Leveraging Risk ManagementPublished: March 01, 2006 in Knowledge@Wharton
In the business world, risk is everywhere-- fires, natural disasters, exchange-rate fluctuations, changes in interest rates, credit ratings and commodities prices. It's the wild card that can upset even the most carefully crafted business plan.
So it is not surprising that over the past couple of decades, executives have become ever more adept at neutralizing risk with a battery of instruments, including not just insurance but a variety of derivatives based on currencies, securities and credit ratings, as well as customized contracts with counterparties. It's even possible to hedge the weather.
But hedging costs can add up. Consider an example from Evolution Markets LLC, a risk-management firm based in White Plains, NY. A New York brewer paid $175,000 for weather-based derivatives contracts to protect up to $1 million in revenue it might lose if cooler-than-normal weather cut into summer sales. If the weather was hot, the money would be spent for nothing.
In another example, Cephalon Inc., the pharmaceutical company, wanted to be sure in the late 1990s that if its prospective drug for Lou Gehrig's disease received government approval, the company would have cash to buy out the other firms that had helped finance the drug's early development. Instead of keeping that cash on hand, it used a combination of options on its own stock.
With its shares trading at $19.25, the company bought 2.5 million options that would be "in the money," or profitable, if the stock rose above the strike price of $21.50. Analysts had predicted the stock would rise to $30 or $40 if the drug were approved. At the same time, Cephalon sold an equal number of call options giving the purchaser the right to buy Cephalon shares for $39.50. Thus, Cephalon would profit if the share price rose above $21.50, but the profit would be capped by the obligation to sell shares if they rose above $39.50. The maximum potential gain would be $18 a share, or $45 million. Cephalon paid for the deal by turning 490,000 shares over to its investment banker. Since they were trading at $19.25, cost of the transaction was about $9.4 million.
Besides cost, hedging has its own risks. Some hazards may be overlooked. Others may be overestimated, inflating the cost of risk control. Either way, addressing risk inefficiently can dampen shareholder returns. Many companies address this problem by assigning enterprise risk management (ERM) to a "chief risk officer" -- often the chief financial officer with expanded duties -- who attempts to map and parry all of the organization's risks, with special attention to how they interact.
Ideally, executives should look at the forest, not the individual trees, when it comes to managing risk, but that has not been the general practice, says Neil A. Doherty, who is a professor of insurance and risk management at Wharton and teaches an executive education course titled Enterprise Risk Management.
"I think the problem has always been that organizations often have silo structures," he says. "There are some advantages to that, because it can make people accountable for the operations they control." But academic work over the past few years has shown that a more sophisticated and comprehensive approach to risk management can increase a company's value by three to five percent -- a significant amount, Doherty adds.
Looking at the Forest
Recently, Doherty advised a major British oil company to take a more comprehensive ERM approach with an array of risks it faced. The company had various divisions set up as independent profit centers operating in different parts of the world. Each used currency derivatives to hedge risks on its own transactions. But by standing back to look at the company's currency risk as a whole, it became clear that in some cases an exchange-rate change that would hurt one unit would actually benefit another.
Hedging costs vary widely depending on how long the strategy will be in place, the amount of coverage sought, the volatility of foreign exchange rates and other factors. But in one example, investment bank Credit Suisse First Boston set up a currency hedge to protect the value of $150 million U.S. Dollars that a U.S. investment firm expected to convert to euros some months later. The hedge cost $1.2 million -- an expense best avoided if it were not providing real value.
"What you want to do is look at all the foreign exchange transactions in the company," he says. "A lot of those are going to net out against each other." If so, the company is hedged naturally, and money spent on further hedging strategies is wasted. And avoiding that unnecessary cost can improve the bottom line.
Another example, Doherty said, would be an organization that might face numerous types of risk which, added together, appear very threatening. But the currency risk, interest-rate risk, fire risk and others would each be driven by different factors. The chance of all hazards occurring at once -- a perfect storm -- would be small. Hence, it may be cheaper to absorb the occasional hit than to hedge against all hazards all the time.
Still, old habits are hard to break. Even the insurance industry, which specializes in assessing risk, falls prey to silo thinking, Doherty notes. On one side are the people who deal with liabilities, such as the risk of having to pay insurance claims. On the other are those who deal with assets, such as the firm's holdings in real estate and securities. Each side tends to address its unique set of risks independently.
The Ideal Risk Officer
It is not surprising that the integrated approach to risk management is still more the exception than the rule, as many of the instruments for transferring risk are relatively new. Most derivatives involving interest rates, currencies, commodities and credit ratings did not exist 20 years ago, and many have only come into wide use in the past decade. It took modern computers and some Nobel Prize-winning economic breakthroughs before users could confidently track and project derivative values. In recent years, academics, money managers and hedge-fund operators have been busy unearthing subtle relationships in the behavior of different financial areas, such as currencies and interest rates.
A key step was new international banking requirements instituted about a decade ago that required banks to have chief risk officers, Doherty says. Success in that industry helped spread word about the benefits of taking the comprehensive view.
The ideal risk officer is a person with a combination of financial and people skills, since risk strategy should work across various operating units, Doherty says. "I guess the chief skill is one of bringing people together and trying to get them to work in a coordinated fashion," he said. It does not hurt to have a strong background in computer modeling and math, particularly statistics, he added.
Traditionally, companies tended to turn to insurance to mitigate risk, and this function was partitioned off from the rest of the company's financial management. Now many companies see that risk management is an integral part of financial management.
"Risk is really a potential cost on capital," Doherty says. "So you can think of managing risk as really the other side of the coin from managing capital."
The Cost of Risk
Using this perspective can produce strategies very different from the traditional notion of mitigating risks like fire. For example, a company worried about the risk of going bankrupt could adopt a financial strategy that uses less debt and more equity; in a crisis, falling equity values do not trigger bankruptcy the way debt default does.
Once risk is seen as a cost it becomes clear that reducing it can enhance firm value, Doherty adds. "Managing capital and managing risk are really the same thing," he says. "Risk is a hit to capital. So you try to make capital secure from the volatility" that arises from risk. Hence, a company concerned about maintaining a ready source of cash to finance growth might use an interest-rate derivative to smooth cash flows.
Similarly, an insurance company might want to mitigate the problems that occur when a natural disaster strikes, Doherty notes. Disasters often spur new demand for insurance, but an insurer may not be able to write new policies because, having just paid out large claims, it could fall short of regulators' capital-reserve requirements.
While this problem can be addressed through the reinsurance market, that can be very expensive, Doherty adds. So, a smart risk officer might seek another company to act as counterparty in an arrangement that would provide the insurer with capital if large claims are filed. The counterparty, in exchange for some form of compensation, could hold put options on the insurer's stock. If massive claims are filed, the contract will be triggered, enabling the insurer to issue new shares for sale to the counterparty at the agreed-upon price.
In another case, a company might want a large cash reserve to finance acquisitions. But keeping too much cash on hand could make the company a takeover target. So it would find a counterparty that would provide financing if certain events occur -- like a general downturn in equity prices that would make acquisitions appealing.
The Sarbanes-Oxley law passed after the Enron-era scandals may make enterprise risk management more attractive to some companies, Doherty says. Those rules were intended to make corporate financing more transparent. Hence, there is a value in reducing the impact of events that have no significant long-term effect on results, so that the company's true health can be seen more clearly.
"I call it 'noise hedging,'" Doherty says. For example, weather-related hits to sales and earnings are typically only temporary. To minimize their effect, a company can use weather-based derivatives that pay off if given weather conditions occur. These were developed by the energy industry for hedging against events like an unusually warm winter that would depress heating oil prices.
This kind of exotic tool is relatively new. But other industries are coming to see new ways to use them. A retailer, for instance, might use weather derivatives to hedge against the risk that severe weather would keep people from shopping.It's a long way from taking out a fire policy. And to wring the most value out of today's risk-hedging tools, a risk officer has to stand back and see the big picture -- the ebb and flow or risks washing over all parts of the company, moment by moment.