are scarcely worth a thought, but there are others that might cause a serious setback or even bankrupt the company.
2. Is the company being paid for taking these risks? Managers are not paid to avoid all risks, but if they can reduce their exposure to risks for which there are no corresponding rewards, they can afford to place larger bets when the odds are stacked in their favor.
3. How should risks be controlled? Should the company reduce risk by building extra flexibility into its operations? Should it change its operating or financial leverage?

Or should it insure or hedge against particular hazards?

3. The Evidence on Risk Management

Which firms use financial contracts to manage risk? Almost all do to some extent. For exam­ple, they may have contracts that fix prices of raw materials or output, at least for the near future. Most take out insurance policies against fire, accidents, and theft. In addition, as we shall see, managers employ a variety of specialized tools for hedging risk. These are known collectively as derivatives. A survey of the world’s 500 largest companies found that most of them use derivatives to manage their risk.⁷ Eighty-three percent of the companies employ derivatives to control interest rate risk. Eighty-eight percent use them to manage currency risk, and 49% to manage commodity price risk.

Risk policies differ. For example, some natural resource companies work hard to hedge their exposure to price fluctuations; others shrug their shoulders and let prices wander as they may. Explaining why some hedge and others don’t is not easy. Peter Tufano’s study of the gold-mining industry suggests that managers’ personal risk aversion may have something to do with it. Hedging of gold prices appears to be more common when top management has large personal shareholdings in the company. It is less common when top management holds lots of stock options. (Remember that the value of an option falls when the risk of the underly­ing security is reduced.) David Haushalter’s study of oil and gas producers found the firms that hedged the most had high debt ratios, no debt ratings, and low dividend payouts. It seems that for these firms hedging programs were designed to improve the firms’ access to debt finance and to reduce the likelihood of financial distress.⁸

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.