A FRAMEWORK FOR RISK MANAGEMENT

I n recent years, managers have become increasingly aware of how their organizations can be buffeted by risks beyond their control. In many cases, fluctuations In principle, both Dresser and Caterpillar could have insulated themselves from energy-price and exchange-rate risks by using the derivatives markets. Today more and more companies are doing just that. The General Accounting Office reports that between 1989 and 1992 the use of derivatives—among them forwards, futures, and swaps— grew by 145%. Much of that growth came from corporations: one recent study shows a more than fourfold increase between 1987 and 1991 in their use of some types of derivatives. In large part, the growth of derivatives is due to innovations by financial theorists who, during the 1970s, developed new methods—such as the BlackScholes option-pricing formula—to value these complex instruments. Such improvements in the technology of financial engineering have helped spawn a new arsenal of risk-management weapons. Unfortunately, the insights of the financial engineers do not give managers any guidance on how to deploy the new weapons most effectively. Although many companies are heavily involved in risk management, it’s safe to say that there is no single, well-accepted set of principles that underlies their hedging programs. Financial managers will give different answers to even the most basic questions: What is the goal of risk management? Should Dresser and Caterpillar have used derivatives to insulate their stock prices from shocks to energy prices and exchange rates? Or should they have focused instead on stabilizing their near-term operating income, reported earnings, and return on equity, or on removing some of the volatility from their capital spending? in economic and financial variables such as exchange rates, interest rates, and commodity prices have had destabilizing effects on corporate strategies and performance. Consider the following examples: In the first half of 1986, world oil prices plummeted by 50%; overall, energy prices fell by 24%. While this was a boon to the economy as a whole, it was disastrous for oil producers as well as for companies like Dresser Industries, which supplies machinery and equipment to energy producers. As domestic oil production collapsed, so did demand for Dresser’s equipment. The company’s operating profits dropped from $292 million in 1985 to $149 million in 1986; its stock price fell from $24 to $14; and its capital spending decreased from $122 million to $71 million. During the first half of the 1980s, the U.S. dollar appreciated by 50% in real terms, only to fall back to its starting point by 1988. The stronger dollar forced many U.S. exporters to cut prices drastically to remain competitive in global markets, reducing short-term profits and long-term competitiveness. Caterpillar, the world’s largest manufacturer of earthmoving equipment, saw its real-dollar sales decline by 45% between 1981 and 1985 before increasing by 35% as the dollar weakened. Meanwhile, the company’s capital expenditures fell from $713 million to $229 million before jumping to $793 million in 1988. But by that time, Caterpillar had lost ground to foreign competitors such as Japan’s Komatsu.