The Nature of Risk
Management
Alicia Garcia
What is it?
A potential gain or loss that occurs as a result
of an exchange rate change.
Should Firms Manage Risk?
They consider any use of risk management tools, such as
forwards, futures and options, as speculative. Or they argue
that such financial manipulations lie outside the firm's field of
expertise.
They claim that exposure cannot be measured. They are right
-- currency exposure is complex and can seldom be gauged
with precision.
Managing Firms Economic
Value
Reduces volatility of firms value by reducing volatility of
income and return on assets without altering firms expected
value
Creates value because firms expected value is higher in the
presence of a risk management strategy
Financial Distress
Risk worth managing is that which may have
material impact on the value of the firms
periodic cash flows
Large, highly diversified firms may not be at
much risk from risk exposure
Small, poorly diversified firms are at greater
risk because more transactions are large
Risk Aversion Loss
Aversion
Requires corporations
Recognizes risk is
give up the chance for
upside foreign exchange
gains to protect
themselves from
possible downside
foreign exchange losses
Hedging with options
concern because of the
downside losses rather
than the upside gains
Fear of Bankruptcy
Three Preliminary Questions
What exchange risk does the firm face, and what
methods are available to measure currency exposure?
What hedging or exchange risk management strategy
should the firm employ?
Which of the various tools and techniques of the
foreign exchange market should be employed: debt
and assets; forwards and futures; and options
Forward/Futures
Require future performance, and sometimes one party
is unable to perform on the contract. When that
happens, the hedge disappears, sometimes at great
cost to the hedger. Most big companies use forwards;
futures tend to be used whenever credit risk may be a
problem.
Debt as a Hedge
Debt -- borrowing in the currency to which
the firm is exposed or investing in interestbearing assets to offset a foreign currency
payment -- is a widely used hedging tool that
serves much the same purpose as forward
contracts.
Debt Example
Money Market Hedge:
Fredericks sold Canadian dollars forwards. Alternatively she
could have used the Eurocurrency market to achieve the same
objective. She would borrow Canadian dollars, then exchange
them into francs in the spot market, and hold them in a US
dollar deposit for two months. When payment in Canadian
dollars was received from the customer, she would use the
proceeds to pay down the Canadian dollar debt.
The cost of the money market hedge is the difference between
the Canadian dollar interest rate paid and the US dollar interest
rate earned.
Elimination of Downside
Losses
Options
As loss aversion
Managers have incentive to undertake profitable
projects when allowed to hedge using options
Last Thought
Risk management adds value because it helps
ensure that a corporation has sufficient internal
funds available to take advantage of profitable
investment opportunities. Risk management
helps the firm avoid short-run and
intermediate-run capital constraints to survive
in the long run
Questions??
Ex. 1: Hedging practice at GE
Use a portfolio approach (50%: forward, 25%:
option, and 25%: spot)
Keep its individual business units well-
educated about risk management
Encourage them to bill in premium currencies
like Japanese yen and receive invoices in
discount currencies such as Italian lira
Ex. 2: Hedging practice at Baxter Int.
Educate a wide range of people within the
company in the proper use of risk management
tools
Make many of its risk-management decisions
by consensus (as an effective check-andbalance system)
Try to interact and share information with
several investment banks correctly
Elimination of downside losses
Managers and shareholders
Not worried about impacts of foreign exchange
gain, but exchange losses
Options are best justified as hedging tools.
Because of asymmetric pay-off structure
Because of no possibility for loss beyond the
amount of the premium paid
Because of costs to symmetric hedges like
forwards, money markets, and futures
Does risk management create value ?
If marketing resources are allocated where currencies are
overvalued and are taken away from locations where
currencies are undervalued
If production is increased where currencies are
undervalued and is decreased where currencies are
overvalued
The firm as a whole is more profitable.
Risk management may indeed create value as well as
reduce the variability of firm value.