MIT OpenCourseWarehttp://ocw.mit.edu 15.997 Practice of Finance: Advanced Corporate Risk Management Spring 2009 For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.Lecture Notes on Advanced Corporate Financial Risk Management John E. Parsons and Antonio S. Mello Chapter 3: Why Companies Manage Risk 3.1 Which Side Are You On? Although the many different parts of the firm all face problems involving risk, the problems are very different. As we mentioned in the last chapter, the problem facing a commodity trader is not the same problem that faces the business unit manager and not the same problem that faces the CFO. Because the problems facing each actor within the firm are different, they require a focus on different risk related issues. It is helpful to think about the different offices and activities of a company along the same dividing line used to organize a typical accounting balance sheet: assets on the left and liabilities on the right. Figure 3.1 is a listing of different activities within a typical corporation organized in a layout that mimics a balance sheet’s layout—assets on the left, liabilities on the right. Organizing the different activities according to this left/right, asset/liability split is instructive and useful. Activities on the left are the traditional sources of value for non-financial corporations. Investments are made, operations are managed, and value is produced and realized through the sale of the company’s products. This is where the firm’s competitive advantage is usually thought to lie, whether in the low cost of its production, or the premium margins on its products, or the value of its R&D portfolio, or the organization of its human capital. On the right-hand-side of Figure 3.1 are the auxiliary activities that support and facilitate the productive activities of the firm. These are the activities that are normally considered the domain of the financial office or related departments. This side includes the main interface with the capital markets.Chapter 3: Why Companies Manage Risk Figure 3.1 Where Is Risk Management Relevant? A Balance Sheet Metaphor Assets Liabilities Valuation of New Assets Cash Management Optimization of Operations Tax Management Product Pricing Foreign Operations Reporting Supply Chain Management Interest Rate Risk Management R&D Strategy Accounting Third Party Contracts Debt Funding Management Incentives Equity Issuances Financial Flexibility It is tempting to think of this right hand side as the natural locus of risk management activities. The buying and selling of derivative securities is often restricted to the treasury or other offices falling under the chief financial officer. When people think of “hedging” and “who hedges”, this is what usually comes to mind. And if risk management were purely a zero-sum game played on the financial markets, then this assignment would be true. But that’s a wrong, limited view of corporate risk management. It overlooks half of the ways that risk management raised shareholder value. Risk management happens on both sides of the balance sheet. But the sources of value are different on the two sides. The Left-Hand-Side: Taking Risks to Earn a Return On the left-hand side are the various business units actually making investments, optimizing the operation of assets, choosing product lines and pricing structures, setting up supply chain structures, doing performance evaluation. For these activities, risk management is first and foremost a decision making tool. page 2Chapter 3: Why Companies Manage Risk If management is to build a successful business, it needs to be able to answer questions such as these: • What is the value of that asset? How much is this extra risk worth? • If I target a riskier value added product line, is the incremental profit worth the risk? • What is the risk-reward tradeoff involved in delaying an investment, in developing a more flexible production scheme? • Do I pay a premium to lock in a more reliable supply schedule? What is the downside risk worth? • How long do I keep funding a speculative research and development program? When do I pull the plug? In none of these situations is management trying to avoid risk. In none of these situations is the objective to hedge risk. Businesses make money by assuming risk. Every capital investment project involves spending cash up front in exchange for the gamble of future, uncertain cash flows. Expanding operations means expanding risk. The task in all of these situations is to accurately assess, measure and price the risk, so that management can then make the right decisions about what to pay, how much to invest, how to operate assets, organize production, price and market products, and so on. Risk management is an input to all elements of good business management. The task is not to reduce risk, but to face it wisely. In a few cases the correct business decision may be to lay off the risk, to pass it to another party. • For example, this is done in the case of major construction projects by writing the terms of the contract to specify whether the contractor or the investor is responsible for cost overruns or changes in input prices. Assigning the risk of delays to the contractor is done as an incentive device, to motivate the contractor to perform on time, or as a negotiating device, to motivate the contractor to provide a realistic estimate up front. The investor does not have an aversion to the risks, per se—just an aversion to a contract structure that would create unnecessary risks. • The Bombardier example from Chapter 2 is another case in which the company did not hold onto the risk created the money-back guarantee it offered to customers. It hedged this risk to its counterparty, Enron. In this case, the company is laying off the risk because it has no expertise in estimating the size and price of the risk. To make the right business decision on whether to offer the guarantee, it needs to know the cost, and the most reliable estimate of cost comes in the form of a simple price charged by an arms-length transaction with another party willing to accept the risk. page 3Chapter 3: Why Companies Manage Risk The profitable management of a business always involves choosing among alternatives, and may involve accepting some risks while avoiding others. What is the company’s competitive advantage in risk taking? It should