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As the sopllistication of risk management instn•- requitts a detailed understanding of the instruments and
ments l1as increased, the scope of corporate risk manage- their uses.
ment policy has become much broader. These instruments This article reviews the logic of the links betw«n
provide great flexibility in structuring a risk management risk managtmtnt and value aution as wtll as tht accumu-
strategy for tl1e firm. But to realize their potential lating empirical evidence.
orporate risk management has expanded understanding why a firm hedges has direct implica-
what is written about corporate risk management I. RISK EXPOSURES AND HEDGING
focuses primarily on the use of derivatives - for-
wards, futures, swaps, and options - in hedging cor- Of the numerous risks to which firms are
porate exposures to interest rates, foreign exchange exposed, some affect only individual firms, while
rates, and commodity prices. But the array of risk othen affect a broad cross-section of firms in the
management instruments is much broader. marketplace. In Exhibit 1, I array these risks along a
In this article I discuss the underlying theory risk spectrum. At one end of this spectrum are mar-
of the mechanisms through which risk management ketwide risks; these risks are not loc:alized to a spe-
increases the value of a 5.rm. I believe this is the criti- cific: firm or industry - for example. the impact of
cal initial step in designing an effective risk manage- unexpected changes in interest rates. FX rates, or oil
ment program. For example, there is little agreement prices. At the other end are firm-specific risks; these
on how one should measure these corporate expo- include fires, lawsuits, outcomes of exploration and
sures - should risk management attempt to reduce development activities for 6rms in natural resoui:ce
fluctuations .in reported earnings, or focus on cash industries, and outcomes of research and develop-
flows and firm value? As we will see in this analysis, ment projects.
THl,JOUl\HALOl'Dlllt.rVATMS 21
EXHIBITt
C.0RPORATE RISJC SPECTRUM
'
Risk Management Imtnunenta real production activities also can be used to manage
its risk exposures. For example, moving production
A major advantage of arraying the sources of
oveneas can change the firm's foreign exchange expo-
risk as in Exhibit 1 is that it clearly lets us see that dif-
sure dramatically. But producing in a new market with
ferent risks are managed with clifFerent hedging instru-
new suppliers, new workers, and different labor laws is
ments. In the second column, for example, insurance
not a small decision. One materiaJ advantage offered
policies are employed to manage firm-specific risks
by financial market risk management products is that
like fires. Marketwide risks, such as exposures to
they allow more effective separation of production
interest rates, can be managed with off-balance sheet
and risk management activities. Moreover, financial
derivative instruments like forwards, futures, swaps,
contracts are more liquid, so if market conditions and ·
and options. 1
exposures change, this added flexibilir:y allows more
Over the past decade, many new financially
rapid adjustments.
engineered securities have been introduced to provide
customized solutions to corporate risk management Risk&po1me
problems. Since these hybrid securities are built
around bonds or preferred stock. they are on the It is important to understand the relation
firm's balance sheet. In creating these hybrids, finan- between an underlying risk and firm value in analyz-
cial engineen operate much like General Motors in ing a firm's hedging incentives. Some relations are
producing automobiles to meet specific customer straightforward; an uninsured casualr:y loss, for exam-
demands: GM achieves customization by assembling ple, directly reduces firm value. Yet. other exposures
various combinations of off-the-shelf components - can be more subde.
frames. trim packages. engines, interior appointments, In Exhibit 2. I illustrate the exposure pmfile for
and so on. Similarly, financially engineered inscru- an oil company. Because this firm owns substantial
ments are customized securities, but the components reserves of oil. higher oil prices raise revenues and
that make up the securities are themselves fairly basic increase firm value. Thus, the exposure profile relating
off-the-shelf loans, forwards, swaps, and options.2 the unexpected change in firm value to an unexpect-
As illustrated in Exhibit l, the firm's choice of ed change in oil prices has a positive slope. (For siln-
S.ll!oWIA 1"5
EXIUBIT2 It is important to note that this hedging activi-
Ex.PosURE PROFILE FOR AN OIL CoMJtANY llELA11NC 111E ty. although designed to change our chemical firm's
l1NExPECTED OIANCE IN FIRM VALlJE TO AN exposure to oil prices, generally will not affect the
UNEXPECTED CHA.NcE IN OIL PRICES firm's optimal pricing or production decisions. Basic
economic theory implies that optimal production and
pricing occur where marginal cost equals marginal
AV revenue. The opportunity cost of the oil is its spot
Core Oil
price, and thus the firm's relevant marginal cost is
Business
determined by the current spot price of oil. For that
reason, this hedging activity affects neither the firm's
relevant marginal costs nor marginal revenues.
Therefore, firms' decisions to use 6.n.ancial instruments
AP(oil) to hedge their exposures and their pricing and pro-
duction decisions generally are separable.
'l'HIJQUkNALOFDEP.l\Anv& 25
risks through a risk management policy. offsetting benefits from increases in producti"Vity. If
Note, however, that there is one important managers had instead hedged the division's expo~ure to
aspect of achieving these potential risk management oil price changes, the target against which the employ-
benefits that has received little attention - a firm's ees were being assessed would have been more direcdy
ability to precommit to a hedging strategy. This is less linked to employee actions, and the bonus would have
a problem with some firm-specific risks; supplier, been a more constructive motivating force.
employment, and customer contracts long have stipu-
'Dlxes
lated levels of insurance coverage. But it is rare to see a
supplier contract that specifies that interest rate risk be So long as the effective tax function is linear
managed on an ongoing basis. (the 6.rm faces a constant eff'ective marginal tax rate),
Without an ability to precommit to hedge, the hedging will not affect the firm's expected tax liability.
realized gains to a firm in these dimensions will be But if the 6.rm faces some form of tax progrcssivity -
lower. It is difficult to rely on implicit reputational the firm's effective tax function is convex - then
eff'ects to support an ongoing hedging policy because hedging taxable income by reducing the volatility of
of basic incentive incompatibility problems. In some pre-tax income reduces the firm's expected tax liabili-
circumstances where these claimholders would value ty. (This result follows Crom Jensen's inequality, and
hedging quite highly, the firm's stockholders face big hence this implication is quite general - see Smith
incentives to unwind the hedge. and Stub: (1985].)
Consideration of comparative advantage in The logic of the impact of risk management on
risk-bearing also has implications for the design of taxes is quite simple. If the effective tax function is
compensation contracts. Effective compensation plans convex, in yean when taxable income is low, the
achieve an appropriate balance between two potential- effective tax rate will be low; but in years when tax-
ly conflicting goals - strengthening employees' per- able income is high, the tax rate will be high. If tax-
formance incentives and insulating them from risks able income is hedged. the tax increase in bad yean
beyond their control. Incentive considerations dictate would be less than the tax reduction in good years so
that firms link compensation to performance measures that the firm's expected tax liability falls.
such as share price changes or earnings. Yet a potential Convexity of the 6.rm's eff'ective tax function
problem with such performance proxies is that they arises 6:om three general sources: statutory progressivi-
contain significant variation that is unrelated to ty, limitations on the use of tax preference items, and
employees' actions. Because financial price risks are a the alternative minimum tax. Although it is the most
potential source of such noise, companies also may straightforward. the importance of statutory progressiv-
achieve economies in risk-bearing by more eff'ectively ity is generally small because its range is quite limited.
excluding them from performance measures that serve Tax preference items like tax-loss carryfor-
as the basis for employee evaluations and bonuses. wards, foreign. tax credits, and investment tax credits
Perhaps an example would. make this point typically have limitations on their use. Thus if taxable
more clearly. In 1988, the iiben division of DuPont income falls below some level, the value of the tax
announced .. one of the most ambitious pay-incentive preference item is reduced either by loss of the tax
programs in America:• The plan covered nearly all of shield or postponement of its use (see DeAngelo and
the division's 20,000 employees with a bonus tied to Masulis (1980]). Finally, the alternative minimum tax
the division's profits. Yet in 1990, the plan was can- linb tax liabilities to the difference between reponed
celled. Profits were off' 26%, in part because of the and taxable income.
increases in oil prices (and hence the division's costs) Tax considerations thus suggest that the eco-
due to the Gulf War. nomic incentives to hedge should be greater for firms,
By keying compensation to performance mea- 1) the higher the probability that the firm's pre-tax
sures that were largely uncontrollable for the vast income is in the progressive region of the tax schedule
majority of the division's employees, the plan created (for example, smaller firms or stan-up firms), 2) the
significant worker discontent while providing limited more tax preference items the 6.rm has, and 3). the
greater the potential tax liability under the alternative out-of-pocket fees plus the implicit cost of the bid-ask
minimum tax. spread plus the opportunity eost of management's
time in the administration of the program.3 For stan-
Hedging Motives and Methods
dard swaps, these eosts lu.ve fallen dramatically over
Understanding the motives for risk manage- the past decade.
ment is a eritical step in designing an effeet:ive hedg- In the early 1980s, the bid-ask spread for swaps
ing program for a firm. If the primary motive for a at times exeeeded 100 basis points. In 1995, it can be
particular firm to hedge is wees, then this firm should as low as 2 basis points for a standard interest rate
focus on hedging its taxable income. If hedging is swap. This profound reduetion in hedging costs,
prompted by risk-sharing coneerns, then a firm like reflecting the material increase in the liquidity of these
DuPont (where the fiben division bonus w:as keyed to markets, makes the net benefits from accessing the
accounting returns) should focus on hedging account- market greater, and explains part of the observed
ing earnings. If the cost of financial distress and the growth in these markets. Moreover, standardization
underinvestment problem is the primary factor that and increased familiarity with these instruments and
motivates hedging, the firm should hedge firm value. their uses have lowered the administrative costs.
It is important to note that, in general, hedging In addition to this variation in eost over time,
value and hedging earnings are not the same thing. there is also important variation in costs across hedg-
FASB rules have evolved to a point where it is typical- ing instruments at a given date. In general, the eosts of
ly difficult to obtain hedge accounting treatment for hedging will be lower: the greater the volume of
an off-balance sheet hedge. Most firms that use stan- transactions in a given market, the lower the volatility
dard derivatives thus are required to mark the hedge of the underlying asset priee, and the less private
to market in each aecounting period. Yet accounting information is relevant for prieing the underlying
rules also generally prohibit the firm &om marking its asset. Therefore, hedging costs are generally lower for
core assets or liabilities (whieh give rise to the expo- derivatives on inten:st rates and major currencies but
sure) to market. This means that a firm can engage in higher for more eustomized hedging instruments.
risk management activities that, while redueing the
volatility of firm value, increase the volatility of IY. EVIDENCE ON CORPORATE HEDGING
reported earnings.
As access to hedge accounting treatment for Recent press coverage of Procter &: Gamble,
off-balance sheet derivatives has been restricted, there Orange County, California, and Barings Bank indi-
has been a dramatic inerease in the use of structured cates dearly that derivative instruments can be used
notes and other hybrid securities. This has occurred in either to speculate on financial priee movements or to
part because accounting rules generally do not require hedge. Thus, a basic question to be addressed is: Do
that a risk management contract bundled with a loan firms use derivatives to hedge or to speeulate?
or preferred stoek issue be marked to market. Although the evidenee is still preliminary, the answer
Finally, note that with three independent appears to be, for the most part, to hedge.
instruments, three different targets can be achieved. Perhaps the most eomprehensive survey to date
Therefore, in principle, with .the appropriate choice of of the corporate use of derivatives was conducted by
hedging instruments, a firm could simultaneously Dolde (1993]. The overwhelming majority of the 244
manage the impaet on its value, reported earnings, Fortune 500 companies that responded to Dolde's
and taxable income. questionnaire report that their policy is t.o use deriva-
tives primarily to hedge their exposures. At the same
m. THE COSTS OP RISK. MANAGEMENT time, however, only about 20% of the responding
.. firms report that they attempt to hedge their expo-
It is important to identify the aspects of the risk sures eompletely. Moreover, smaller firms - those
management tn.nsaetions that iepresent real costs. The likely to have lower credit ratings and hence greater
relevant eost of hedging is basically the sum of any default risk - report hedging larger percentages of
THEJOUIUW. Of DEl\.IVA'i'lVIS 29
is an option to buy; a put is an option to sell. Note that Structure Under Corporate and Penonal Taxation.." )""'""I
buying a call plus writing a put with the same terms creates of Financial Economics, 39 (1980), pp. t t 99-1206.
payoffi that are equivalent to those of buying a forwud;
this equivalence is called put-call parley. Dolde, W. ..The Trajectory of Corporate Financial P..isk
2for example, in 1973 PEMEX, the m.te-owned Management." }Ollfltlll tf Applied Corporate Finona:, Vol 6,
Mexican oil producer, issued bonds that included a (orward No. 3 (Fall 1993). pp. 33-41.
contract on oil. In 1980, Sunshine Mining issued bonds
incorporating an option on silver. And in t 988 Mapua Froot, K.A .• D.S. Scharfstein, and J.C. Stein-. .. Risk
Copper issued a bond giving investon a strip of copper Management: Coordinating Corporate Investment and
options, one at every coupon payment (see Smith and Financing Policies." Jo1,,nol of FiMnct, 48 (1993), pp.
Smithson [1990]). 1629-1658.
31n this regard, confusion is perhaps greatest in the
case of options. The option premium is not the cost of Houston, C.O., and G.G. Mueller. "Foreign Exchange
hedging. This is perhaps easiest to see by considerir.g the Rate Hedging and SFAS No. 52 - Relatives or
cue of an idealized "perfect market" (no transaction costs Str.angers?" Accounting Horizons, 2 (1988), pp. 50-57.
or taxes). In this cue, the costs 0£ hedging are zero by con-
struction, although the option price is positive. Mayers, D., and C.W. Smith. .. Corporate Insurance and
4
Because leverage and hedging are both endoge- the Underinvestment Problem." Journal of Rislt ond
nous policy choices, this result potentially reflec:&s two otr- lnsurona, 54 (l 987), pp. 45-54.
setting effects. IC. given the firm's investment opponunities,
higher leverage raises the probability of financial distress, it - ...On the Corporate Demand (or Insurance." Jowmal
raises the demand for hedging. But firms with high leverage of Business, SS (1987), pp. 281-296.
tend to be firms with fewer growth options (see Smith and
Wam [1992)). If fewer gro\vth options reduce the demand - ...On the Corporate Demand for Insurance: Evidence
for hedging, then we might observe little correlation &om the Reinsurance Market." Jowmal of Business, 63
between leverage and hedging. (1990), pp. 19-40.
5Note that this result is observed despite the &ct
that one would expect that the use of derivatives to hedge Mian, S.L "Evidence on the Determinants of Corporate
corporate exposures should reduce risk and thereby increase Hedging Policy." Wo.dcing Paper, :Emory University, 1994.
the firm's credit rating. Without explicitly examining the
firms' core business exposures and the speciiic derivatives Myen, W. "Detenninants of Corporate Borrowing."
positions that the firms adopt, however, you cannot reject Joun..r of Financial Economics, S (t 977), pp. 147-17S.
the hypothesis that as a firm's financial condition deterio-
rates, it is more likely to use these markets to speculate. Nance, D.R., C.W. Smith, and C.W. Smithson. ..On the
Detenninants of Corporate Hedging." Journol tf FiJUD11«, 48
REFERENCES (1993), pp. 267-284.