Anda di halaman 1dari 17

Journal of Applied Corporate Finance

W I N T E R 2 0 0 2 V O L U M E 14 . 4

A Senior Managers Guide to Integrated Risk Management


by Lisa K. Meulbroek,
Harvard Business School
A SENIOR MANAGERS by Lisa K. Meulbroek,
Harvard Business School*
GUIDE TO INTEGRATED
RISK MANAGEMENT

anagers have always attempted to mea- ments and markets that have evolved over the past
M sure and control the risks within their
companies. The enormous growth and
decade. A sophisticated and globally tested legal and
accounting infrastructure is also now in place to
development in financial and electronic support the use of such instruments on a large scale
technologies, however, have enriched the palette of and at low cost. Of equal importance to this evolu-
risk management techniques available to managers, tion in capital markets is the cumulative experience
offering important new opportunities for increasing and success in applying modern finance theory to
shareholder value. Integrated risk management the practice of risk management. Today, managers
involves the identification and assessment of the can analyze and control various risks as part of a
collective risks that affect firm value and the imple- unified, or integrated, risk management policy.
mentation of a firm-wide strategy to manage those Integrated risk management is by its nature
risks. For some managers, risk management imme- strategic rather than tactical. Tactical risk man-
diately evokes thoughts of derivatives and strategies agement, currently more common, has a narrower
that magnify rather than reduce risk. But derivatives, and more limited focus. It usually involves the
when used as a risk management tool, are only a hedging of contracts or other explicit future commit-
small part of the integrated risk management pro- ments of the firm such as interest rate exposures on
cess. Moreover, a proper risk management strategy its debt issues. Consider a U.S. dollar-based firm that
does not involve speculation or betting on future buys steel from a Japanese firm for delivery in three
commodity prices or interest rates and, indeed, is the months. The U.S. firm may decide to tactically
antithesis of such speculation. Instead, the goal of hedge the dollar price of its steel purchase. By using
integrated risk management is to maximize value by forward currency contracts, the firm locks in the
shaping the firms risk profile, shedding some risks dollar cost of its steel purchase, offsetting the effect
while retaining others. of dollar-yen exchange rate movements that may
Companies have three fundamental ways of occur before delivery and payment. The treasurers
implementing risk management objectives: modify- office of the firm typically executes such tactical
ing the firms operations, adjusting its capital struc- currency hedging without consideration of other
ture, and employing targeted financial instruments hedging or insuring activities carried out in the firm,
(including derivatives). Integration refers both to even when the risks across units are significantly
the combination of these three risk management correlated. In contrast, strategic currency hedging
techniques and to the aggregation of all the risks addresses the broader question of how exchange
faced by the firm. While managers have always rate fluctuations affect the value of the entire firm as
practiced some form of risk management, implicit or well as the firms competitive environment, includ-
explicit, in the past, risk management has not ing the pricing of its products, the quantity sold, the
traditionally occurred in a systematic and integrated costs of its inputs, and the response of other firms in
fashion across the firm. Integrated risk management the same industry.
has only recently become a practical possibility, both Exchange rate risk is, of course, only one
because of the enormous improvements in com- potential risk a firm faces. Managers using an inte-
puter and other communications technologies and grated risk management approach must depart from
because of the wide-ranging set of financial instru- the standard practice of viewing each risk in isolation

*The author gratefully acknowledges the financial support of Harvard


Business Schools Division of Research. Email: Lmeulbroek@hbs.edu

56
JOURNAL OF APPLIED CORPORATE FINANCE
and instead devise a strategy to respond to the full HOW RISK MANAGEMENT ADDS VALUE
range of risks, taking into account that a risk
management policy designed solely to respond to Managers seeking to implement a risk manage-
exchange rate risk may have unintended conse- ment program must consider a number of basic
quences for the firms other business operations. questions: Is the goal of the program to reduce
This article presents a managerial overview of inte- earnings fluctuations, or to reduce fluctuations in
grated risk management, using a series of examples firm value? Should the firm fully hedge its risk
to illustrate the range of applicable management exposures, or only part of them? Should it hedge only
decisions and the benefits for the firm from its the downside risk, while retaining the upside (as
implementation. with an option or more traditional insurance con-
By applying integrated risk management, man- tract)? Or should it hedge both the downside and the
agers will benefit from new insights about the upside (as a forward contract would permit)? None
interplay among different types of risk and tradi- of these questions can be answered in the abstract,
tional financial decision areas, connections easily because the answers will vary from firm to firm. Still,
missed without a comprehensive framework. Be- the fundamental goal of risk management is unam-
cause the three ways to manage risk are functionally biguous: to maximize shareholder value. The ability
equivalent in their effect on risk, their use connects to reduce risks does not automatically imply that the
seemingly unrelated managerial decisions. For in- firm should reduce its risk. Because the benefits (and
stance, because capital structure is one component costs) of risk management vary by firm, a risk
of a firms risk management strategy, effective capital management strategy must be tailored to the indi-
structure decisions cannot be made in isolation from vidual company. For some firms, targeting a particu-
the firms other risk management decisions. This lar level of earnings or cash flow fluctuations will
papers discussion of the integrated risk manage- increase the value of the firm. For other firms, the
ment framework emphasizes the connection between value-maximizing strategy is to target a particular
the three mechanisms to alter the firms risk profile, and range of fluctuation in market value of the firm or
offers guidance on their practical application. shareholder equity.1 To determine the optimal risk
There are those who question whether firm- management policy, the manager must begin by
wide risk management can add value to the firm. In understanding how the degree of uncertainty about
the hypothetical Modigliani-Miller world of corpo- future earnings and firm value affects the current
rate finance, neither capital structure choices nor market value of the firm. That is, to assess whether
corporate risk management affects the value of the and to what extent the firm should target its risk, the
firm. Indeed, the direct expenses and distraction of manager must first understand the channels through
managements attention would make risk manage- which risk management can potentially affect firm
ment a negative net-present-value proposition for value. This understanding forms the critical under-
the firm. Thus, the next section describes the various pinning of any risk management strategy: without it,
ways that risk management can enhance the value of attempts to evaluate the costs and benefits of risk
the firm in the imperfect environment of the real management within the context of a particular firm
world. With this value proposition established, I will prove fruitless.
offer a functional analysis of integrated risk manage-
ment using a wide-ranging set of illustrative situa- Corporate Risk Management Can Facilitate
tions to show how the risk management process Risk Management by the Firms Stockholders
influences, and is influenced by, the overall business
activities and strategy of the firm. Finally, I present Financial theory distinguishes between system-
an overall managerial framework for formulating atic (market or beta) risk and total risk. Investors can
and designing an enterprise-wide risk management reduce the amount of total risk they bear by diver-
system, and conclude by providing a perspective on sifying their holdings. Systematic risk is the risk that
the future evolution of risk management. remains after such diversification is fully imple-

1. Ren Stulz offers another take on how risk management maximizes firm as possible. See R. Stulz, Rethinking Risk Management, Journal of Applied
value; he argues that risk management should eliminate costly lower-tail Corporate Finance, Vol. 9 No. 3 (Fall 1996).
outcomes, that is, limiting the downside while preserving as much of the upside

57
VOLUME 14 NUMBER 4 WINTER 2002
mented. If diversification opportunities are widely firm can target specific levels of systematic and total
available to investors, systematic risk is the only risk risk. Using risk management techniques, they can
for which they must be compensated. By definition, amplify or dampen the risk of the firms operations
diversification by either the firm or its investors to stabilize it at a targeted level. If the firms risk level
cannot reduce systematic risk. But investors can is held constant, investors can more easily adjust
control their own exposures to systematic risk by their own risk exposures, even if the firms opera-
adjusting their holdings of risky assets and cash or by tions are otherwise opaque to them. Moreover, to the
using futures, forwards, or swap contracts. By hold- extent there are economies of scale in managing risk,
ing a larger fraction of cash or by hedging with corporate-level risk management is likely to be less
futures, forwards, and swaps, investors can limit expensive than risk management by investors. Think-
their systematic risk exposures, but at the cost of ing about the firms risk profile in these terms may
reducing their expected returns. The availability of be new to many managers. However, such targeting
these targeted financial instruments greatly en- has a clear analogue in the more familiar territory of
hances the efficiency of investors in managing debt policy: companies routinely use target debt
systematic risk exposures for themselvespro- ratios to maximize shareholder value, even though
vided, of course, they have a clear understanding investors could certainly duplicate that level of debt
of the firms exposures. in their own portfolios. By the same logic, corporate-
The apparent ability of outside investors to level risk targets can increase shareholder wealth by
adjust their own systematic risk exposures may seem facilitating investor-based risk management, even
to leave no role for firm-based risk management. when investors assume much of the responsibility
Indeed, some observers conclude that attempts by for managing risk. For example, a multinational with
managers of the firm to manage risk are at best significant currency risk may increase its value by
redundant and at worst wasteful, because investors communicating to shareholders the extent of the
can easily increase or decrease their own risk exchange rate exposure remaining after it under-
exposures. But estimating the firms risk can be takes its risk management program.
difficult for investors, especially if it changes con- But, as we now consider, corporate-level risk
tinually over time. Outside investors can estimate the management can also create value in ways that
systematic risk of the firm by using the volatility of investors cannot accomplish on their own. Specifi-
past equity returns, but they typically do not have cally, as discussed below, corporate risk manage-
other information that would enable them to im- ment can increase shareholder wealth by reducing
prove on that estimate. Managers, on the other hand, the costs associated with financial distress, moderat-
have proprietary information about the current and ing the risk faced by important non-diversified
future activities of the firm, both in scale and scope, investors and stakeholders, decreasing taxes, reduc-
which bears directly on the firms systematic risk. It ing monitoring costs, and lowering the firms fund-
may not be feasible or prudent from a competitive ing costs.
standpoint for managers to simply reveal this private
information, but they can use it to manage the firms Risk Management Can Reduce Financial
risk in a way that shareholders cannotagain, Distress Costs
because the shareholders do not fully understand
the exposures. For this reason alone, the classic By reducing the firms total risk, risk manage-
Modigliani-Miller argument for invariance of firm ment makes financial distress less likely. Even highly
value to risk management does not always apply. successful businesses are vulnerable to financial
That is, in cases where investors cannot hedge for distress. Microsoft, for example, competes in a
themselves easily or cheaply, companies can use risk rapidly changing and volatile industry. If a bad turn
management to lower their cost of capital. More of events were to create uncertainty about the
precisely, investors may accept a smaller risk pre- companys future dominance, then customers, sup-
mium on the firms equity in return for greater pliers, or employees might alter their behavior,
certainty about their own exposure to systematic worsening the impact of the initial negative shock.
risks from holding that equity. Customers may defect, questioning Microsofts abil-
To assist investors in managing risk and thereby ity to provide future service and upgrades; other
lower the companys cost of capital, managers of the software developers may be less likely to tailor their

58
JOURNAL OF APPLIED CORPORATE FINANCE
To assess whether and to what extent the firm should target its risk, managers must
first understand the channels through which risk management can potentially affect
firm value. This understanding forms the critical underpinning of any risk
management strategy.

products to Microsofts operating platform; and key At the other end of the distress-cost spectrum
employees may leave for a more stable environment. are financial firms like insurance companies and
In short, financial distress has the ability to destroy commercial banks. In large part because their cus-
substantial value. tomers are also major liability holders, the costs of
Consider the fate of Thinking Machines Corp., financial distress in such credit-sensitive businesses
a pioneer in massively parallel supercomputers. are enormous. A consumer purchasing a retirement
Despite its reputation for superior technology, Think- life annuity, for example, is unlikely to buy the
ing Machines encountered financial difficulties when annuity from an insurance company that is perceived
the government cut its supercomputer funding, as vulnerable to financial distress. No matter what the
difficulties that hobbled its ability to compete. Intel initial savings and how favorable the terms, few
and IBM entered the market, luring customers away customers would willingly risk default on their
from smaller and less stable companies like Thinking retirement annuities. In sum, a proper analysis of the
Machines. As the president of Thinking Machines costs of financial distress must consider both the
explained, the issue of our viability kept arising. No probability of reaching distress and the expected
one wants to spend $4 million on a machine from a costs once in distress. Risk management techniques
company that may not be around. Financial distress can be used to reduce either or both.
impaired the firms ability to compete against more
stable companies, causing further erosion in firm Risk Management Can Reduce the Risk Faced
value and ultimately bankruptcy.2 by Key Undiversified Investors
The potential destructiveness of financial dis-
tress is not limited to technology firms. Retailers, for Another way that risk management can add
example, rely heavily upon their suppliers for financ- value is by lowering the risk faced by managers who
ing. These suppliers in turn regulate their own risk have most of their wealth invested in their companys
exposures through their selection of customers, and stock. The dramatic increase in stock- and option-
tend to respond rapidly to changes in customer based compensation and the long-running bull
creditworthiness. In 1999, Hechinger Co., a U.S.- market have created tremendous paper wealth for
based retailer of do-it-yourself home products, de- managers. Without the ability to diversify their
faulted on an interest payment. Anxious suppliers holdings, however, managers find that the value of
cut back on credit, intensifying the companys cash their personal wealth fluctuates in tandem with their
crunch. During the critical warm months when do- companys equity. Such fluctuations can be substan-
it-yourself sales typically peak, potential Hechinger tial, especially in highly volatile technology stocks,
customers were greeted by nearly empty stores, where stock and option compensation reigns su-
leading to further deterioration of the firms condi- preme. Risk management techniques can lower the
tion as customers left to shop elsewhere. Hechinger risk faced by such managers.
was soon forced to liquidate its operations. But extreme volatility in the value of personal
Even the mere prospect of financial distress can wealth is not a problem limited to managers in
cast a costly shadow over the firm. Hence, managers technology firms. In the first few months of 2000, the
must estimate the probability of encountering dis- stock price of blue-chip Procter & Gamble dropped by
tress. Again, this estimate will vary from firm to firm. more than 50%, from a high of $115 in January to $54
The value of a company in a cyclical industry may be in March. Ninety percent of the value of the employees
more volatile and its probability of distress higher. retirement plans had been invested in P&G stock. In
Before embarking upon a campaign to manage risk, less than one calendar quarter, this unanticipated stock
such a firm also needs to evaluate its costs once in price drop halved the accumulated value of employ-
distress. If some level of financial distress would not ees retirement funds. Again, risk management can
be too disruptive to the business, a firm may choose help prevent such severe fluctuations.
to accept a relatively high probability of distress. Of course, financial theory has long made the
LBOs, for example, typically occur in industries case for equity-based compensation plans as an
where the cost of financial distress is not high. effective means to align managers incentives with

2. Aaron Zitner, Fishman: Wariness from the Gut, 08/16/1994, The Boston
Globe (Copyright 1994).

59
VOLUME 14 NUMBER 4 WINTER 2002
those of shareholders. But if managers own signifi- firm will do better by trying to stay consistently in the
cant stakes in the firm, they will, by necessity, have lower tax-rate region rather than have negative
poorly diversified portfolios. In essence, the expo- earnings one year and earnings that result in a higher
sure to firm-specific risk that is essential for gener- tax rate the following year. Suppose that the tax rate
ating the right managerial incentives also imposes a for $10 million or less in earnings is 20%, and that
cost on managers by compelling them to hold above $10 million, the marginal tax rate is 30%. If a
inadequately diversified investment portfolios. firm earns $10 million in each of two consecutive
Risk-averse managers will thus require higher years, its total tax will be $4 million over the two-year
compensation for bearing this non-systematic or period. But if first-year earnings are $0 and second-year
diversifiable risk that ordinary investors do not face. earnings are $20 million, the total tax bill will now be
With a higher required return for holding the firms $5 million, or $1 million higher than when earnings are
stock, managers will apply a larger discount rate to evenly distributed over the two-year period.
the expected future earnings of the firm in privately As a practical matter, the penalty for volatility
valuing their holdings. That is, they will typically in taxable earnings is even greater whenever the
place a lower private value on their holdings of the ability of a company to carry its losses forward or
firm than the market value of the shares. And in such backward is limited. For instance, if a firm has
circumstances, to induce managers to have concen- negative earnings for an extended period of time, it
trated holdings of company stock, the firm must pay may never have enough positive earnings to offset
a higher total value in shares than would be required its losses and use its tax credits. Using risk manage-
for straight cash compensation. ment, a firm can smooth its earnings and reduce its
This deadweight wedge in value between tax bill.
equity compensation and cash compensation repre- Risk management can also decrease the firms
sents the cost to the firm of this compensation taxes by increasing its debt capacity and the tax
policy.3 The firms deadweight loss is greatest for shield provided by interest payments. Debtholders
high-volatility firms whose managers have most of care about total firm volatility, because it is the total
their personal wealth tied up in the firm. Note that riskand not just the systematic-risk component of
the same type of costs apply to all forms of perfor- that riskthat determines the probability that the
mance-based compensation, including options, firm will default. If risk management can reduce a
phantom stock, and earnings-based bonuses. There- companys total risk without reducing the net present
fore, a company with a large proportion of pay-for- value of its operations, then the firm can support a
performance compensation may be able to reduce greater debt-to-equity ratio and shelter more of its
the deadweight cost of that compensation by reduc- income from taxes.
ing the total risk of the firm without reducing the net The value of the incremental tax shield created
present value of its projects. by increased debt capacity will vary by firm. Many
start-up firms, for example, have negative profits
Risk Management Can Reduce Taxes during their early years; at the margin these firms
cannot capture the tax benefits of debt until they
Risk management also creates value by reduc- have used their net operating losses. But new risk
ing a companys tax burden. A progressive tax management techniques and instruments could
structure gives firms an incentive to smooth earnings present an opportunity for established, cash-gener-
to minimize taxes, and risk management enables ating companies to rethink their capital structures
such smoothing. Progressive tax rates mean that a and raise their target debt levels.4, 5

3. For a method of estimating this deadweight loss, see my article, The 152). Walt Dolde also finds the same positive correlation between hedging and
Efficiency of Equity-Linked Compensation: Understanding the Full Cost of leverage (after controlling for primitive risk exposure). See Dolde, W., 1995,
Awarding Executive Stock Options, Financial Management (Summer 2001), 5- Hedging, Leverage, and Primitive Risk, Journal of Financial Engineering 4 (2),
30. Use of my method suggests that, in volatile firms, the private value an 187-216.
undiversified manager places on her stock options can be as little as half their 5. Another way risk managementparticularly, the communication of and
market value. adherence to a firm-wide risk targetcan contribute to a firms debt capacity is
4. Some firms appear to have begun this process. David Haushalters study by reducing potential bondholder-stockholder conflicts that arise when higher
shows that oil and gas companies with higher leverage hedge more of their oil price debt ratios cause managers to increase asset volatility in the hopes of a higher equity
risks, see (Haushalter, G. D., 2000, Financing Policy, Basis Risk, and Corporate payoff. By committing themselves to targeting a total risk level, management
Hedging: Evidence from Oil and Gas Producers, Journal of Finance 55 (1), 107- decreases their opportunity for risk shifting at the expense of debtholders.

60
JOURNAL OF APPLIED CORPORATE FINANCE
Investors may accept a smaller risk premium on the firms equity in return for
greater certainty about their own exposure to systematic risks from holding that
equity. To assist investors in managing risk and thereby lower the companys cost of
capital, managers of the firm can target specific levels of systematic and total risk.

Risk Management Can Reduce Monitoring which risk exposure targeting can be particularly
Costs by Improving Performance Evaluation valuable. The asset and liability portfolios of banks,
securities firms, and insurance companies are typi-
Risk targeting can lower the costs of evaluating cally quite opaque to outsiders. Furthermore, rela-
and monitoring corporate performance for inves- tive to most non-financial firms, these companies
tors, creditors, customers, and corporate boards of have the ability to change the composition of their
directors. Performance evaluation requires a mea- assets and liabilities rapidly without public detec-
sure of the firms risk in order to construct an tion, suggesting that an efficient way for investors to
appropriate benchmark for gauging performance.6 If manage their risk is for the firm to target a specific
the firms risk exposures are changing or if the firms risk level. Of course, the high leverage typical in this
operations are opaque to outsiders, constructing industry can mean that firm performance is very
such a benchmark is difficult. To the extent outside sensitive to its underlying risk exposures, providing
investors or creditors find monitoring and evaluation another reason why financial firms may want to
difficult and costly, they will require an additional manage risk. It is therefore not surprising that
expected return premiumand customers may even financial institutions have been the pioneers in
pay a lower price for the firms productsto offset implementing sophisticated, integrated risk man-
this higher monitoring cost. Although some compa- agement. Industries that are rapidly evolving and
nies may be able to avoid paying this premium by changing, and that have few tangible assets (and
providing full disclosure about their operations and therefore less transparency), might also be good
associated risk, such disclosure may not always be candidates for risk exposure targeting.
practicalagain, perhaps for competitive reasons.
By setting a benchmark level of either systematic Risk Management Can Provide Internal Funds
or total risk, managers can facilitate investor moni- for Investment
toring without disclosing proprietary information
about the firms operations. If a company needs funding for a potentially
Another way that risk management can contrib- profitable project, and issuing debt or equity is either
ute to better performance evaluation is by making impossible or too costly, management must fund the
corporate disclosures more informative, not only to project internally or forgo it. Internal funding re-
outside investors, but to corporate boards as well. quires that the firm either stockpile cash or have
For example, to the extent that the effect of oil price steady cash flows from other projects. By smoothing
fluctuations are removed by hedging from an oil and out cash flow volatility, risk management can help to
gas companys reported earnings and cash flows, ensure that the firm will be able to fund profitable
those measures can provide outside investors with projects internally.8
a more accurate reflection of managerial ability and Internal funding, however, is a double-edged
performance. And besides providing more useful sword. Companies with too much cash on hand
information to outsiders, such risk-adjusted perfor- avoid the discipline of outside review that accompa-
mance measures may also provide corporate boards nies external capital raising and can prevent manag-
with a more effective basis for management compen- ers from proceeding with bad projects.9 Thus, the
sation, one that helps insulate managers from risks benefit of internal funding will vary from firm to firm,
beyond their control.7 but will tend to be greater for companies with more
In addition to energy and mining companies, growth opportunities and a larger information gap
the financial services industry is another one in between managers and investors. Larger firms, be-

6. Risk measurement is an integral part of performance evaluation. High-risk Energy Industry, Journal of Applied Corporate Finance Journal, Vol. 13 No. 4
ventures may be accompanied by high returns, but investors cannot evaluate (Winter 2001).
whether the firm has earned excess returns without an estimate of how much risk 8. For more complete descriptions of how risk management enhances the
the firm took to achieve those returns. The S&P 500 Index, for instance, is neither firms ability to internally fund valuable new investments, see Kenneth Froot, David
an appropriate benchmark if the firm invests in low-risk, market-neutral or counter- Scharfstein, and Jeremy Stein, A Framework for Risk Management, Harvard
cyclical projects, nor is it an appropriate benchmark if the firm invests in well- Business Review Vol. 72 No. 6 (1994).
above-average-risk, pro-cyclical projects. 9. For an argument suggesting that the absence of capital market scrutiny for
7. For an extended discussion of this role of risk management in strengthening new investments leads to the acceptance of sub-optimal projects, see Peter Tufano,
management incentives in the energy industry, see the roundtable discussion of Agency Costs of Corporate Risk Management, Financial Management Vol. 27
Derivatives and Corporate Risk Management: The Transformation of the U.S. No. 1 (1998).

61
VOLUME 14 NUMBER 4 WINTER 2002
sides being less capital constrained, are less likely to by its financial policies. The company has no out-
suffer from such an information gap between man- standing debt and, indeed, holds about $18 billion
agers and investors due to their greater analyst in cash. Besides providing financial flexibility that
coverage. Consequently, the role of risk manage- can help the company in responding to demand or
ment as a means of ensuring internal funding should other shocks, Microsofts no-leverage (or negative
be more important for smaller, more specialized firms. leverage) policy may also reflect an attempt to
reduce the risk borne by some of its senior execu-
A FUNCTIONAL APPROACH TO INTEGRATED tives, who together own a substantial fraction of the
RISK MANAGEMENT outstanding shares.
In sum, Microsofts operational policy of using
Integrated risk management extends across temporary employees and its no-leverage financial
functional boundaries within the firm, and a risk policy both serve to reduce its overall level of fixed
management perspective yields insights into seem- costs, increase flexibility, and thereby reduce the
ingly unrelated managerial decisions. Consider, for firms total risk. Both types of policies, although quite
example, Microsofts heavy reliance on temporary different in their application, are functionally equiva-
employees. Microsofts personnel officer, Doug lent and thus can be viewed as substitutes for one
McKenna, explains that we count on them [temps] another.12 An integrated risk management approach
to do a lot of important work for us. We use them to recognizes that a firm has many ways to manage its
provide us with flexibility and to deal with uncer- risk, and that both the optimal amount of risk
tainty.10 And the companys director of contingent retained and the tools used to achieve that level of
staffing, Sharon Decker, adds that we want to be risk will differ from firm to firm. What integrated risk
very flexible as a company, to be able to react to management provides is a systematic way of think-
competitive challenges and react quickly.11 By ing about risk and identifying its multidimensional
reducing operating leverage (here the fixed costs of effects on the firm, coupled with a framework for
a more permanent workforce), Microsoft has greater deciding upon the best strategy for implementation.
flexibility to respond to unexpected shocks in de- Integration, then, means both integration of
mand, technology, or regulation. risks and integration of ways to manage risk. Inte-
Without such flexibility, a bad turn of events grated risk management evaluates the firms total risk
could create uncertainty about the companys com- exposure, instead of evaluating each risk in isolation,
petitive position and its ability to continue setting because it is the total risk of the firm that typically
industry standards. Customers may begin to defect, matters to the assessment of the firms value and its
as they question Microsofts ability to provide future ability to fulfill its contractual obligations in the
service and upgrades. With further deterioration, future. Furthermore, individual risks within the firm
software developers may be less likely to tailor their will partly or completely offset each other (thereby
products to Microsofts operating platform. Key reducing the total expense of hedging or otherwise
permanent employees may leave for a more stable managing those risks). Thus, in implementing hedg-
environment. Microsofts policy of using temporary ing and insurance transactions to manage the risk of
workers allows the company to respond more the firm, one need only address the net exposures
rapidly to such shocks, thereby improving its chances instead of covering each risk separately. This netting
of remaining a lead player in its industry. can significantly reduce transaction costs.
And Microsofts operational policies, at least in Moreover, such an analysis is essential in chart-
the sphere of risk management, are complemented ing an effective risk management strategy because,

10. Los Angeles Times, 12/7/97, p. D1. are 30 percent higher than a comparable Microsoft employee. And many
11. The News Tribune (Tacoma, WA), 2/21/99, p. G1. nontraditional workers enjoy the flexibility of the arrangement. Seattle Times, 12/
12. Each policy, of course, has its particular costs and benefits. Without debt, 16/97, p. A1. Sometimes the short-term nature of Microsofts commitment to its
Microsoft loses out on the debt tax shield. And temporary workers may not be as temporary employees can engender dissatisfaction and resentment, As a part-
motivated as permanent employees In the words of one Microsoft permanent timer, you are like a tool, said Philip Hirschi, a Web designer who recent left a
employee (a former temp), Temps are tempsthey come and go. They are temporary job at Microsoft to take a full-time position elsewhere. If you are a
probably not working as hard. They arent invested in the company, so its not in Phillips screwdriver, and they need a flat head, they just get rid of you, they wont
their interest to work 70-hour weeks. Los Angeles Times, 12/7/97, p. D1. Microsoft retool you. Los Angeles Times, 12/7/97, p. D1. This perception suggests that
seems fully aware of the incentive problem, and tries to compensate: What they at least some temporary employees may be less willing to invest in firm-
lack in status and benefits, temps often make up in salary; typically, their paychecks specific human capital.

62
JOURNAL OF APPLIED CORPORATE FINANCE
In large part because their customers are also major liability holders, financial firms
like insurance companies and commercial banks face enormous costs of
financial distress.

by focusing narrowly on one specific risk, managers offs. These trade-offs sometimes involve comparing
may create or exacerbate other types of risk for the the costs of reducing a particular risk with the
company. Interactions between risks are not always benefits of that reduction; at other times, managers
obvious, especially when they occur among unre- must trade off risks among businesses. Risk manage-
lated businesses within the firm. A nice example of ment decisions must be made on a company-wide
this comes from the late 1980s, when Salomon level because the consequences of managing any
Brothers, the investment bank, attempted to move particular risk affect the value of the entire company.
into the merchant banking business on a large scale Integration of risk management can also add
by leading an investment group in an unsuccessful value to the firm by permitting the purchase of more
effort to acquire control of RJR Nabisco in a leveraged efficient insurance contracts that provide a lower
buyout. Although it did not succeed, the attempt cost way to manage its overall or enterprise risk.
signaled bond rating agencies and other stakehold- Consider a hypothetical company that faces non-
ers that Salomon was prepared to increase the total operating risks of three types: losses from product
risk it faced. This change in Salomons risk profile liability, losses from fire, and losses from foreign
hurt its existing customer-based derivatives busi- exchange rate exposures. Suppose that the firm is
ness, which had been a significant source of profits. willing to self-insure against these risks up to a
Salomons prospective merchant banking busi- maximum total loss of $3 million. If, as is typical,
ness would seem to have little connection to its responsibility for each type of risk is delegated
existing customer-based derivatives business: the separately and a separate policy is purchased to
employees were different, the technology was differ- protect for each, then to meet the overall firm
ent, the customers were different, even the buildings maximum-loss constraint, the maximum deductible
housing the businesses were different. But because on each of the three policies is $1 million. However,
Salomon owned both businesses, its shift into a this collection of separate policies provides more
riskier business affected the overall risk and credit- insurance than the firm really needs. For example,
worthiness of the company. The value of derivative suppose that the firm experiences a product liability
contracts is acutely sensitive to the credit ratings of judgment of $2.5 million and no losses from either
derivatives providers. Just by contemplating a move fire or foreign exchange. The firm is covered for all
into the merchant banking business, Salomon showed but $1 million even though it was prepared to take
its willingness to increase the companys overall risk the entire $2.5 million loss within its maximum-loss
exposure, jeopardizing the strong and stable credit- limit. Of course, after the fact, the firm would have
rating so important to its customers and reducing its been happy to have the greater coverage. But
ability to compete in the credit-sensitive, customer- beforehand, when it made its risk management
based derivatives business. decisions, the firm paid higher insurance premiums
When different businesses share the same cor- for that extra, unwanted coverage.
porate umbrella, then, the risk of each business is If instead the firm could purchase a comprehen-
shared among all businesses. For Salomon, the sive policy covering all three types of risks, it could
combination of the two businesses destroyed value have a deductible of $3 million and receive the
until financial engineering created an AAA-rated coverage it actually wants. Because the three types
derivatives subsidiary that effectively decoupled the of risks are not perfectly correlated with one another,
shared capital structure. the premium for the comprehensive policy with a $3
The Salomon example also underscores the million deductible will be less than the sum of the
reality that risk considerations permeate every major three separate policies with $1 million deductible on
decision of the company. When a company changes each, even when all premiums are absolutely actu-
its business strategy, it likely changes its risk profile, arially fair. 13 When the firm buys a comprehensive
thereby either creating or destroying value. Risk policy that insures against all three risks, it buys a
management almost always requires making trade- different (and lower cost) product. Exposure of the

13. The point is very much analogous to buying an individual put option on on the overall portfolio. If all the investor cares about is protecting against losses
each security in a portfolio versus buying a put option on the portfolio of securities on the overall portfolio value and not on each part separately, then the portfolio
itself. As is well known, the sum of premium charges for a portfolio of individual of put options provides too much coverage. Just so, the firm buys too much
put options on each security is going to be larger than the premium for a put option insurance when it buys a separate policy, or put option, for each risk.

63
VOLUME 14 NUMBER 4 WINTER 2002
firms value, after all, does not depend on the source exchange rate risk, another for product obsoles-
of the risk per se; instead, it depends on the total risk. cence) or type of business.15 Senior management
So, the type of insurance needed by the firm is one must decide which risks are essential to the profit-
that pays off when the effect of the aggregated risks ability of the firm, taking into account cross-risk and
exceeds a certain, pre-specified, amount. If what the cross-business effects, and then develop an inte-
firm really wants is to ensure that the risks do not grated strategy to manage those risks.16
lead to a drop of more than $3 million in value,
then it should insure against the joint event that TOOLS FOR INTEGRATED RISK
the combined risks do not lead to a drop of more MANAGEMENT: OPERATIONS, FINANCIAL
than $3 million. INSTRUMENTS, AND CAPITAL STRUCTURE
Multi-risk policies are just beginning to be
used in practice. Some policies bundle together At the foundation of risk management is the
foreign exchange risks with coverage of more integration of the three mechanisms to alter the firms
conventional insurance risks. And Reliance Insur- risk profile. These three ways to manage risk
ance now offers an omni-risk policy that insures modifying the firms operations, adjusting its capital
a companys earnings against all sorts of risks that structure, and employing targeted financial instru-
are outside of managements control. However, a mentsinteract to form the firms risk management
firm can only use these comprehensive policies strategy. Managers must weigh the advantages and
effectively in the context of a firm-wide integrated disadvantages of any particular approach in order to
risk management approach. find an optimal mix of the three. As in the preceding
Moreover, the integration of different possible section, we explore each of these mechanisms in a
ways to manage risks can be just as important as the series of examples.
aggregation of the risks. As we saw earlier in the case
of Microsoft, just as different categories of risks can Operational Risk Management
affect firm value in a similar fashion, so different
ways of managing risks can be combined to achieve Managers typically have many different ways to
a common objective. Thus, Microsoft can reduce its address risk by adjusting operations. Microsofts use
total risk through the operational policy of using of temporary workers discussed in the last section is
temporary workers; it can also reduce that risk by an example, but there are many others. Consider the
carrying a low level of debt.14 What is important to effect of weather on Disneys theme parks and their
keep in mind, however, is that the goal of risk customers. Bad weather dramatically reduces the
management is not to minimize the total risk faced number of visitors, exposing the theme parks own-
by a firm per se, but to choose the optimal level of ers to considerable weather-related risk. This risk
risk to maximize shareholder value. Effective risk extends to customers as well. A vacation destination
management requires a thorough understanding of with unpredictably unpleasant weather compels
the firms operations as well as its financial policies. potential visitors to bear some weather risk. Disneys
Given the breadth of firm-specific knowledge re- 1965 decision to build Disney World in a warm and
quired and the potential for impact on overall firm sunny location (Orlando, Florida) reduced both its
value, risk management is a direct responsibility of own exposure, and that of its customers, to inclem-
senior managers. It should be delegated neither ent weather.17
entirely to outside risk experts nor to internal But Disneys decision to locate in Florida, while
managers by type of risk (such as one policy for reducing weather risk, also altered its risk exposure

14. Debt actually has a two-fold effect. First, lowering debt means lowering intimate understanding of the firms business, the competitive landscape, and how
fixed costs, thereby reducing the firms chances of getting into financial distress. the various risks feed back and affect firm value.
Second, debt acts as a magnifier of other risks. So, while changing the debt level 16. Of course, senior managers will rely upon the managers of a specific
does not affect whether an operational risk occurs or not, if an operational risk does business unit or project to provide them with information to measure the firms
occur, a low debt level will cushion the impact of an operational risk, but a high exposures. Likewise, the estimation of the costs of addressing those risks
debt level will exacerbate its effect. operationally necessitates business and project-specific information. The firms
15. Derivatives and other outside experts will be involved to the extent that senior management must then integrate the risks and their effects across businesses
they must provide information about whether its feasible to manage a particular or projects.
type of risk, and how costly it might be. Other consultants might be helpful in 17. Customers are rarely the best bearers of risk. In this instance, customers
providing guidance on the type of information needed before embarking on a risk are unlikely to be exceptionally skilled weather forecasters, suggesting they may
management program. But, the one thing consultants do not typically have is an not be the ideal bearers of risk.

64
JOURNAL OF APPLIED CORPORATE FINANCE
Risk management can contribute to better performance evaluation by making
corporate disclosures more informative not only to outside investors, but to
corporate boards as well. For example, to the extent that the effect of oil price
fluctuations is removed by hedging from an oil companys reported earnings, those
earnings can provide investors with a more accurate reflection of managerial ability
and performance.

along other dimensions. At the time of Disneys recently expanded its product line by introducing a
27,500-acre purchase, Orlando was not particularly less-expensive model, the S-type model. Jaguar
near any population centers, and air travel was surely had multiple reasons for broadening its prod-
relatively expensive. So one cost of Disneys location uct line. But whether intended or not, this decision
choice was that most of its customers had to travel has risk management implications for the firm.
long distances to visit, increasing Disneys exposure Introduction of the S-type helps buffer Jaguar against
to fuel prices, the cost of air travel, and fluctuations a softening of the luxury car market and volatility in
in the economy. the overall state of the economy. But, of course, this
Another case where a company chose to elimi- decision was not without its own risks: one
nate a risk facing its customers was that of the potential cost of Jaguars product expansion was
producer of Fresh Samantha fruit juices. From their the possibility that the S-type would dilute Jaguars
introduction, the hallmark of Fresh Samantha juices high-end image. 19
was their freshly squeezed taste, attributable in large Disneys theme park locations, Fresh Samanthas
part to the fact that the juice was not pasteurized, a pasteurization decision, and Jaguars expanded prod-
departure from standard industry practice. But with- uct line all illustrate how changes in the firms
out pasteurization, the risk of contamination in- operations can alter its risk exposure. Risk manage-
creases. Furthermore, consumers are typically not ment is not only a decision about how much risk the
the best bearers of this risk because they cannot firm should bear, it is also a decision about how
easily detect contamination. In 1995, the magnitude much risk the firms customers or suppliers are
of this risk became apparent. Odwalla, a California- prepared to bear. As a more general matter, suppli-
based fresh (non-pasteurized) juice maker, sold ers, customers, community members, firm share-
juice contaminated with E. coli bacteria, resulting in holders, and employees are all potential risk bearers
the death of one child and illness in 60 others. The for the firm. Managers must determine the optimal
incident raised consumer awareness of the potential level of risk for all parties and consider not only how
heath risks associated with non-pasteurized juice, each individual risk affects the firms total risk
and had an immediate impact on sales of Fresh exposure, but also evaluate the optimal way of
Samantha, even though Fresh Samantha was not managing and distributing those risks.
involved in the episode. Forbes reported that retail-
ers demanded to know if Fresh Samantha was safe. Risk Management Using Targeted Financial
Some threatened to cancel orders; several new Instruments
accounts delayed payment.18 Fresh Samanthas
managers decided that the firms product liability risk Some risks cannot be managed effectively
exposure (and that of its customers) was simply too through the operations of the firm, either because no
great and responded by upgrading the firms quality feasible operational approach exists or because an
control department and pasteurizing its juice. As this operational solution is simply too expensive to
case suggests, the impact of product failure or implement or too disruptive of the firms strategic
mismanagement on the reputation of a firm can be goals. Targeted financial instruments such as deriva-
devastating, especially for those reputation-sensitive tives (futures, swaps, or options) or insurance can be
firms involved in financial services, food, medicine, an alternative to using operations directly to reduce
or anything else that goes inside our bodies. risk. Such instruments are available for many com-
Jaguar Cars faced a different product market modities, currencies, stock indices, and interest
risk: their limited product line was focused on a very rates; and the menu is continually expanding to
narrow segment of the luxury car market, which left reflect a variety of other risks, including even the
Jaguar more exposed to economic fluctuations than weather. Targeted financial instruments affect the
other luxury car manufacturers whose customers firms risk profile in the sense that if a risk does occur,
might shift down to one of their less expensive targeted financial instruments can reduce or elimi-
luxury cars in more difficult economic times. Jaguar nate the effect on firm value. In Disneys case,

18. Forbes, April 6, 1998. drawn from Jaguar when it was an independent company that illustrates the
19. Jaguar is entirely owned by Ford, which surely affects its risk profile and application of financial instruments as an alternative risk management tool to
thus its risk management strategy. The next sections text offers another example operational actions.

65
VOLUME 14 NUMBER 4 WINTER 2002
purchasing insurance against bad weather might be Jaguar can manage its risk using targeted financial
a substitute for locating in a warm and sunny instruments; it calls for continuous assessment of the
climate.20 Whether buying weather insurance domi- firms total risks and of the costs of the various ways
nates physically locating in a temperate climate to manage those risks. After engaging in an inte-
depends upon the relative cost of the insurance grated risk management evaluation, Jaguars manag-
versus the cost of putting the theme park in the ers may decide that using contractual agreements to
middle of Florida. decrease Jaguars product line exposure to overall
To illustrate how financial contracts can be used economic fluctuations in this fashion is too costly, or
as an alternative to operational solutions, we return too difficult to execute. They may instead conclude
to the case of Jaguar, but this time when it was an that, to achieve the optimal level of total firm risk,
independent British company (that is, prior to its they can more profitably moderate some of Jaguars
acquisition by Ford). Although almost all of Jaguars other risks.
production was located in the United Kingdom, That risk exposures individually can be difficult
more than 50% of its revenue came from sales in the to hedge directly using existing financial instruments
U.S., subjecting the firm to sterling-dollar exchange is not of course limited to luxury car manufacturers.
rate risk. Moreover, Jaguars main competitors in Microsofts continued success will depend upon the
the luxury car market in the U.S.Daimler-Benz, future evolution of the Internet, on the technology
BMW, and Porschewere German car manufac- sector more broadly, and perhaps on the outcome of
turers that produced their cars in Germany. The the governments antitrust suit. Hedging each of
German car manufacturers U.S.-based sales, both these risks individually would be difficult using
individually and collectively, swamped those of traditional derivative instruments. Instead, Microsoft
Jaguar. Jaguar therefore had little influence on might choose to buy put options on its own stock to
market prices of luxury cars sold in the United reduce its aggregate risk of loss in stock value from
States, which depended more on prices set by the all sources; or it might buy insurance to protect its
German car manufacturersprices that were sen- operating earnings against adverse events that are
sitive to the mark-dollar exchange rate. The com- beyond managements control. Although compa-
petitive environment in U.S. luxury cars, then, nies do sometimes buy limited quantities of put
exposed Jaguar to substantial exchange rate risk options on their own stock, such strategies also have
from movements in mark relative to the dollar, significant shortcomings in implementation. Market
even though Jaguar had neither sales nor produc- participants may view the firms decision to buy puts
tion in Germany. Such currency risk could have as negative information, either about the firms
been hedged using derivatives, such as currency future prospects or its future volatility.22 A similar
future or forward contracts.21 issue arises with earnings-protection insurance. As
In a similar vein, suppose that the demand for noted previously, Reliance Group has announced
Jaguars is found to be sensitive to the stock market, that it will sell such an insurance product covering
both because many potential owners work in finan- events outside managements control. But determin-
cial services and because employees often use ing what is or is not under managements control is
bonuses and stock option gains to buy luxury cars. no easy task.23
A partial hedge could be constructed using futures, Targeted financial instruments are especially
swaps, or options on the stock market. Or if interest suited for firms with large exposures to commodity
rates and the price of gasoline were found to be prices, currencies, interest rates, or the overall stock
linked to consumer demand for luxury cars, then market. These exposures derive not only from the
derivatives on interest rate and gasoline may buy firms inputs, outputs, or production processes, but
Jaguar further protection. To be sure, integrated risk also from risks passed along from its suppliers,
management requires more than an observation that employees, customers, or competitors. A candy

20. Such insurance was not available in 1965 when Disney made its decision. firms purchases of puts does convey information about its belief concerning
21. For a more detailed description of Jaguar and its risk exposures, see expected future volatility.
Tim Luehrman, Jaguar PLC 1984, Harvard Business School Case No. 9-290- 23. Of course, earnings insurance could introduce a substantial moral hazard
005, May 1990. problem, as managers who have such insurance might have little incentive to work
22. Because a firm can also issue or buy stock to convert its puts to calls and hard. Also, the insurance company will face significant asymmetric information
vice versa, inferring a directional signal from its actions may be difficult. Still, the problems when it tries to sort out the bad managers from the good ones.

66
JOURNAL OF APPLIED CORPORATE FINANCE
Targeted financial instruments such as derivatives (futures, swaps, or options) or
insurance can be an alternative to using operations directly to reduce risk.

producer, for instance, may have a substantial risk which no there are no specific targeted financial
exposure to sugar prices and can hedge this risk instruments. The greater the risk that cannot be
using sugar futures. Likewise, an oil producer can accurately measured or shed, the larger the firms
sell its production forward to reduce its exposure to equity cushion should be.
oil price risk. A manufacturer of recreational vehicles A well-known disadvantage of using equity as
typically has substantial exposure to oil and gasoline a risk management tool is the loss of the interest tax
price risk; it can hedge these risks contractually shield that debt provides. Another disadvantage of
through oil or gasoline futures or forwards. So the managing risk via the capital structure is that a
benefit of risk management via targeted financial reduction in debt can create or exacerbate certain
instruments is that specific risks can be offset without agency problems, including a well-documented
disrupting the firms operations. But this type of risk tendency of managers to waste free cash flow and
management is effective only against the risks that excess capital.24 In contrast, managers who use
managers are able to foresee in type and magnitude. operational adjustments and targeted financial in-
It is also possible to manage risk by changing struments as a substitute for more equity capital
the payment form of the firms debt. A case in point typically have greater flexibility to avoid the negative
is the ability to issue debt denominated in a foreign tax and incentive consequences of their risk manage-
currency or to issue debt denominated in an asset ment actions. And as this argument implies, manag-
other than money, such as debt denominated in gold ers can effectively increase their firms debt capacity
or oil. Foreign currency debt can lower the firms by reducing risks operationally or with targeted
exchange rate exposure, and gold- or oil-denomi- financial instruments.
nated debt can reduce the firms exposure to oil or
gold prices. Catastrophe bonds (CATS) are another IMPLEMENTING INTEGRATED RISK
example of debt tailored to address a specific type MANAGEMENT
of risk, namely that of a catastrophic event, which
can reduce the risk exposure of the issuing insurance Having explored the three basic tools for firm-
company. CATS pay off only if the pre-specified wide risk management, we close by framing the
event risk does not occur. Such structured ap- broad managerial issues surrounding the develop-
proaches to risk management might just as easily be ment and implementation of a risk management
classified as a capital structure tool as a financial system. Whether risk reduction actually increases
instrument tool. The boundaries between the two firm value depends upon the cost of that reduction.
are indeed both permeable and imprecise. Managers must estimate the effect of each risk on
firm value, understand how each risk contributes to
Risk Adjustment via the Capital Structure total firm risk, and determine the cost of reducing
each risk.
The third tool to manage risk does not require In order to quantify the value of a given risk
a precise forecast of the source or magnitude of a management strategy and so arrive at the value-
specific risk. By decreasing the amount of debt in the maximizing strategy, this information must be incor-
capital structure, managers reduce the shareholders porated into a model of firm value that encompasses
total risk exposure. Besides reducing the probability managements knowledge of the economics of the
of financial distress, lower debt means that the firm business and the competitive environment, as well
has fewer fixed expenses and thus greater flexibility as its beliefs about the ways in which risk potentially
in responding to any type of volatility that affects firm affects firm value. By varying the inputs to the model,
value. Equity provides an all-purpose risk cushion managers can observe how firm value changes when
against loss. There are some types of risks that a firm various risks are hedged or not. In this fashion,
can anticipate and measure relatively precisely and managers will be able to determine the optimal level
these can be shed through targeted risk manage- of total risk, the configuration of risks constituting
ment. Equity provides protection against risks that this level of risk (i.e., the risks to be divested, and the
cannot be readily anticipated or measured, or for risks to be retained), and the best way to achieve the

24. See Tufano (1998), cited in footnote 9, on agency costs of risk management.

67
VOLUME 14 NUMBER 4 WINTER 2002
FIGURE 1 RISK REVIEW

Product Market Risk Operational Risk Input Risk

Customer loss Machinery breaks down Input prices increase


Product obsolescence Product defects increase Labor strikes
Competition increases Weather destroys plant Key employees leave
Product demand Inventory obsolesces Supplier fails
decreases

Financial Risk Tax Risk

Capital costs change Income tax increases


Exchange rate changes Industrial revenue
Inflation bonds end
Covenant violation Sales tax increases
TOTAL
Default on debt
FIRM

RISK

Legal Risk Regulatory Risk

Product liability Environmental laws change


Restraint of trade charges Stricter antitrust
Shareholder lawsuits enforcement
Employee discrimination Price supports end
lawsuits Import protection ceases

desired risk profile. Of course, creating such a To illustrate how one might begin mapping a
valuation model requires extensive information about risk management strategy, consider the risks faced
consumer demand and the nature of competition in by a rapidly growing company. The managers know
the industry as well as continuous refinement. that the firms rapid growth introduces substantial
The first key step in the development of a risk risk. The goal of the risk inventory is to transform this
management strategy is to inventory all the risks faced general observation into a more detailed description
by the firm. As shown in Figure 1, corporate risks can of how the risks associated with a growth strategy are
be classified into seven categories. Operational risk, likely to affect the value of the firm. Suppose the firm
product market risk, input risk, tax risk, regulatory risk, is a toy manufacturer, and the firms rapid growth is
legal risk, and financial risk constitute the broad classes a result of the success of one particular toy. The
of risks faced by most firms. After management has managers expect the demand for this toy to drop as
both inventoried the various risks and assessed the the fad wanes, so volatile consumer demand is one
probability of their occurrence (both as separate events major source of risk for this firm. Suppose further that
and concurrently), the next step is to estimate the effect the firm is based in Japan and exports much of its
of a particular risk on firm value. product to the U.S. In this case, the firms U.S. sales

68
JOURNAL OF APPLIED CORPORATE FINANCE
Whereas tactical risk management typically confines itself to hedging specific
contracts or other explicit future firm commitments, strategic risk management
addresses the broader question of how risk affects the value of the firm and the
firms competitive environmentthe pricing of its products, the quantity sold, the
costs of its inputs, and the response of other firms in the same industry.

may depend upon relative yen/dollar exchange information about how both revenues and costs will
rates, where the nature of the competition in the U.S. shift with changing demands, which in turn will enable
determines the relation between exchange rates and them to arrive at an estimated probabilityor, better
firm value. For simplicity, assume that the toy yet, a probability distributionfor the toys life.
manufacturer has no other risks.
The managers of the company need to identify CHALLENGES IN CREATING AN INTEGRATED
the precise ways that these risks are expected to RISK MANAGEMENT SYSTEM
affect firm value. If consumers tire of the toy, how
much will sales decrease? What is the expected Corporate risk management is evolving rapidly,
length of time before a sharp decrease in demand but the practice of risk aggregation is not yet
occurs? Can the toy company prolong the fad widespread. Instead, the typical firm tends to isolate
through advertising or by decreasing the price? and manage risks by type. The treasurers office
Volatile demand also increases the possibility that manages exchange rate exposures and, in some
the firm will be stuck with obsolete inventory after cases, credit risk. Commodity traders, sometimes
the toy fad ends, which will certainly be costly. If the located within the purchasing area, focus on com-
firm has expanded by buying more toy-making modity price risk. Production and operations man-
machinery, does this machinery become obsolete as agement consider risks associated with the produc-
well, or can it be used in the production for other tion process. The insurance risk manager focuses on
toys? If it can be used for other toys, how profitable property and casualty risks. Human resources typi-
are these other toys likely to be?25 In sum, precision cally addresses employment risks. As a practical
in specifying risks translates into greater ability to matter, integrated risk management requires the
measure the effects of those risks. coordination (at least for the function of risk manage-
To then evaluate the effect of exchange rates, ment) of all these previously independent organiza-
managers must first determine how sales are related tional units. The firm, rather than the type of risk,
to exchange rates, and then explicitly link firm sales provides a frame of reference.
to exchange rates in their valuation model. A useful And coordination of risk management across
valuation model will specify how much the U.S. separate areas is only the first step. Managers must
market price will change with a given percentage expand the often narrow focus of their current risk
movement in the yen/dollar exchange rate, and then management practices, moving from a tactical to a
define how a shift in the market price will affect strategic approach. Whereas tactical risk manage-
demand for the product in the U.S. The toy companys ment typically confines itself to hedging specific
managers should also assess the probability of large contracts or other explicit future firm commitments,
and small exchange rate movements, and whether or strategic risk management addresses the broader
how exchange rate risk is correlated to the expected question of how risk affects the value of the firm and
life of the toy.26 the firms competitive environmentthe pricing of
Of course, none of this information is likely to its products, the quantity sold, the costs of its inputs,
be known with certainty. Managers can analyze past and the response of other firms in the same industry.
fads and complement this historical information with Indeed, a firm can be completely hedged tactically,
their insights about why their particular product yet still have substantial strategic exposure. Inte-
might be either longer- or shorter-lived. The market- grated risk management demands that managers
ing area might be able to contribute information look beyond the usual definition of hedging.
about the expected duration of high demand, as well Because an integrated approach to risk manage-
as information about how sales change in response ment departs from the rigid compartmentalization of
to price decreases. Likewise, the operations area may risks, and requires a thorough understanding of the
be the best source for information on how practi- firms operations as well as its financial policies, risk
cable and costly it is to use the machinery for other management is the clear responsibility of senior
purposes. Managers need to collect the necessary managers. It cannot be delegated to derivatives

25. An operational approach to managing the risk of toy fads is that the 26. That is, they must estimate the probability density function of exchange
machinery used to produce toys can be easily adapted to produce a variety of toys, rate changes and the covariance between exchange rate changes and the expected
rather than be specific to one toy. life of the toy.

69
VOLUME 14 NUMBER 4 WINTER 2002
experts, nor can management of each individual risk manage those risks. The rapidly expanding universe
be delegated to separate business units. Although of tools available for risk measurement and manage-
management will no doubt seek counsel from ment offers managers significant opportunities for
managers of business units or projects, it must value creation, but this growth also creates new
ultimately decide which risks are essential to the responsibilities. Managers must understand how the
profitability of the firm, taking into account cross-risk tools work, and then make decisions about how and
and cross-business effects, and develop a strategy to when their use is likely to add value.

LISA MEULBROEK

is Professor of Business Administration at the Harvard Business


School.

70
JOURNAL OF APPLIED CORPORATE FINANCE
Journal of Applied Corporate Finance (ISSN 1078-1196 [print], ISSN Journal of Applied Corporate Finance is available online through Synergy,
1745-6622 [online]) is published quarterly on behalf of Morgan Stanley by Blackwells online journal service which allows you to:
Blackwell Publishing, with ofces at 350 Main Street, Malden, MA 02148, Browse tables of contents and abstracts from over 290 professional,
USA, and PO Box 1354, 9600 Garsington Road, Oxford OX4 2XG, UK. Call science, social science, and medical journals
US: (800) 835-6770, UK: +44 1865 778315; fax US: (781) 388-8232, UK: Create your own Personal Homepage from which you can access your
+44 1865 471775, or e-mail: subscrip@bos.blackwellpublishing.com. personal subscriptions, set up e-mail table of contents alerts and run
saved searches
Information For Subscribers For new orders, renewals, sample copy re- Perform detailed searches across our database of titles and save the
quests, claims, changes of address, and all other subscription correspon- search criteria for future use
dence, please contact the Customer Service Department at your nearest Link to and from bibliographic databases such as ISI.
Blackwell ofce. Sign up for free today at http://www.blackwell-synergy.com.

Subscription Rates for Volume 17 (four issues) Institutional Premium Disclaimer The Publisher, Morgan Stanley, its afliates, and the Editor cannot
Rate* The Americas $330, Rest of World 201; Commercial Company Pre- be held responsible for errors or any consequences arising from the use of
mium Rate, The Americas $440, Rest of World 268; Individual Rate, The information contained in this journal. The views and opinions expressed in this
Americas $95, Rest of World 70, 105; Students**, The Americas $50, journal do not necessarily represent those of the Publisher, Morgan Stanley,
Rest of World 28, 42. its afliates, and Editor, neither does the publication of advertisements con-
stitute any endorsement by the Publisher, Morgan Stanley, its afliates, and
*Includes print plus premium online access to the current and all available Editor of the products advertised. No person should purchase or sell any
backles. Print and online-only rates are also available (see below). security or asset in reliance on any information in this journal.

Customers in Canada should add 7% GST or provide evidence of entitlement Morgan Stanley is a full service nancial services company active in the securi-
to exemption ties, investment management and credit services businesses. Morgan Stanley
may have and may seek to have business relationships with any person or

Customers in the UK should add VAT at 5%; customers in the EU should also company named in this journal.
add VAT at 5%, or provide a VAT registration number or evidence of entitle-
ment to exemption Copyright 2004 Morgan Stanley. All rights reserved. No part of this publi-
cation may be reproduced, stored or transmitted in whole or part in any form
** Students must present a copy of their student ID card to receive this or by any means without the prior permission in writing from the copyright
rate. holder. Authorization to photocopy items for internal or personal use or for the
internal or personal use of specic clients is granted by the copyright holder
For more information about Blackwell Publishing journals, including online ac- for libraries and other users of the Copyright Clearance Center (CCC), 222
cess information, terms and conditions, and other pricing options, please visit Rosewood Drive, Danvers, MA 01923, USA (www.copyright.com), provided
www.blackwellpublishing.com or contact our customer service department, the appropriate fee is paid directly to the CCC. This consent does not extend
tel: (800) 835-6770 or +44 1865 778315 (UK ofce). to other kinds of copying, such as copying for general distribution for advertis-
ing or promotional purposes, for creating new collective works or for resale.
Back Issues Back issues are available from the publisher at the current single- Institutions with a paid subscription to this journal may make photocopies for
issue rate. teaching purposes and academic course-packs free of charge provided such
copies are not resold. For all other permissions inquiries, including requests
Mailing Journal of Applied Corporate Finance is mailed Standard Rate. Mail- to republish material in another work, please contact the Journals Rights and
ing to rest of world by DHL Smart & Global Mail. Canadian mail is sent by Permissions Coordinator, Blackwell Publishing, 9600 Garsington Road, Oxford
Canadian publications mail agreement number 40573520. Postmaster OX4 2DQ. E-mail: journalsrights@oxon.blackwellpublishing.com.
Send all address changes to Journal of Applied Corporate Finance, Blackwell
Publishing Inc., Journals Subscription Department, 350 Main St., Malden, MA
02148-5020.