SMB2F2 5

Strategic Financial Management
Block
5
STRATEGIC RISK MANAGEMENT
UNIT 17
Corporate Risk Management
05
UNIT 18
Risk Management and Corporate Strategy
22
UNIT 19
Organization Architecture, Risk Management,
and Security Design
47
UNIT 20
The Practice of Hedging
76
UNIT 21
Enterprise Risk Management
98
Expert Committee
Dr. J. Mahender Reddy
Vice Chancellor
IFHE (Deemed University), Hyderabad
Prof. P. A. Kulkarni
Vice Chancellor
Icfai University, Dehradun
Prof. Y. K. Bhushan
Vice Chancellor
Icfai University, Meghalaya
Dr. O. P. Gupta
Vice Chancellor
Icfai University, Nagaland
Dr. Lata Chakravorty

Director
IBS Bangalore
Prof. D. S. Rao
Director
IBS Hyderabad
Prof. P. Bala Bhaskaran

Director
IBS Ahmedabad
Dr. Dhananjay Keskar

Director
IBS Pune
Prof. P. Ramnath
Director
IBS Chennai
Course Preparation Team

Shri T. S. Rama Krishna Rao
Icfai University
Prof. Hilda Amalraj

IBS Hyderabad
Dr. M. Syambabu
Icfai University
Prof. Bratati Ray

IBS Kolkata
Ms. C. Padmavathi
Icfai University
Dr. Vijaya Lakshmi S

IBS Hyderabad
Ms. Sudha
Icfai University
Dr. Vunyale Narender

IBS Hyderabad
Ms. Sunitha Suresh

Icfai University
Prof. Arup Chowdhury

IBS Kolkata
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BLOCK 5
Value creation to stakeholders of the firm is not merely the outcome of growth in
revenues but more from the trade-offs between the required rates of growth and the
prospective effects of the concomitant associated risks undertaken with it. It has become
more important for managers to understand these trade-offs instead of targeting only at
revenue enhancements. Such trade-offs between returns and risks spread across the
businesses can be clearly and completely evaluated by the managers only when the
corporate culture incorporates the right framework of risk management and imbibes the
right risk awareness. This scientific understanding and logical evaluation stems from the
art and science of risk management. Strategic Risk Management culture encompasses
several features which are discussed in this block. This block consists of five units.
Corporate Risk Management can be considered to be a logical extension of risk
management. Nowadays, businesses are extending globally and their foreign exchange
risk exposures need to be taken care of. Units 17 and 18 provide a primary platform for
risk management concepts. These discuss the various sources of risk and the different
types of risk. Further, we will also discuss the various approaches towards risk
management. Apart from this, the basics of risk management techniques are also
explained.
The structure of organizational architecture can be broken down into two basic
components viz., Business architecture and Financial architecture. Unit 19 deals with
the structure of organizational architecture.
Unit 20 deals with the practice of hedging. Hedging means the purchase or sale of equal
quantities of the same or very similar instruments in two different markets at
approximately the same time, with the expectation that a future change in price in one
market will be offset by an opposite change in the other market. This requires the
calculation of returns, beta, co-variance, and risk exposures.
Unit 21 enumerates the process of enterprise risk management and discusses at length
the types of risks. It also discusses the framework of risk management. An enterprisewide risk management culture encompasses several features like identification, report
and trade off.
UNIT 17 CORPORATE RISK

MANAGEMENT
Structure
17.1
Introduction
17.2
Objectives
17.3
Meaning of Risk
17.4
Sources of Risk
17.5
Approaches to Risk Management
17.6
The Process of Risk Management
17.7
Techniques of Risk Management
17.8
Guidelines for Risk Management
17.9
Summary
17.10 Glossary
17.11 Suggested Readings/Reference Material
17.12 Suggested Answers
17.13 Terminal Questions
17.1 INTRODUCTION
Business is a continuous process and investment in business depends on the future
profits, but future is not certain. There may be variance between the expected profits
and actual profits. The more the gap, the more it creates uncertainty and may not
motivate the owners to contribute the capital. Hence, it is very essential to reduce the
gap between the expected events and actual events. That procedure is known as risk
management. Since time immemorial, human beings have tried to manage risks faced in
their day-to-day life. Keeping inflammable material away from fire, saving for possible
future needs, creation of a legal will are all examples of an attempt at managing risk. In
this unit, you will learn much more about risk management.
17.2 OBJECTIVES
After going through the unit, you should be able to:
Understand the meaning of risk;
Know the sources of risk;
Identify the approaches to risk management;
Explain the techniques of risk management; and
Learn the guidelines for risk management.
17.3 MEANING OF RISK

Risk is the possibility of the actual outcome being different from the expected outcome.
It includes both the downside and the upside potential. Downside potential is the
possibility of the actual results being adverse compared to the expected results. On the
other hand, upside potential is the possibility of the actual results being better than the
expected results. Although the terms risk and uncertainty are often used interchangeably,
they are in fact not synonymous. There is a clear distinction between certainty, uncertainty
and risk. Certainty is the situation where it is known what will happen and the happening
or non-happening of an event carries a 100% probability. Risk is the situation when there
are a number of specific, probable outcomes, but it is not certain as to which one of
them will actually happen. Uncertainty is where even the probable outcomes are
unknown. It reflects a total lack of knowledge of what may happen.
Risk is not an abstract concept. It is a variable which can be caliberated, measured and
compared. The degree of risk attached to an event is generally linked to the likelihood
of the occurrence of that event. The higher the probability of the actual outcome being
different from the expected outcome, the higher is the risk attached to the event.
However, risk is a function of not only the probability of an outcome being different
from that expected, but also its potential intensity, if it occurs. The magnitude of the
probable outcomes and the probability of their occurrence, together determine the
riskiness of an event. Hence, risk is generally measured using the concept of standard
deviation.
Risk is different from the terms peril and hazard. While risk is the possibility of a
loss, peril is a cause of loss. Hazard, on the other hand, is a factor that may create or
increase the possibility of a loss in face of an undesired event, or may increase the
possibility of the happening of the undesired event. For example, fire is a peril that may
cause loss. Inappropriate structure of a building is a hazard that increases the possibility
of a loss in case of a fire. Inappropriate wiring is a hazard that increases the probability
of a fire. Risk is the possibility of a loss due to these factors.
The degree of risk present in a particular situation is not an absolute, independent
amount. It is dependent on the level of information available with the entity facing the
risk. The degree of information available determines the entitys perception of the
expected value and the probability distribution, which in turn determines the degree of
risk. Even when the complete information is available, risk is dependant on the
interpretation of the information by the entity and its perception as to the future outlook.
Two different entities may interpret the same information differently, or may have
different expectations for the future, which would lead to two different sets of
probability distributions. Hence, the same set of circumstances may translate into
different levels of risk for different people.
A corporates aim is to create wealth for its shareholders. This wealth is reflected in the
market value of its shares. Hence, for a company the risk faced is reflected in the
possibility of the actual market value of its shares being different from the expected
market value. As the market value of a firms shares is closely related to the profit
earned by it, corporate risk can also be termed as the possibility of a companys actual
Profits After Tax (PAT) being different from the expected PAT. For a corporate,
downside risk may stem from the possibility of either costs being higher than expected,
or revenues being lower than expected. Similarly the upside risk may result from either
the possibility of costs being lower than expected, or the possibility of revenues being
higher than expected.
17.4 SOURCES OF RISK

The profits of a company are at risk from different sources. The various risks faced by a
firm are interest rate risk, exchange risk, default risk, liquidity risk, business risk,
financial risk, market risk and marketability risk. While the list is not exhaustive, it does
cover the most significant risks.
Interest Rate Risk: Interest rate risk is the risk of an adverse effect of interest rate
movements on a firms profits or balance sheet. Interest rates affect a firm in two ways
by affecting the profits and by affecting the value of its assets or liabilities.
For
example, a firm that has borrowed money on a floating rate basis faces the risk of lower
profits in an increasing interest rate scenario. Similarly, a firm having fixed rate assets
faces the risk of lower value of investments in an increasing interest rate scenario.
Interest rate risk becomes prominent when the assets and liabilities of a firm do not
match in their exposure to interest rate movements. For example, a firm that has fixed
rate borrowings and floating rate investments has a higher exposure than a firm having
fixed rate borrowings and fixed rate investments for the same term.
Exchange Risk: Exchange risk is the possibility of adverse effect on the value of a
firms assets, liabilities or income, as a result of exchange rate movements. Adverse
movements in exchange rate can affect a firms profits, assets or liabilities, even if it is
not operating in foreign markets. This happens due to the interlinkages between the
various markets.
Default Risk: Default risk is the risk of non-recovery of sums due from outsiders,
which may arise either due to their inability to pay or unwillingness to do so. This risk
has to be considered when credit is extended to any party.
Liquidity Risk: Liquidity risk refers to the risk of a possible bankruptcy arising due to
the inability of the firm to meet its financial obligations. There is a misconception that a
profitable firm will have little or no liquidity risk. It is possible that a firm may be very
profitable but may have a severe liquidity crunch because it has blocked its money in
illiquid assets. Liquidity risk also refers to the possibility of having excess funds, i.e. the
risk of having more funds than it can profitably deploy.
Business Risk: Business risk is the risk faced by a business from its external and
internal environment. The risk may come from internal factors like labor strike, death of
key personnel, machinery breakdown, or external factors like government policy,
changes in customer preferences, etc.
Financial Risk: Financial risk refers to the risk of bankruptcy arising from the
possibility of a firm not being able to repay its debts on time. Higher the debt-equity
ratio of a firm, higher the financial risk faced by it. Liquidity risk and wrong capital
structure are the prime reasons for financial risk.
Market Risk: Market risk is the risk of the value of a firms investments going down as
a result of market movements. It is also referred to as price risk. Market risk cannot be
distinctly separated from other risks defined above, as it results from interplay of these
risks. Interest rate risk and exchange risk contribute most to the presence of market risk.
Marketability Risk: This is the risk of the assets of a firm not being readily
marketable. The situation of having non-marketable assets may or may not be linked to
a need for funds. When such assets are required to be sold due to a need for funds, the
non-marketability may lead to liquidity risk.
RISK MANAGEMENT
Corporate risk management refers to the process of a company attempting to managing
its risks at an acceptable level. It is a scientific approach to deal with various kinds of
risks faced by a corporate. According to Mark Dorfman, risk management is the
logical development and execution of a plan to deal with potential losses. It is a
dynamic process which changes according to the evolving scenario. The aim of risk
management is to maintain overall and specific risks at the desired levels, at the
minimum possible cost.
Though it is a fact that risk includes both the upside and the downside potential, generally
the upside is acceptable, and even desired. Hence, corporate risk management generally
attempts to manage the possibility of profits being lower than expected. In fact, there are
tools like options that help in managing the downside risk while retaining the upward
potential. However, a part or whole of the upward potential may sometimes need to be
foregone in order to manage the downward potential in a cost effective manner.
There is a misconception that the goal of risk management is the complete elimination
of risk. In reality, risk management aims at ensuring that risk remains at the desired and
acceptable level, or within an acceptable range. Complete elimination of risk can take
place only when no business activity is undertaken. In fact, the return earned on
government securities, which is generally referred to as the risk-free rate of return, is
also not free from risks. The only risk such investments do not carry is default risk. In
order to earn returns it is essential to bear some risks. Risk management only aims at
bringing the risk to a level that is in line with the returns expected to be generated by the
investment. As the factors affecting risk change continuously, the risk faced by a firm
also changes. Therefore, a company needs to continuously evaluate its risk level and
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make an attempt to bring it at the targeted level. This may even include efforts at
increasing risk when it is below the targeted level.
For the purpose of risk management, risks need to be classified as primary risks and
secondary risks. Primary risks are those risks that are essential parts of the business
undertaken. Secondary risks are those that arise out of the business activities, but are not
integrally related to them. For example, the risks arising out of the industry structure are
primary in nature, foreign currency exposure arising due to exports are secondary in
nature. To a large extent, primary risks have to be borne in order to generate cash flows.
They can be covered only partly. Unlike primary risks, secondary risks can be covered
to a large extent, and only a part of them are unavoidable. This distinction becomes very
important while deciding on the risks to be covered. Further, it is generally observed
that when a firm faces a high degree of primary risk, it can bear less of secondary risk.
A firm having a low degree of primary risk may be able to bear higher secondary risk,
depending on the managements risk bearing capacity.
Traditional theories hold that the possibility of profit is the reward for taking risk. Still,
the actual occurrence of the possible loss that presence of risk implies is not always
welcomed by the party taking on the risk. In addition to the financial loss itself, there
are a number of factors that make risk undesirable. The presence of risk induces the
investor in the risky venture to demand a higher rate of return on his investment.
This ultimately translates into a higher cost of goods and services produced by the
investment. There may be situations where a high expected return may be accompanied
by a very high expected variance, thus making an otherwise attractive opportunity
unacceptable. The presence of risk may also warrant keeping aside some cash for the
bad times. As this cash cannot be invested in any security other than a highly liquid one,
it involves opportunity cost. This cost may turn out to be quite high in some cases.
These factors give rise to the need to manage risks.
There are two schools of thought regarding the need to manage unsystematic risk.
Traditional financial theory states that the market rewards only the systematic risk faced
by firm. As the unsystematic risk can be diversified away, the market does not compensate
the investors for bearing it. So the presence of unsystematic risk does not increase the cost
of capital for a firm. Thus, it is argued, a firm is not required to manage its unsystematic
risks, as the costs involved reduce the return on investment, without reducing the cost of
capital. This argument, however, does not take into consideration the indirect effect of
unsystematic risk on the cash flows of a firm. A firm having a high degree of systematic
risk, faces reduced confidence of the various stakeholders, i.e. the suppliers, the
customers, the employees. As the suppliers feel that their payments are at risk, they either
do not extend credit to the firm, or hike up the price of their supplies to make up for the
increased risk. The customers do not show interest in buying the firms products.
This happens due to the perception that a risky firm is likely to cut down on its products
quality. Another reason for lack of consumer interest is that bankruptcy of the firm (which
is highly probable for a firm facing a high degree of risk) would result in the lack of spare
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parts and after sales services for the firms products. At the same time, the firms
employees also demand a higher compensation because of the higher possibility of them
losing their source of earnings. All these factors result in the firms operating cash flows
falling down. Lower earnings would mean a lower market value for the firm, even if the
firms cost of capital remains unchanged. In practice, the providers of capital may be
unwilling to fund highly risky ventures without extra returns. Hence, it can be said that
managing unsystematic risks is essential for a firm to stabilize its earnings and to add
value to its investors wealth.
Self-Assessment Questions 1
a.
What is meant by Liquidity risk?
b.
How do you define risk management?
17.5 APPROACHES TO RISK MANAGEMENT

The following are the different approaches to managing risks:
Risk avoidance
Loss control
Combination
Separation
Risk transfer
Risk retention
Risk sharing.
Risk Avoidance: An extreme way of managing risk is to avoid it altogether. This can
be done by not undertaking the activity that entails risk. For example, a corporate may
decide not to invest in a particular industry because the risk involved exceeds its risk
bearing capacity. Though this approach is relevant under certain circumstances, it is
more of an exception rather than a rule. It is neither prudent, nor possible to use it for
managing all kinds of risks. The use of risk avoidance for managing all risks would
result in no activity taking place, as all activities involve risk, while the level may vary.
Loss Control: Loss control refers to the attempt to reduce either the possibility of a loss
or the quantum of loss. This is done by making adjustments in the day-to-day business
activities. For example, a firm having floating rate liabilities may decide to invest in
floating rate assets to limit its exposure to interest rate risk. Or a firm may decide to
keep a certain percentage of its funds in readily marketable assets. Another example
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would be a firm invoicing its raw material purchases in the same currency in it which
invoices the sales of its finished goods, in order to reduce its exchange risk.
Combination: Combination refers to the technique of combining more than one
business activities in order to reduce the overall risk of the firm. It is also referred to as
aggregation or diversification. It entails entering into more than one business, with the
different businesses having the least possible correlation with each other. The absence
of a positive correlation results in at least some of the businesses generating profits at
any given time. Thus, it reduces the possibility of the firm facing losses.
Separation: Separation is the technique of reducing risk through separating parts of
businesses or assets or liabilities. For example, a firm having two highly risky
businesses with a positive correlation may spin-off one of them as a separate entity in
order to reduce its exposure to risk. Or, a company may locate its inventory at a number
of places instead of storing all of it at one place, in order to reduce the risk of
destruction by fire. Another example may be a firm sourcing its raw materials from a
number of suppliers instead of from a single supplier, so as to avoid the risk of loss
arising from the single supplier going out of business.
Risk Transfer: Risk is transferred when the firm originally exposed to a risk transfers it
to another party which is willing to bear the risk. This may be done in three ways. The
first is to transfer the asset itself. For example, a firm into a number of businesses may
sell-off one of them to another party, and thereby transfer the risk involved in it. There
is a subtle difference between risk avoidance and risk transfer through transfer of the
title of the asset. The former is about not making the investment in the first place, while
the latter is about disinvesting an existing investment.
The second way is to transfer the risk without transferring the title of the asset or
liability. This may be done by hedging through various derivative instruments like
forwards, futures, swaps and options.
The third way is through arranging for a third party to pay for losses if they occur,
without transferring the risk itself. This is referred to as risk financing. This may be
achieved by buying insurance. A firm may insure itself against certain risks like risk of
loss due to fire or earthquake, risk of loss due to theft, etc. Alternatively, it may be done
by entering into hold- harmless agreements. A hold-harmless agreement is one where
one party agrees to bear another partys loss, should it occur. For example, a
manufacturer may enter into a hold-harmless agreement with the vendor, under which it
may agree to bear any loss to the vendor arising out of stocking the goods.
Risk Retention: Risk is retained when nothing is done to avoid, reduce, or transfer it.
Risk may be retained consciously because the other techniques of managing risk are too
costly or because it is not possible to employ other techniques. Risk may even be
retained unconsciously when the presence of risk is not recognized. It is very important
to distinguish between the risks that a firm is ready to retain and the ones it wants to
offload using risk management techniques. This decision is essentially dependent upon
the firms capacity to bear the loss.
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Risk Sharing: This technique is a combination of risk retention and risk transfer. Under
this technique, a particular risk is managed by retaining a part of it and transferring the
rest to a party willing to bear it. For example, a firm and its supplier may enter into an
agreement, whereby if the market price of the commodity exceeds a certain price in the
future, the seller foregoes a part of the benefit in favor of the firm, and if the future
market price is lower than a predetermined price, the firm passes on a part of the benefit
to the seller. Another example is a range forward, an instrument used for sharing
currency risk. Under this contract, two parties agree to buy/sell a currency at a future
date. While the buyer is assured a maximum price, the seller is assured a minimum
price. The actual rate for executing the transaction is based on the spot rate on the date
of maturity and these two prices. The buyer takes the loss if the spot rate falls below the
minimum price. The seller takes the loss if the spot rate rises above the maximum price.
If the spot rate lies between these two rates, the transaction is executed at the spot rate.
17.6 THE PROCESS OF RISK MANAGEMENT

Risk management needs to be looked at as an organizational approach, as management
of risks independently cannot have the desired effect over the
long-term. This is
especially necessary as risks result from various activities in the firm, and the personnel
responsible for the activities do not always understand the risk attached to them. The
risk management function involves a logical sequence of steps. These steps are:
Determining Objectives: Determination of objectives is the first step in the risk
management function. The objective may be to protect profits, or to develop
competitive advantage. The objective of risk management needs to be decided upon by
the management, so that the risk manager may fulfill his responsibilities in accordance
with the set objectives.
Identifying Risks: Every organization faces different risks, based on its business, the
economic, social and political factors, the features of the industry it operates in like the
degree of competition, the strengths and weaknesses of its competitors, availability of
raw material, factors internal to the company like the competence and outlook of the
management, state of industry relations, dependence on foreign markets for inputs,
sales, or finances, capabilities of its staff, and other innumerable factors. Each corporate
needs to identify the possible sources of risks and the kinds of risks faced by it. For this,
the risk manager needs to develop a fundamental understanding of all the firms
activities and the external factors that contribute to risk. The risk manager especially
needs to identify the sources of risks that are not so obvious.
RISK EVALUATION
Once the risks are identified, they need to be evaluated for ascertaining their
significance. The significance of a particular risk depends upon the size of the loss that
it may result in, and the probability of the occurrence of such loss. On the basis of these
factors, the various risks faced by the corporate need to be classified as critical risks,
important risks and not-so-important risks. Critical risks are those that may result in
bankruptcy of the firm. Important risks are those that may not result in bankruptcy, but
may cause severe financial distress. The not-so-important risks are those that may result
in losses which the firm may easily bear in the normal course of business.
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DEVELOPMENT OF POLICY
Based on the risk tolerance level of the firm, the risk management policy needs to be
developed. The time-frame of the policy should be comparatively long, so that the
policy is relatively stable. A policy generally takes the form of a declaration as to how
much risk should be covered, or in other words, how much risk the firm is ready to bear.
Generally, the level of secondary risk acceptable to a firm depends on the degree of
primary risk faced by it. A firm facing low primary risk may be more open to bear
secondary risk than a company that faces a high degree of primary risk. The policy may
specify that a specific percentage, say 50%, of all risks are to be covered or that not
more than a specific sum can be at risk at any point of time. The development of Value
at Risk (VAR) model provides a solution.
Barry Schachter describes Value at Risk as an estimate of the level of loss on a
portfolio which is expected to be equaled or exceeded with a given, small probability.
VAR is a statistical measure calculated over a specific investment horizon. It measures
the expected loss arising due to normal market movements in the variables responsible
for the portfolios risk. A particular portfolio having a VAR of X at 95% confidence
level implies that there is a 5% probability of the portfolios value falling by more than
X. The concept of VAR is closely linked to the concepts of mean, standard deviation,
and normal distribution. Let us see an illustration to understand VAR.
Mr. A holds 1000 shares of X Ltd. The current market price of the share is Rs.500 per
share. The monthly standard deviation is Rs.50. Assuming that the price of the security
follows a normal distribution, we can say that at the end of the month, the situation will
be as follows:
At 68.3% confidence level, the price of the security will lie between +/ 1 standard
deviation of the current value, i.e. between Rs.450 and Rs.550. At 95.5% confidence
level, the price of the security will lie between +/ 2 standard deviation of the current
value, i.e. between Rs.400 and Rs.600.
At 99.7% confidence level, the price of the security will lie between +/ 3 standard
deviation of the current value, i.e. between Rs.350 and Rs.650.
The normal distribution for the security will look as below:
Figure 1: Normal Distribution of Security

Value at Risk is different from other methods of measuring risk is that it makes a
distinction between the downside movements and the upside movements. As upside
movements are generally welcome, VAR calculates the possible downside movement at
the given confidence level. In the above illustration, there is a 99.7% probability that the
price of the security will be between Rs.350 and Rs.650. In other words, there is a 0.3%
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probability that the price of the security will be below Rs.350 or above Rs.650. As we
have assumed that the price of the security follows a normal distribution, there is an
equal chance of the price being below Rs.350 and its being above Rs.650. Thus, there is
a 0.15% probability of the price being above Rs.650. Hence, there is a 99.85%
probability of the price being equal to or above Rs.350. Since the loss at this price will
be Rs.150, we can say that for a one-month holding period, at 99.85% confidence level,
the VAR is Rs.150.
The concept of VAR is also used to quantify the risk arising out of individual
assets/liabilities. These can then be summed up to arrive at the Value at Risk for the
organization as a whole. In addition to measuring the existing risk level, VAR can also
be used to lay down the policy for the level of overall risk that is acceptable to the
management. The value can then be disaggregated to arrive at certain prudential limits
for different activities, as a part of the risk management framework of the organization.
For example, an investment bank may decide that a VAR of $100 million at a
confidence level of 98.5% is acceptable for the organization as a whole, while the
corresponding value for the fixed income securities division will be $20 million. Thus,
at no time the possible loss of the fixed income securities division can exceed $20
million.
However, VAR cannot be used in isolation to quantify risk. An important reason is that
it does not measure event risk, i.e. the risk of drastic movements in the underlying
variables. The probability of such movements is specified by the given confidence level,
but the quantum of possible loss in the event of such drastic movements cannot be
calculated using VAR.
DEVELOPMENT OF STRATEGY
Based on the policy, the firm then needs to develop the strategy to be followed for
managing risk. The tenure of a strategy is shorter than a policy, as it needs to factor-in
various variables that keep changing. A strategy is essentially an action plan, which
specifies the nature of risk to be managed and the timing. It also specifies the tools,
techniques and instruments that can be used to manage these risks. A strategy also deals
with tax and legal problems. It may specify whether it would be more beneficial for a
subsidiary to manage its own risk, or to shift it to the parent company. It may also
specify as to how it will be most beneficial to shift the losses to a branch located at a
particular location. Another important issue that needs to be specified by the strategy is,
whether the company would try to make profits out of risk management (from active
trading on the derivatives market) or would it stick to covering the existing risks.
While the strategy is to be designed within the guidelines laid down by the top
management, and in a manner that best satisfies the objectives of risk management, the
actual leeway available to the manager for making the decision changes from companyto-company. In some corporates, the guidelines may only specify the broad framework
to be followed while making the risk management decision, giving him a lot of scope
for deciding about the specific technique and instrument to be used for managing a
specific risk. On the other hand, some corporates lay down rigid and detailed guidelines
14
that need to be followed while making risk management decisions, leaving the manager
very little scope for exercising his judgment. Finally, the devices used for risk
management will depend on the managements willingness to take risks, to shift
production centers, to change the product mix, to use derivative products, etc.
IMPLEMENTATION
Once the policy and strategy are in place, they are to be implemented for actually
managing the risks. This is the operational part of risk management. It includes finding
the best deal in case of risk transfer, providing for contingencies in case of risk
retention, designing and implementing risk control programs, etc. It also includes taking
care of the details in the operational part, like the back office work, ensuring that the
controls are complied with, etc.
REVIEW
The function of risk management needs to be reviewed periodically, depending on the
costs involved. The factors that affect the risk management decisions keep changing,
thus necessitating the need to monitor the effectiveness of the decisions taken
previously. Sometimes, the decisions taken earlier may not prove to be correct, or the
changing circumstances may make some other option more effective. A periodic review
ensures that the risk management function remains flexible, and the tools, techniques
and instruments used to manage risk change according to the changing circumstances.
In effect, review helps the risk manager analyze whether the risk management function
is achieving the set objectives or not, and to find an alternative course of action if the
results are not in accordance with expectations.
The process of risk management has to be flexible because a companys risk profile
keeps changing. Hence, it needs to be remembered that the emphasis of the risk
management process is not on identification of any specific risk, but on developing a
method of assessment of risk and of arriving at the best possible way of dealing with
them, as and when they arise.
17.7 TECHNIQUES OF RISK MANAGEMENT

There are two kinds of techniques that can be used for management of various
categories of risk. These are internal techniques and external techniques. Internal
techniques are those that are a part of the day-to-day operations of the firm, while
external techniques are those that require the company to enter into some kind of
financial contract with a market entity. Both internal and external techniques can be
used to manage different risks. The following section describes these techniques.
MANAGEMENT OF BUSINESS RISK
Most of the business risks are not manageable, i.e. they have to be borne. However,
some of these operational risks can be managed by building flexibility into the
operations. For example, if the designing of products is done in such a manner that
standardized machines can be used for production purposes instead of specialized
equipment, the risk of obsolescence of machinery is reduced to some extent. Some of
the pure risks can be managed using external hedging techniques like insurance.
15
Another important part of the business risk is the possibility of adverse movement in the
cost of raw materials and the price of a firms final product. These risks can also be
managed by buying and selling commodity futures. By buying commodity futures for
those raw materials which are essential to the production process and whose value is
expected to be volatile in future, a firm can lock-in its cost. Similarly, by selling
commodity futures for its final product, the firm can lock-in its revenues, thus managing
a part of its business risks.
MANAGEMENT OF CURRENCY AND INTEREST RATE RISK
Currency and interest rate risk can be managed using both external and internal
techniques. The external techniques are mostly dependent on the use of derivatives.
A company may use products like forwards, futures, options and swaps for managing
these risks. For example, an exporter who is expecting to receive $1 million at the end
of 6 months is exposed to currency risk. He may hedge this risk by selling the foreign
currency in the forward market. Alternatively, he may sell futures contracts for the
relevant amount. Further still, the exporter may buy a put option for the foreign
currency. Under the last alternative, while he limits his downside risk, he retains the
upside potential. Similarly, a financial institution that is exposed to interest rate
movements because it has fixed rate investments financed through floating rate
borrowings, may enter into a swap transaction whereby it pays interest on a fixed rate
basis and receives interest on a floating rate basis.
In addition to these external hedging techniques, there are a few internal hedging
techniques that are available for managing currency risk. These are exposure netting,
leading and lagging, and choosing the currency of invoice. Exposure netting refers to
creation of exposures in the normal course of business which offset the existing
exposures. Leading refers to advancing a payment and lagging refers to postponing a
payment. This is done in anticipation of exchange rate movement. A company may lead
a payment that is due in a currency which is expected to appreciate. Similarly, it may
lag a payment that is due in a currency which is expected to depreciate. Thus, while the
company does not have to pay a higher amount due to the subsequent appreciation of
the foreign currency, it ends up paying a lesser amount due to the depreciation of the
foreign currency. A firm can also manage exchange risk by invoicing all its exports and
imports in the domestic currency. Alternatively, it may invoice its exports in a currency
that is expected to appreciate, and its imports in a currency that is expected to
depreciate. However, it needs to be remembered that the other party is likely to factor in
these considerations while arriving at the acceptable price.
The internal techniques of managing interest rate risk form a part of asset-liability
management.
ASSET-LIABILITY MANAGEMENT
Marshall and Bansal describe asset-liability management as an effort to minimize
exposure to price risk by holding the appropriate combination of assets and liabilities so
as to meet the firms objectives and simultaneously minimizing the firms risk.
16
Asset-liability management can be used to manage both interest rate risk and exchange
risk. It can be used in addition to, or in the place of the risk management tools described
above. However, generally asset-liability management is used to manage interest rate risk
as a complementary tool to the other tools.
a.
How does combination be termed as an approach to risk management?
b.
What is meant by Value at Risk?
17.8 GUIDELINES FOR RISK MANAGEMENT

There are a number of instruments and tools available for management of risk. While
going through the risk management process in general, and deciding the instrument to
be used for hedging a particular risk, the following guidelines need to be kept in mind:
Common Goal of Risk Management and Financial Management: The overall goal
of financial management is to create shareholder wealth. Shareholders wealth is created
by undertaking projects which generate a positive Net Present Value. Thus, the final
goal of risk management should be to make sure that funds for such investments are
available at the appropriate time.
Proper Mix of Risk Management Techniques: No risk management can be complete
or fool proof in itself. A firm has to ensure that it employs the most optimum mix of risk
control, risk prevention, risk transfer and risk retention, as also that of various internal
and external hedging techniques.
Proactive Risk Management: There are a number of uncertainties involved in the
financial and commodities markets. Continuous change in interest rates, exchange rates,
commodity prices, economic variables and external environment is a reality. Though it
is not possible to accurately predict the movement of these variables, the risk manager
needs to make an attempt to forecast the same. These forecasts should be used for
management of risks. Risk management cannot be done after the happening of an event,
it has to be done in its anticipation.
Flexibility: The risk management strategies should not be too rigid. They should be
flexible enough to allow the risk manager to make the most appropriate decision
according to the circumstances.
17
Bringing Risk to the Optimal Level: The process of risk management should aim at
maintenance of risk at the level which is optimal according to the risk bearing capacity
of the firm. While a firm should not be exposed to risks which may result in its
liquidation, the aim of risk management is not to completely eliminate risks.
Risk Substitution: A firm needs to be aware of the fact that generally risk management
techniques do not eliminate the risk completely, but substitute it by another kind of risk.
For example, when a company deals in futures contracts, the risk is not completely
eliminated, but is replaced by basis risk. So essentially, a firm trying to manage its risks
is only exchanging certain unacceptable risks for other risks which are more acceptable
to it. A firm needs to remember this fact while managing its risks.
17.9 SUMMARY
The unit provides a primary platform for risk management concepts. It mention the
various sources of risk and the different types of risk. Further it also explains the
various approach towards risk management. Apart from this, the basics of risk
management techniques are also explained. The unit concludes with a brief introduction
to asset-liability management.
17.10 GLOSSARY
Arbitrage is the simultaneous purchase and sale of the same financial asset in an attempt
to profit by exploiting price differences on different markets or in different forms.
Asset-Liability Management is a strategy adopted by the banks and financial
institutions. Here, the assets as well as the liabilities are designed in such a way that
match the cash flows, duration and maturities of both.[v1]
Basis Risk is the risk to a future investor of the basis widening or narrowing.
Bermudan Option is partly American and partly European which can be exercised on a
limited number of occasions as stated in the contract. Hence, it is also known as quasiAmerican option.
Beta is a statistical measurement of risk associated with an individual stock or a
portfolio of stocks. It is the ratio of the covariance of the security return and market
return to that of the variance of the market return.
Call Option gives the right to buy the underlying asset at the exercise price to its
holder. But the seller has to bear the obligation to sell the same at the above price.
Cost of Carry is the total cost explicit as well as implicit inclusive of financing,
storage and insurance costs needed to be borne regarding holding or carrying a
commodity or an asset.
Credit Risk is the possibility of the failure of a counterparty to a contract to fulfill his
contractual obligation specially in case of a swap deal due to bankruptcy or some other
reason.
18
Default Risk is the possibility of the failure of a party to make payment at the required
time due to insolvency or bankruptcy. In swap banking, the term is considered to
mention swap banks exposure due to credit risk and market risk.
Put Option is an option by which the holder gets the right to sell the underlying asset at
a specified price on or before its maturity, while the writer is obliged to buy it as so.
Swap is an agreement through which a series of exchanges of periodic payments (both
interest and principal) is done with a counterparty.
Unsystematic Risk is the portion of a securitys total risk that is not related to
movements in the market portfolio and hence can be diversified.
Value at Risk is the measurement of loss which has a chance over a certain pre-decided
confidence level of being exceeded. That means, if the confidence level is 99%, the
value at risk will be the measurement of the possible loss over the balance 1%.
17.11 SUGGESTED READINGS/REFERENCE MATERIAL
Aswath Damodaran. Investment Valuation. John Wiley & Sons, Inc., 2002.
Donald De Pamphillis. Mergers, Acquisitions and other Restructuring Activities.

Academic Press, 2001.
Frank C. Evans, and David M. Bishop. Valuation for M&A Building Value in
Private Companies. by John Wiley and Sons, Inc., 2001.
17.12 SUGGESTED ANSWERS

a.
Liquidity Risk: Liquidity risk refers to the risk of a possible bankruptcy arising
due to the inability of the firm to meet its financial obligations. There is a
misconception that a profitable firm will have little or no liquidity risk. It is
possible that a firm may be very profitable but may have a severe liquidity
crunch because it has blocked its money in illiquid assets. Liquidity risk also
refers to the possibility of having excess funds, i.e. the risk of having more funds
than it can profitably deploy.
b.
Risk Management: is the logical development and execution of a plan to deal

with potential losses. It is a dynamic process which changes according to the
evolving scenario. The aim of risk management is to maintain overall and
specific risks at the desired levels, at the minimum possible cost.
a.
Combination refers to the technique of combining more than one business

activities in order to reduce the overall risk of the firm. It is also referred to as
aggregation or diversification. It entails entering into more than one business,
with the different businesses having the least possible correlation with each
other. The absence of a positive correlation results in at least some of the
businesses generating profits at any given time. Thus, it reduces the possibility of
the firm facing losses.
19
b.
Value at Risk is an estimate of the level of loss on a portfolio which is expected

to be equaled or exceeded with a given, small probability. VAR is a statistical
measure calculated over a specific investment horizon. It measures the expected
loss arising due to normal market movements in the variables responsible for the
portfolios risk.
17.13 TERMINAL QUESTIONS

A. Multiple Choice
1.
2.
3.
4.
20
Which of the following statements defines risk?

a.
Possibility of actual outcome being different from the expected outcome.
b.
There are a number of specific, probable outcomes, but it is not certain as

to which one of them will actually happen.
c.
There are a number of probable outcomes, the outcomes being unknown

and it is not certain as to which one of them will actually happen.
d.
Only (a) of the above.
e.
Both (a) and (b) of the above.
Risk of the assets of a firm not being readily marketable is called

a.
Market risk
b.
Marketable risk
c.
Business risk
d.
Financial risk
e.
Exchange risk.
A currency swap involves

a.
An exchange of principal amounts today
b.
An exchange of interest payments during the currency of the loans
c.
A re-exchange of principal amounts at the time of maturity
d.
An exchange of principal and interest in one currency with principal and

interest in another currency
e.
All of the above.
Creation of exposures in the normal course of business which offset the existing
exposures is called
a.
Exposure netting
b.
Leading
c.
Lagging
d.
Hedging
e.
None of the above.
5.
Asset-liability management can be used to manage

a.
Exchange risk
b.
Interest rate risk
c.
Default risk
d.
Liquidity risk
e.
Both (a) and (b) of the above.
B. Descriptive
1.
What are the sources of risk?
2.
Enumerate the different approaches to managing risks.
3.
Risk management is not a single step to manage, but it is a process. Explain the
logical sequence steps to manage risk.
These questions will help you to understand the unit better. These are for your
practice only.
21
UNIT 18 RISK MANAGEMENT AND

CORPORATE STRATEGY
Structure
18.1
Introduction
18.2
Objectives
18.3
Risk Management and the Modigliani-Miller Theorem
18.4
The Investors Hedging Choice
18.5
Hedging and Managerial Incentives
18.6
Foreign Exchange Risk Management

18.6.1 Types of Foreign Exchange Risk Management
18.7
Summary
18.8
Glossary
18.9
Suggested Readings/Reference Material

18.1 INTRODUCTION
Corporations throughout the world are devoting increasing amounts of resources to risk
management. Risk management involves assessing and managing the corporations
exposure to various sources of risk through the use of various financial products such as
financial derivatives, insurance, and other instruments.
The idea that corporations should manage exposure to various sources of risk is
relatively new, but it is becoming not only increasingly important but also a routine
activity within the organizations. Today, the process of hedging is not restricted to the
narrow boundaries of the finance department. In contrast to the past, when the Chief
Financial Officer (CFO) of a corporation would spend a small portion of his time on
hedging, many corporations now have entire departments devoted to hedging and risk
management. There can be a number of factors that can be attributed towards greater
attention to risk management, most notably, the increased volatility of interest rates and
exchange rates, and the increased importance of multinational corporations. Coupled
with this, the growing understanding of derivative instruments has also contributed to
their increased acceptance as tools for risk management. In this unit, you will learn the
various aspects of risk management, hedging and foreign exchange risk.
18.2 OBJECTIVES
Understand the implications of the Modigliani-Miller Theorem for Hedging;
Identify the link between Managerial Incentives and Hedge as well as

speculation;
Risk Management
and Corporate Strategy
Identify the types of Foreign Exchange Risk;
Understand the reasons of Exchange Rate Changes; and
Know hedging of Economic Risk.
18.3 RISK MANAGEMENT AND THE MODIGLIANI-MILLER

THEOREM
Many of the major financial innovations of the 1980s were associated with the markets
for derivative securities, such as options, forward contracts, swap contracts, and futures.
These contracts provide relatively inexpensive and efficient ways for corporations and
investors to bundle and unbundle various aspects of risk, allowing those who are least
able to bear the risks to pass them off to others who can bear them more efficiently.
To understand this, let us understand the factor model used to re-examine the stock
returns of a particular company. Those returns are expressed as:
rABC = ABC + ABC,1F1 + ABC,2 F2 + ... +ABC,K FK +ABC
(1)
Where,
represent macroeconomic factors like interest rate movements, currency

changes, oil price changes, and changes in the aggregate economy.
represent the stocks sensitivity to those factors, or factor betas.
represents firm-specific risk.
A stocks sensitivity to factor risk as well as firm-specific risk is determined by the

firms capital expenditure and operating decisions and its financial decisions. Factor risk
is generally not diversifiable, but often it can be hedged by taking offsetting positions in
financial derivatives.
Firm-specific risk is just the opposite; it is generally diversifiable but cannot be hedged
with derivative contracts. It is possible, however, to hedge many sources of firmspecific risk with insurance contracts. For example, a fire insurance contract provides a
good hedge against the losses incurred as a result of a fire.
18.4 THE INVESTORS HEDGING CHOICE

Before analyzing the hedging choice of firms, let us first consider the possibility that
individual investors hedge on their own. Assume that the investor observes the factor
sensitivities of the different investments and constructs an evenly balanced portfolio
which diversifies away from firm-specific risk and is weighted to give the investor his
or her preferred exposure to the various sources of risk, as represented by a particular
configuration of factor betas. It is to be kept in mind that the betas or factor sensitivities
of the portfolio are the weighted averages of the sensitivities of the different securities
held in the portfolio. In addition to buying and selling stocks and bonds with the
appropriate risk profiles, the investor may use derivatives to more directly alter the
portfolios exposure to particular sources of systematic risk. For example, if in equation
(1) represent uncertain movements in oil prices, investors can directly change the
exposures of their portfolios to oil price movements by buying or selling oil price
futures or forward contracts.
23
Derivatives like forwards and futures are indeed used by many investors exactly in this
manner. However, the most important users of derivative instruments are corporations
and financial institutions, like banks, that want to alter the risk profiles of their firms.
IMPLICATIONS OF THE MODIGLIANI-MILLER THEOREM FOR HEDGING
The Modigliani-Miller Theorem states that in the absence of taxes and other market
frictions, the capital structure decision is irrelevant. In other words, financial decisions
cannot create value for a firm unless they in some way affect either a firms ability to
operate its business or its incentives to invest in the future.
The initial application of the Modigliani-Miller Theorem was done to the analysis of the
firms debt-equity choice. However, the theorem is really much more general and can
be applied to the analysis of all aspects of the firms financial strategy. In all cases,
these choices affect firm values only when there are relevant market frictions like taxes,
transaction costs, and financial distress costs. The Modigliani-Miller Theorem also
applies to other financial contracts and instruments. Firms can benefit from futures,
forwards, and swap contracts, but only in the presence of these same frictions.
The Modigliani-Miller Theorem can be proved by showing that individual investors can
use homemade leverage on their own accounts to undo or duplicate any leverage
choice made by the firms they own. Further it can also be shown that, in the absence of
market frictions, shareholders are indifferent between hedging on their own accounts
and having their firms do the hedging for them. In other words, investors can form
portfolios with the same factor risk and the same expected returns regardless of how
firms hedge. As a result, in frictionless markets where the operations side of the firm is
held fixed, investors gain nothing from the hedging choices of the firm.
Thus it can be said that if hedging choices do not affect cash flows from real assets,
then, in the absence of taxes and transaction costs, hedging decisions do not affect firm
values. This is nothing other than the Modigliani-Miller Theorem.
RELAXING THE MODIGLIANI-MILLER ASSUMPTIONS
The frictionless markets assumption of the theorem implies that investors and
corporations have equal access to hedging instruments, and that there are no transaction
costs. In reality, corporations are often in a much better position to hedge certain risks
than their shareholders. For example, most institutional and individual investors would
find it costly to learn how to hedge a food companys exposure to changes in the price
of palm oil even though markets for such hedging instruments exist. In addition,
corporate executives are much more knowledgeable than shareholders about their firms
risk exposures and thus are in a much better position to know how much to hedge.
There are a number of difficulties that are associated with the difficult-to-hedge risks
which may affect the volatilities of individual stocks, though most volatility is
diversified away in large portfolios. Thus, hedging is unlikely to reduce a firms cost of
capital significantly. If hedging cannot reduce the discount rate a firm applies to value
its cash flows, then hedging must increase expected cash flows if it is to improve firm
values. So we now come to the conclusion that hedging is unlikely to improve firm
values, if it does no more than reduce the variance of a firms future cash flows.
To improve firm values, hedging also must increase expected cash flows.
24
Risk Management
HOW HEDGING REDUCES TAXES

Taxes play a key role in most financial decisions, and hedging is no different. Tax gains
often accrue from hedging because of an asymmetry between the tax treatment of gains
and losses. A US corporation that has earned $100 million will pay about $34 million in
federal income taxes. However, if that same corporation loses $100 million, the IRS
(Internal Revenue Service, Department of Treasury) will rebate its share of the losses
only up to the amount of taxes the firm paid in the past three years. Hence, the firm
loses more value from a $100 million pre-tax loss than it gains in value from a $100
million pre-tax gain. The following example illustrates how firms can gain from
hedging risks in situations of this kind.
Illustration 1
Taxes and Hedging
Get Well Pharmaceuticals sells a large fraction of its arthritis drugs in France for which
it receives payments in francs. Given that its costs are denominated in rupees, the firms
taxable earnings are subject to currency risk. Currency fluctuations are the firms only
source of risk, so the firms pre-tax hedged and unhedged positions in two equally
possible exchange rate scenarios can be described as follows:
The firm will thus achieve higher pre-tax profits, if it chooses not to hedge. Assume,
however, that there is a 40% profits tax, but no tax deduction on losses. Show that the
expected after tax profits will be higher if the firm choose to hedge.
Pre-tax Income for Two Equally Likely Scenarios
(Rs. in million)
Weak (Rs.)
Strong (Rs.)
Average
Unhedged
100
20
40
Hedged
35
35
35
So we can now say that because of asymmetric treatment of gains and losses, firms may
reduce their expected tax liabilities by hedging.
HEDGING TO AVOID FINANCIAL DISTRESS COSTS
Financial distress can be costly. Distress costs include costs arising from conflicts
between debt holders and equity holders and those arising from the reluctance of
many of the firms most important stakeholders (for example, customers and
suppliers) to do business with a firm having financial difficulties. By hedging its
risks, a firm can increase its value by reducing its probability of facing financial
distress in the future.
After-Tax Income for Two Equally Likely Scenarios
(Rs. in million)
Weak (Rs.)
Strong (Rs.)
Average
Unhedged
60
20
20
Hedged
21
21
21
25
Disneys Motivation to Hedge

Executives at Disney believe that by reducing the volatility of their profits from
individual business units they are better able to evaluate the business unit managers and
assess the profitability of their different lines of business. The executives also believe
that if the overall firm is hedged, analysts will find the firms profits easier to interpret
and predict, so that the firms stock price will reflect the firms true value more
accurately.
As part of their evaluation system, the top executives at Disneys central headquarters
and the top managers of the individual units agree on a target for each units operating
profits in the next evaluation period. Managers must then implement a strategy that
minimizes their chances of not meeting the target. As part of this strategy, the individual
units initiate transactions with Disneys treasury group to hedge their exposures to
currency fluctuations and other sources of hedgeable risks. The treasury group in turn
would hedge their exposures in the derivatives markets.
HOW HEDGING IMPROVES DECISION-MAKING
The Disney discussion suggests that an active risk management program can improve
managements decision-making process by reducing the profit volatility of individual
business units. Less volatile profits for a companys business units provide management
at the firms central headquarters with better information about where to allocate capital
and which managers are the most deserving of promotions.
Using Futures Prices to Allocate Capital
Firms with sophisticated risk management groups have further advantages derived from
their greater understanding of market prices, which they can utilize to make better
capital allocation decisions. It is to be kept in mind that the futures prices, viewed as
certainty equivalents, provide an assessment of the current value of any traded delivered
in one year, enabling a farmer to make intelligent decisions about whether to increase
production process. If the farmers costs are less than the futures price, he can increase
his production and sell the futures contracts to lock in his gains. If the costs exceed the
futures price, then the farmer should probably cut his production.
a.
What is the main theme of Modigliani-Miller Theorem?
b.
Is it possible to hedge financial distress cost?
26
Risk Management
The Motivation to Hedge Affects What Is Hedged?

The previous section noted that hedging can improve the values of firms for a number
of reasons. In designing their risk management strategies, firms should consider each of
the individual reasons for hedging. For example, firms would like to minimize taxes as
well as the costs of financial distress, and they also would like a risk management
system that improves the quality of their management. Unfortunately, it may be difficult
to do all of these things simultaneously. A firms taxable income is not the same as the
income that it reports to shareholders, so minimizing the volatility of its taxable income
will not always minimize the volatility of its reported income. More importantly, a
hedge that minimizes the volatility of a firms earnings will not always effectively
insure against longer term changes in the firms value, which is likely to be more
important if there is concern about financial distress in the future.
Let us consider, for example, an Indian textile firm which we will call Denim
International. The firm manufactures a variety of shirts that it sells mainly in Europe.
The firm is partially owned by one of Indias wealthiest families, the Kalwanis, who
also own a construction business and other small manufacturing firms. The Kalwani
family fully delegates the management of Denim International to a group of executives
whom they have recently hired. The Kalwanis have let it be known, however, that the
new managers will be replaced if they do not perform well within the next two years.
The Kalwani family can best assess their managers if they require them to completely
hedge the firms foreign exchange risk over the next two years. They would prefer to
avoid replacing the managers because of poor performance if the problems were due
entirely too unfavorable and unexpected movements in exchange rates. Likewise, they
would not want to retain a poor-quality management team that was lucky enough to
experience favorable movements in exchange rates. These objectives suggest that the
Kalwani should require their management team to minimize the volatility of the firms
earnings over the next two years. Unfortunately, this objective may only partially solve
a second concern of the Kalwani family. Denim International is a highly levered firm
with Rs.100 million note due at the end of five years. To minimize the chances of
default, which would greatly embarass the family, the Kalwanis would like to instruct
management to enter into forward contracts that minimize their chances of defaulting on
this note. However, implementing a hedge that minimizes the chances of default will
probably require larger positions in the forward and futures markets than would be
required to minimize uncertainty over the next two years because the firms value
represents the discounted value of all future cash flows, not just the cash flows accruing
in the next two years. So, we can very well conclude that if a firms main motivation for
hedging is to better assess the quality of management, the firm will probably want to
hedge its earnings or cash flow rather than its value. However, if the firm is hedging to
avoid the costs of financial distress, it should implement a hedging strategy that takes
into account both the variance of its value and the variance of its cash flows.
27
How Should Companies Organize their Hedging Activities?

Apart from having a thorough understanding whether to hedge and how to hedge, firms
must consider the organization of their risk management activities. Should risk
management be centralized, operating out of the firms treasury department, or should
hedging be performed at the level of the individual divisions? The answer to this
question depends on the level of expertise in the various divisions, the availability of
information about the divisions exposures, the transaction costs of hedging, and the
motivation for hedging.
At present, most risk management programs are implemented at the corporate rather
than the divisional level. One reason for this has to do with the costs of trading. In
illiquid markets, trading costs can be high, and it might make sense to consolidate
trading. Consolidating allows the exposures of each of the business units to be netted
against one another. Corporate managers then execute trades in the financial markets to
hedge only the firms aggregate exposure. A second reason has to do with the relative
newness of the field of risk management and the likelihood of limited expertise in it at
the divisional level. A final reason is the fixed costs associated with setting up a risk
management department.
As risk management expertise becomes more widespread and the futures and swap
markets become more liquid, we expect to see hedging performed more at the divisional
level. This is especially true when the principal motivation for hedging has to do with
improving management incentives. Division heads, which have the best information
about risk exposures in their divisions, ultimately should be responsible for hedging
those risk exposures. Divisions also may want to hedge to assure themselves of
investment funds if investment funds from corporate headquarters are tied in some way
to the divisional profits. If, however, a firms principal motivation for hedging has to do
with either lowering expected tax liabilities or reducing the probability of bankruptcy,
then most hedging should be carried out at the corporate level. So it can be summarized
that Corporations should organize their hedging in a way that reflects why they are
hedging. Most hedging motivations suggest that hedging should be carried out at the
corporate level. However, the improvements in management incentives that can be
realized with a risk management program are best achieved when the individual
divisions are responsible for hedging.
How Hedging Affects the Firms Stakeholders?
Up to this point, it has been examined hedging from the perspective of managers who
are trying to maximize total firm value (i.e., the value of the debt plus the value of the
equity), however, managers have competing pressures and may not choose to maximize
total firm value. Perhaps the instances where firms were observed to be speculating
rather than hedging arose because managements objective was not to maximize total
firm value. In this section, we explore the effect of hedging on the debt holders and
equity holders separately, and how hedging can affect other stakeholders of the firm.
28
Risk Management
How Hedging Affects Debt Holders and Equity Holders?

Considering the case of the real option, equity can be viewed as a call option on the
firms value. To the extent that hedging reduces volatility without increasing firm
value, it reduces the value of this option, transferring value from equity holders to
debt holders. From an equity holders perspective, the value-maximizing benefits of
hedging may be reduced, and possibly even reversed, by this transfer. The actions of
managers to hedge in these circumstances certainly would not endear them to these
equity holders. However, a firms bankers and bondholders would certainly like the
firm to hedge.
How Hedging Affects Employees and Customers?
The interests of most of a firms employees are closer to the interests of debt holders
than to equity holders. Their jobs and reputations are at risk in the event of bankruptcy,
and they may not realize substantial benefits if the firm does extremely well. Managers
who look out for the interest of their employees would then have an incentive to hedge.
Customers generally like to see a firm that will honor its warranties, supply replacement
parts, and generate additional products that will enhance the value of existing products.
Since firms in financial distress are less likely to make choices that benefit their
customers, hedging also benefits a firms customers.
18.5 HEDGING AND MANAGERIAL INCENTIVES

The discussion in the previous subsection suggests that managers who are loyal to their
employees and customers may want to hedge more than the firms shareholders would
like them to. In this subsection, we will discuss other reasons why the managers
incentives to hedge may differ from those of shareholders.
MANAGERIAL INCENTIVES TO HEDGE
Consider the case of an entrepreneur, like Bill Gates at Microsoft, who starts a
successful business and continues to hold a sizable fraction of the firms shares. Gates is
probably more concerned about Microsofts risk than other shareholders because he is
much less diversified than they are. As a result, Gates might want Microsoft to hedge to
reduce his personal risks even when doing so has no effect on the firms expected cash
flows. In this case, and in the absence of transaction costs, Gates is indifferent between
hedging on his personal account and hedging through the corporation. However, it
might be more efficient to have the transaction costs borne by Microsoft, which has a
trained staff of risk management experts, rather than by Gates personally.
MANAGERIAL INCENTIVES TO SPECULATE
Managers also may have an incentive to speculate when the firm would be better off
hedging. As noted in the previous section, this sometimes happens when managers have
misguided notions that they possess superior information about future trends in currency
and commodity prices. In addition, managers may have an incentive to speculate if they
are compensated with executive stock options, which are worth more when stock price
volatility is higher. Longer-term considerations may provide managers with even more
incentives to take speculative risks and choose not to hedge. Managers who realize a
29
favorable outcome as a result of a risky strategy are likely to receive an attractive bonus
and, in addition, be promoted and have many more opportunities in the future. As long
as their upside potential exceeds their downside risk, managers will want to speculate
rather than hedge.
The case of Nick Leeson and the bankruptcy of Barings Bank illustrate how perverse
management incentives, along with a lack of oversight, can lead to disaster. By making
a series of enormous speculative bets on Japanese stock index futures, Leeson managed
to lose US$1.4 billion for his firm, Barings Bank, which ultimately led to the firms
demise in 1994. If these trades had been successful and Barings had earned instead of
lost over a billion dollars, Leeson would have received a generous bonus and enjoyed
increased opportunities and prestige within the firm. The upside associated with this
risky strategy was clearly quite high. Perhaps, Leeson believed that all he had to lose in
the event of a bad outcome was his job. Unfortunately, Leeson lost not only his job, but
was sentenced to six years in a Singapore jail.
The Motivation to Manage Interest Rate Risk
Until now, we have discussed the motivations for risk management in general terms,
without reference to the particular sources of risk. In reality, however, a firms
motivation to hedge interest rate risk, which is closely tied to the capital structure
choice, may be quite different than its incentive to hedge either commodity or foreign
exchange risk.
The choice between debt and equity financing is only the first step that firms must take
when they determine the overall makeup of their liabilities. Because they affect who
owns and controls the firm, decisions relating to the level of equity financing (e.g.,
whether to issue new shares or repurchase existing shares) are important decisions and
are typically made at the highest levels of the corporation, generally the board of
directors, suggesting that a treasurers staff is unlikely to face these types of decisions
on a day-to-day basis. However, the nature of a firms debt is something that the
treasurers staff faces on a continuing basis. For example, people who perform the
treasury function are continually making choices about whether to borrow at fixed or
floating rates, or whether to roll over short-term commercial paper. In addition, they
must decide whether to borrow in the domestic currency, in a foreign currency or
perhaps with commodity-linked bonds, such as those whose principal is tied to the price
of oil. These decisions all affect the firms liability stream, which is the stream of
interest costs that a firm will be paying in the future.
We can view all of the above as liability management decisions because they affect the
nature of the firms liabilities. However, the decisions can be viewed equivalently as
risk management choices, because the decisions affect the firms exposure to various
sources of risk. In general, when a firm determines its exposure to interest rates,
commodities, and foreign exchange through its borrowing choices without using
derivatives, we think of these choices as liability management choices. When the firm
30
Risk Management
alters these risk exposures with the aid of derivatives, we refer to this as risk
management. However since, in many cases, a firm might be close to being indifferent
between, for example, (i) borrowing in rupees and swapping the rupee debt for a yen
obligation, and (ii) simply borrowing in yen, this distinction between liability
management and risk management becomes largely irrelevant.
ALTERNATIVE LIABILITY STREAMS
It is useful to think about the different liability streams that a US firm can create when it
is restricted to borrowing only in US dollars. We further simplify this analysis by
assuming that there are only two possible maturities for the debt: short term and longterm. One might want to think of short-term debt as debt due in one year and long-term
debt as debt due in five years.
Whether the firm is borrowing short-term or long-term, its cost of borrowing will
consist of the sum of a risk-free component, r, which we can think of as a Treasury bond
rate, and a default spread, d, which is determined by the firms credit rating. As we will
see below, the firm can create four separate liability streams, depending on whether the
firm borrows short-term or long-term and whether it chooses to hedge its interest rate
exposure.
If the firm chooses to roll over short-term debt, its liability structure can be described by
the following equation:
ist = rst + dst
(2)
Where,
ist = the firms short-term borrowing cost for period t, which is composed of.
rst = the default-free short-term interest rate for period t.
dst = the default spread for period t.
Note that the t subscripts indicate that short-term borrowing rates and the firms credit
rating change overtime.
If the firm instead chooses to borrow long-term at a fixed rate, then its liability structure
can be described as:
ii = ri + di
(3)
Where,
ri = the long-term interest rate.
di = the default premium.
Since these rates are fixed for the life of the loan, they do not have the t subscript.
The third approach involves a floating-rate loan. Firms may be able to obtain the
floating rate loans directly from their banks or they can obtain the loans by borrowing
31
long-term and swapping a default-free fixed rate obligation for a default-free floating
rate obligation. In either case, the floating rate liability can be described by:
ift = rst + dl
(4)
Where
ift = firms period t borrowing rate on the long-term floating rate loan.
This liability stream subjects the firm to interest rate risk (i.e., changes in rst), but not to
risk relating to changes in its credit rating.
The final possibility is a liability stream, iht that hedges the risk of changing levels of the
default-free interest rate, rst, but which leaves the firm exposed to changes in its credit
rating or default spread.
iht = ri + dst
(5)
Firms were unable to create the liability stream described by equation (5) prior to the
introduction of interest rate swaps and interest rate futures. Before the introduction of
these instruments, borrowing short-term implied exposure to interest rate risk and credit
risk, while borrowing long-term implied exposure to neither. Indeed, the principal
advantage of these derivative instruments is that they allow firms to separate their
exposures to interest rate risk and changes in their credit ratings. In particular, the
liability stream described in equation (5) can be created by borrowing short-term and
swapping a floating for fixed-rate obligation.
The above discussion can thus be summarized as follows. A firms liability stream
can be decomposed into two components: one that reflects default-free interest rates
and one that reflects the firms credit rating. When a firm borrows at a fixed rate, both
components are fixed. When it rolls over short-term instruments, the liability streams
fluctuate with both kinds of risks. Derivative instruments allow firms to separate
these two sources of risk: to create liability streams that are sensitive to interest
rates but not their credit ratings, as described in equation (4), and to create liability
streams that are sensitive to their credit ratings but not interest rates, as described in
equation (5).
HOW DO CORPORATIONS CHOOSE BETWEEN DIFFERENT LIABILITY
STREAMS?
To understand how corporations decide between the various liabilities streams, consider
the two components of their borrowing costs separately. We will first think about how
firms should structure their liabilities in terms of their exposure to changing levels of
interest rates. Then, we will consider how firms decide on their exposure to changes in
credit risk. To determine the optimal exposure of their liabilities to interest rate risk,
firms must first think about the interest rate exposure they face on the asset side of their
balance sheets. In other words, firms must ask whether their ability to make a profit is
tied in any way to the overall interest rates in the economy.
32
Risk Management
a.
How do Managerial Incentives to be speculated?
b.
What are the decomposed components of a firms liability stream?
DECOMPOSING INTEREST RATES INTO REAL AND INFLATION

COMPONENTS
In many cases, a firms cash flows are unaffected by changes in the real interest rate, but
they are affected by changes in the inflation rate. For example, a manufacturer of
furniture may see its nominal profits increase when the general price level in the
economy increases if the prices that it charges and its labor costs increase at the overall
rate of inflation. The furniture manufacturer might then prefer to have a floating-rate
liability structure because it does not want to run the risk of being locked into high longterm interest rates when inflation is reduced.
The experience many firms faced in 1982 provides a valuable lesson about the risks
connected with locking in long-term interest rates when inflation is uncertain. In the
early 1980s, interest rates were very high and many firms were locked into fixed
obligations with rates in excess of 15 percent. The high rates did not seem excessive at
the time since inflation was running at well over 10 percent per year. Firms were
counting on paying back expensive loans with cheaper dollars in the future. However,
policies to reduce inflation appeared to be successful by the middle of 1982,
substantially increasing the real cost of existing fixed-rate loans. Short-term rates
dropped substantially in 1982, so that firms with a substantial amount of floating rate
debt did much better than firms that were stuck with fixed-rate obligations. So we can
say that if changes in interest rates mainly reflect changes in the rate of inflation and if a
firms operating profits generally increase with the rate of inflation, then the firm will
want its liabilities to be exposed to interest rate risk. If, however, interest rate changes
are not primarily due to changes in inflation (i.e., real interest rates change) and if the
firms ability to sell its product is affected by the level of real interest rates, then the
firm will want to minimize the exposure of its liabilities to interest rate changes.
HEDGING EXPOSURE TO CREDIT RATE CHANGES
In addition to evaluating a firms interest rate exposure, we must ask how exposed the
firm is to changes in its own credit rating. In general, a firm would like to limit its
exposure to changes in its own credit rating since lenders almost always require larger
default spreads when firms can least afford to pay the higher interest rates. Firms prefer
financing alternatives that keep their default spreads fixed, such as long-term fixed-rate
loans or floating-rate loans. However, two factors offset this tendency.
33
The first factor arises when there is disagreement about the firms true financial
condition. For example, the lender might believe that the firm will face financial
difficulties in the future, but the borrower believes that its credit rating is likely to
improve in the future. In this case, the borrower may not want to lock-in what it
considers an unfavorable default spread, preferring instead to borrow short-term in
hopes that its credit rating will improve in the future. The second factor arises because
of the conflicts between debt holders and equity holders. Note that a lender who is
concerned that the firm will take on excessively risky investments (i.e., the asset
substitution problem) is not willing to provide long-term financing on favorable terms.
Both of these factors imply that the firm takes on greater exposure to changes in its own
credit rating than it would otherwise want, because the costs associated with long-term
debt are simply too high. Firms often rollover short-term debt and use interest rates
swaps to insulate the firms borrowing costs from the effect of changing interest rates,
thereby creating the liability stream described in equation (5) earlier.
18.6 FOREIGN EXCHANGE RISK MANAGEMENT

Multinational corporations must pay particular attention to managing their currency
risk. Changes in currency rates affect a firms cash flows as well as its accounting
profits. Currency rate changes also affect a companys market and book values.
18.6.1 Types of Foreign Exchange Risk Management

The various risks associated with changes in the value of currencies are generally
divided into three categories: transaction risk, translation risk, and economic risk, which
the following table defines.
TRANSACTION RISK
To summarize, transaction risk represents only the immediate effect on cash flow of an
exchange rate change. Exposure to transaction risk arises when a company buys or sells
a good, priced in a foreign currency, on credit. Suppose, for example, that IBM sells
computers for DM 10 million when the DM is worth US$0.60, with payment required
in six months. If the DM depreciates in six months and is worth only US$0.50, IBM
will receive the equivalent of US$5 million rather than the US$6 million it had
originally expected to receive.
It is quite easy for firms to hedge against transaction risk. For example, IBM could
simply require payment in US dollars, which would effectively shift the transaction risk
onto its German customer. Alternatively, IBM could enter into a forward contract to sell
DM 10 million at a prespecified dollar/deutsche mark exchange rate, with delivery in
six months, to lock-in the revenues from its sale in US dollars.
Hedges of this type are quite straightforward and are commonly observed in businesses
throughout the world. However, they control only the short-term implications of
exchange rate changes. For example, IBMs profits in Germany are likely to decline if
the deutsche mark weakened unless the company raised the price of its computers in
34
Risk Management
deutsche marks to its German customers. As a result, there are long run implications of
currency changes that are not hedged when risk management is restricted to individual
transactions.
Transaction Risk
Descriptions
Translation Risk
Economic Risk
Associated with individual
Arising from the
Associated with
transaction denominated in
translation of balance
losing competitive
foreign currencies: imports,
sheets and income
advantage due to
exports, foreign assets, and
statements in foreign
exchange rate
loans
currencies to the currency
movements
of the parent company for

financial reporting
purposes
Examples
An Indian company imports

parts from Japan. The Indian
company is exposed to the
risk of the Yen strengthening
and, as a result, the rupees
price of parts increasing
An Indian enterprise has

a German subsidiary. The
Indian enterprise is
exposed to the risk of the
Deutsche Mark
weakening, and the value
of the subsidiarys assets,
liabilities, and profit
contributions decreasing
in Rupees terms in
consolidated financial
statements.
An Indian and a
Japanese company
are competing in
Britain. If the Yen
weakens against the
Pound and the
Rupees-Pound
exchange rate
remains constant, the
Japanese company
can lower its prices in
Britain without losing
Yen income thus
obtaining a
competitive
advantage over the
Indian company
Table: 4 Categories of Currency Risk

In the terminology described in the above table, the economic risk connected with
currency changes is much larger than the transaction risk because it takes into account
the long term consequences of the change in currency value.
TRANSLATION RISK
Translation risk occurs because a foreign subsidiarys financial statements must be
translated into the home countrys currency as part of the consolidated statements of the
parent. For example, suppose IBM purchased a firm in the United Kingdom for 100
million when the pound was worth US$1.90. The British firm is then set up as a wholly
owned subsidiary of IBM with a book value of US$190 million. Subsequently, the
dollar strengthens, so that the pound is worth US$1.60. FASB Rule 52 requires that
IBM restate its balance sheet to account for this currency change, so that the book value
of the subsidiary becomes US$160 million.
35
Importance of Translation Risk

First, changes in value associated with exchange rate changes often reflect real
economic changes that affect the future profitability of the firm. Translation risk may,
however, be an important consideration even when the firms inflation-adjusted cash
flows are unaffected by a change in the exchange rate, as long as the firm has contracts
written with terms that are contingent on the firms book value. For example, firms
often have loan covenants that require it to keep its debt-to-book value ratio above a
certain level. In such cases, exchange rate changes that create a drop in the book value
of a foreign subsidiary create violations of loan covenants. Since covenant violations
can result in real costs, firms may find it beneficial to hedge against such possibilities.
ECONOMIC RISK
The following are the factors that determine the economic risk:
Differences between the location of the production facilities and where the
product is sold.
Location of competitors.
Determinants of input prices: Are they determined in international markets or

local markets?
It is easy to see how a firm with a large percentage of its sales overseas is exposed to
currency fluctuations. However, even firms that sell only in the United States are
subject to currency risk if they import some of their supplies or have foreign
competitors.
Why Do Exchange Rates Change?
To understand foreign exchange hedging in greater detail, it is important to think about
why exchange rates change overtime. Perhaps the most important contributor to
exchange rate changes is the difference in the inflation rates of two countries. For
example, suppose the British pound is initially worth US$1.50. If the inflation rate in
the United Kingdom is 10 percent over the next year while the inflation rate in the
United States is zero and nothing else changes during this time period then the British
pound is likely to fall in value by 10 percent to US$1.35. In this case, the nominal
exchange rate, which measures the US dollar price of British pounds, changes by 10
percent, but the real exchange rate, which measures the relative price of British and US
goods, remains unchanged. An American tourist in the United Kingdom will find
British goods and services selling at the same price in terms of US dollars as they were
selling for in the previous year.
The Case of No Real Effects
If you believe that differential inflation rates are the primary cause of exchange rate
movements, would you need to hedge against unexpected changes? If your main
concern is economic risk or transaction risk, there would be no need for your firm to
hedge. The firm is subject to neither risk. This point is illustrated in the following
example.
36
Risk Management
Example
Currency Risk and Inflation
Chip giant will buy three million circuit boards from a small firm in Taiwan in about
one year. Each circuit board is currently priced at NT$100, which is equivalent to about
US$4 in current exchange rates. Suppose Taiwan has an uncertain monetary policy and
could experience either inflation or deflation, which can cause currency movements of
as much as 10 percent. Is Chip giant exposed to currency risk? Let us find the answer.
If inflation is the only cause of exchange rate changes, then Chip giant is not exposed to
currency risk. A 10 percent increase in the Taiwan price level will result in a price
increase of circuit boards to NT$110. However, the inflation will simultaneously result
in a drop in the value of the Taiwan dollar to US$.036. The US dollar price that Chip
giant pays for the circuit boards is thus unchanged.
In the above example, Chip giant was simply purchasing an item from a foreign
company. Suppose now that Chip giant sets up a plant in Taiwan to produce the circuit
boards. In this case, an exchange rate change driven purely by inflation can have real
effects because it can affect how the firms Taiwanese assets are represented on its
balance sheets which could, in turn, affect bond covenants and other contracts.
Inflation Differences Tend to Generate Real Effects
Of course, it is rare when different inflation rates in two countries are not also
generating real effects in the two countries. For example, when oil was discovered in the
North Sea of Britains coast, the British pound strengthened because, at the prevailing
exchange rate, the United Kingdom was expected to have an excess of exports
(especially oil) over imports. In this case, the strengthening of the pound did affect
relative prices. A US tourist in the United Kingdom after the oil discovery would find
that prices calculated in US dollars had increased. Since the real, or inflation-adjusted,
exchange rate changed, a US firm that imported materials from the United Kingdom
would see its costs increase. If the production costs of the British firm in British pounds
stayed the same, the firms price in pounds also would stay the same, which implies that
US dollar prices would increase if the pound strengthened. A US firm would be exposed
to currency risk in this case. So what do we learn from this? Let us see.
Exchange rate movements can be decomposed into those caused by differences in the
inflation rates in the home country and the foreign country, and those caused by changes
in real exchange rates. In most cases, the incentive is to hedge against real exchange rate
changes rather than the component of exchange rate changes that is driven by inflation
differences between the two countries.
The following table documents both real and nominal exchange rate movements from
1985 to 1993 for five countries: Indonesia, Japan, Spain, Thailand and Turkey. It is
important to note that nominal exchange rates changed dramatically over this time
period for countries experiencing high levels of inflation. However, the real exchange
rates, which are more important for multinational firms, are somewhat less volatile over
longer periods of time.
37
The exchange rates shown in the table represent the number of units of the local
currency that can be exchanged for each US dollar. For example, the 1985 exchange
rate for Turkey is 576.86, which means that 576.86 Turkish liras could be exchanged for
US$1.00 on the spot market at the end of 1985. The Consumer Price Index (CPI) for
each year relates the price levels of each country to the price levels for 1990. An index
value of 100 means that the price level is identical to the prices in that country in 1990.
For example, the CPI of 114.00 for Thailand in 1993 means that price were 14 percent
higher in 1993 than they were in 1990.
The right-hand column summarizes the real exchange rate for each selected currency, or
the equivalent purchasing power that must be exchanged from one currency to another.
To determine the purchasing power being exchanged in the spot market, adjustments
must be made for the rate of inflation in each evaluated country and in the United
States. To accomplish this adjustment, the spot exchange rate is divided by the local
CPI and multiplied by the US CPI, resulting in the real exchange rate. Because all the
local consumer price indexes and the US CPI are stated with a 1990 basis, the real
exchange rate reported is also relative to 1990 prices.
In 1985, for example, Turkeys spot exchange rate was TL 576.86 per US$. However,
the 1985 Turkish lira had 8.35 times the purchasing power of the 1990 lira
(100/11.77). Meanwhile, the 1985 dollar had only 1.21 times the purchasing power of
the 1990 dollar. To take into account the disparities in the inflation rates of the two
countries, divide the spot rate of TL 576.86 by the local CPI of 11.77 and multiply by
the US CPI of 82.40 to find the real exchange rate. In this case, the exchange rate for
1985 is equivalent to TL 4,038.51 per US$ in 1990. As you can see from Table 5, the
real exchange rate between Turkey and the United States dropped between 1985 and
1990. In other words, the US dollar costs of goods and services in Turkey increased at
a higher rate than the US dollar cost of goods and services in the United States.
Indonesia
Consumer Price Indexes
Year
Rupiah Exchange Rate
Indonesia CPI
USCPI
Real Exchange Rate
1990Rupiahper
1990Dollar
38
1985
1,125.00
69.76
82.40
1,328.84
1990
1,901,00
100.00
100.00
1,901,00
1993
2,110.00
128.51
110.60
1,815.94
Risk Management
Japan

Year
Yen Exchange Rate
Japan CPI
US CPI
Real Exchange Rate
1990 Yenper
1990Dollar
1985
200.50
93.50
82.40
176.70
1990
134.40
10..00
100.00
134.40
1993
111.85
106.40
110.60
116.27
Spain
1990 Yenper
1990Dollar
Year
Yen Exchange Rate
Spain CPI
US CPI
Real Exchange Rate
1985
154.15
73.10
82.40
173.76
1990
96.91
10.00
100.00
96.91
1993
142.21
117.30
110.60
134.09
Thailand
Year
Yen Exchange Rate
Spain CPI
US CPI
Real Exchange Rate
1990 Yenper
1990Dollar
1985
26.65
82.70
82.40
26.55
1990
25.29
10..00
100.00
25.29
1993
25.54
114.00
110.60
24.78
Turkey
Year
Yen Exchange Rate
Turkey CPI
US CPI
Real Exchange Rate
1990 Yenper
1990Dollar
1985
576.86
11.77
82.40
4,038.51
1990
2,930.07
100.00
100.00
2,930.07
1993
14,472.50
468.84
110.60
3,414.08
Calculations done by using data from the International Financial Statistics (IFS)
database.
Table 5
39
Hedging when both Inflation Differences and Real Effects Drive Exchange
Rate Changes
Whenever exchange rates can change for purely monetary reasons as well as for real
reasons, it is difficult to implement effective hedges. To understand this, let us consider
the case where a firm needs to purchase an input that will be priced in British pounds.
By buying the pounds in the forward market, the firm effectively hedges against
changes in the value of the pound that are unrelated to price level changes. However, if
the pound fell 10 percent in value because a monetary shift caused a 10 percent increase
in British prices, then the firms loss on its foreign exchange contracts would not be
offset by a decrease in the price of the inputs.
For the most part, short-term exchange rate changes can be considered as real changes,
indicating that short-term hedges should be effective. This follows from the fact that,
over short intervals, exchange rates fluctuate more than inflation rates. Over long
periods, however, inflation accounts for a large part of exchange rate movements.
Perhaps this explains why firms tend to actively hedge short-term currency fluctuations,
but tend to ignore the effect of long-term fluctuations.
WHY MOST FIRMS DO NOT HEDGE ECONOMIC RISK?
Most major multinational firms hedge transaction and translation currency risk, at least
partially. However, most firms do not hedge long-term economic risk. Hedging the
long-term economic consequences of an exchange rate change is substantially more
complicated than hedging either transaction or translation risk. The biggest problem
with implementing such a hedging strategy is in estimating both the current and the
long-term effects of exchange rate changes on the firms cash flows. Considering, the
case of an Indian firm like Wipro, which manufactures computers in India for sale in
France. What is the effect of a change in the Indian rupees/French franc exchange rate
on Wipros long-term profitability?
To answer this question, one must first ascertain whether the change in the French franc
can be attributed to a general change in price levels, so that the inflation-adjusted or real
exchange rate remains constant. As mentioned above, if the real exchange rate remains
constant, then a nominal exchange rate change is likely to have only a minor effect on
Wipros cash flows. However, changes in real exchange rates can have a significant
effect on these cash flows.
Let us consider the case of what happens when the rupee strengthens against the French
franc, making the computers more expensive in francs. If the franc weakened because of
general inflation in France, so that the inflation-adjusted exchange rate remained
constant, then the price of computers in France, relative to other prices, would not have
changed. In this case, demand for Wipro computers would not be affected by the change
in exchange rates. Contrast this case with one in which the real exchange rate does
change, raising the relative price of Wipro computers in France and lowering the
demand for them. Wipros cash flows in France (calculated in Indian rupees) would
probably decrease in this case since it would either sell fewer computers at the same
rupee price or, alternatively, be forced by competitors to cut its rupee price for
computers.
40
Risk Management
As these arguments suggest, one of the major difficulties in assessing the effect of
exchange rate changes on cash flows has to do with predicting the cause of the
exchange rate movement. If we cannot predict whether future exchange rate fluctuations
are, then forward and futures contracts provide imperfect hedges. The following
illustration makes the understanding easier.
Illustration 5
Hedging Real Changes in the Yen
Suppose that Timber cut sells a significant quantity of prefabricated wood in Japan.
These units sell for 10,000 per square foot, with the market price increasing at the
Japanese inflation rate. The exchange rate is currently 100 per Indian rupee. Analysts
predict that it will trade in the range of 90 per Indian rupee to 110 per Indian rupee
over the next 12 months, depending on the differences in the Japanese and Indian
inflation rates as well as productivity changes that can be reflected in trade imbalances.
Forward prices are also at 100 per Indian rupee. Is it possible for Timber cut to create a
hedge to guarantee a Indian rupee price of rupee 100 per square foot for the prefab
units? Let us see
It is not possible to create such a hedge. To understand this, suppose that Japan
experiences 5 percent deflation, causing housing unit prices to fall to 9,500. Although
this would normally cause the yen to depreciate, suppose that a simultaneous increase in
Japanese productivity, which tends to strengthen the yen, offset the effect of inflation on
exchange rates exactly, so that the exchange rate stayed at 100 per Indian rupee. In this
case, timber cut will sell prefab units at rupee 95 per square foot and will break even on
its hedging activities regardless of its forward positions.
So the above example further clarifies the fact that
when exchange rates changes can
be generated by both real and nominal changes, it may be impossible for firms to
effectively hedge their long-term economic exposures.
When it is difficult to hedge in the derivatives markets, firms sometimes undertake what
is known as operational hedging, which involves changing the structure of the firms
operations. [See Chowdhry and Howe (1997) for details.]
WHICH FIRMS HEDGE?
The Empirical Evidence
A number of empirical studies have compared the characteristics of firms that use
derivatives to firms that do not. Although research on this topic is still evolving, a
number of patterns are worth considering.
Larger Firms are More Likely to Use Derivatives than Smaller Firms
A number of studies have found that larger firms are more likely to use derivatives than
smaller firms. The fact that smaller firms are less likely to use derivatives than larger
firms is inconsistent with the view that smaller firms generally face higher risks of
bankruptcy and thus have more to gain from hedging. However, the fixed costs of
setting up a hedging operation and their lower level of sophistication probably explain
41
why smaller firms are less likely to hedge. Indeed, Dolde (1993) found that among
firms that have implemented hedging operations, the larger firms tend to hedge less
completely than the smaller firms, leaving themselves more exposed to interest rate and
currency risks. In other words, size is a barrier to setting up a hedging operation, but
among firms that do hedge, smaller firms facing greater risks of bankruptcy hedge more
completely.
Firms with More Growth Opportunities are More Likely to Use Derivatives
Nance, Smith, and Smithson (1993) and Geczy, Minton, and Schrand (1997) provided
evidence that firms with greater growth opportunities are more likely to use derivatives.
In particular, firms with higher R&D expenditures and higher market-to-book ratios are
more likely to use derivatives than companies that spend less on R&D, have lower marketto-book ratios, and, therefore, probably have fewer investment opportunities. This evidence
is consistent with the idea that firms hedge to ensure that they have enough cash to fund their
investment opportunities internally.
A number of other reasons explain why R&D intensive firms with high market-to-book
ratios are more likely to use derivatives. Firms with these characteristics generally have
higher financial distress costs, suggesting that they should hedge to ensure that they will
meet their debt obligations. Furthermore, because R&D expenditures are tax deductible,
these firms are likely to have lower taxable earnings, implying that the tax argument
discussed earlier in this chapter applies more to firms with high R&D expenditures.
Highly Levered Firms are More Likely to Use Derivatives
Nance, Smith, and Smithson (1993); Block and Gallagher (1986); and Wall and Pringle
(1989) found weak evidence that firms with more leveraged capital structures hedge
more. The positive relation between leverage ratios and the tendency to hedge is
consistent with the view that firms hedge to avoid financial distress costs. However, the
weakness of the evidence probably reflects the tendency of firms with high financial
distress costs, which have the most to gain from hedging, to have the lowest leverage
ratios. For example, high R&D firms tend to use little debt and also tend to hedge
because of their potential costs of financial distress.
Geczy, Minton, and Schrand (1997) found no significant relation between the debt
ratios of most firms and their tendency to use derivatives. However, among those firms
with high R&D expenditures and high market-to-book ratios, firms with more leverage
are more likely to hedge. This implies that firms that suffer the highest costs of financial
distress are more likely to hedge when they are highly levered.
RISK MANAGEMENT PRACTICES IN THE GOLD MINING INDUSTRY
The studies described above examined hedging choices across a number of different
industries. A study by Tufano (1996) looked in greater detail at the risk management
practices within a single industry, gold mining. Within a single industry, proxies for
financial distress costs, financing constraints, and investment opportunities will
probably vary much less than they do across industries. Consequently, differences in the
hedging strategies across firms within a single industry are likely to be related to
differences in the incentives and tastes of the top executives.
42
Risk Management
The evidence described in the Tufano study indicates that management incentives and
tastes do have an important effect on the risk management practices in the gold mining
industry. Specifically, managers who hold large amounts of their firms stock tend to
use forward and futures contracts to hedge more of their firms gold price risk. Thus,
managers who are personally the most exposed to gold price risk choose to hedge more
of the risk. However, those who own relatively more stock options tend to hedge less,
which may reflect the greater value of the options when volatility is increased. Tufano
also found that firms with CFOs hired more recently hedge a greater portion of their
exposure than firms with CFOs who have been on the job longer.
18.7 SUMMARY
In the absence of taxes and transaction costs, hedging decisions do not affect the value
of the firm if such decisions do not affect the cash flows from real assets.
To improve upon the value of the firm, hedging decisions must increase the expected
cash flows. Merely, reducing the variances of its future cash flows is not enough.
Firms which are exposed to a high financial distress cost have a greater reason to hedge.
For firms that have a limited access to outside financial markets and that find it costly to
delay or change their investment plans, hedging would be beneficial.
Hedging shall be more profitable when it is difficult to evaluate and monitor
management.
Corporates should align their hedging in a way that reflects why they are hedging.
Managers have limited financial information at their disposal. Hence it is better if they
hedge rather than speculate.
A firms liability stream can be broken up into two parts one that relates to default
free interest rates and the other to the firms credit rating. Derivative instruments allow
firms to separate these two sources of risk (a) to create liability streams that are
sensitive to interest rates but not to the credit ratings, and (b) to create liability streams
that are sensitive to their credit ratings but not interest rates.
If the interest rate changes are due to inflation, then the firm will want its liabilities to be
exposed to interest rate risk. However, if the interest rate change is due to change in the
real interest rate change, the firm would want to limit its exposure of its liabilities.
When exchange rate changes can be generated by both real and nominal changes, it may
be impossible for firms to hedge their long-term exposures, effectively.
18.8 GLOSSARY
Arbitrage is the simultaneous purchase and sale of the same financial asset in an
attempt to profit by exploiting price differences on different markets or in different
forms.
Basis Risk is the risk to a future investor of the basis widening or narrowing.
Bermudan Option is an option which is partly American and partly European which
43
can be exercised on a limited number of occasions as stated in the contract. Hence, it is

also known as quasi-American option.
Credit Risk is the possibility of the failure of a counterparty to a contract to fulfill his
contractual obligation specially in case of a swap deal due to bankruptcy or some other
reason.
Default Risk is the possibility of the failure of a party to make payment at the required
time due to insolvency or bankruptcy. In swap banking, the term is considered to
mention swap banks exposure due to credit risk and market risk.
Put Option is an option by which the holder gets the right to sell the underlying asset at
a specified price on or before its maturity, while the writer is obliged to buy it as so.
Unsystematic Risk is that portion of a securitys total risk that is not related to
movements in the market portfolio and hence can be diversified.
Value at Risk is the measurement of loss which has a chance over a certain pre-decided
confidence level of being exceeded. That means, if the confidence level is 99%, the
value at risk will be the measurement of the possible loss over the balance 1%.
[v1]18.9
SUGGESTED READINGS/REFERENCE MATERIAL

Private Companies. John Wiley and Sons, Inc., 2001.

a.
The Modigliani-Miller Theorem states that in the absence of taxes and other
market frictions, the capital structure decision is irrelevant. In other words,
financial decisions cannot create value for a firm unless they in some way affect
either a firms ability to operate its business or its incentives to invest in the
future.
b.
Financial distress can be costly. Distress costs include costs arising from
conflicts between debt holders and equity holders and those arising from the
reluctance of many of the firms most important stakeholders (for example,
customers and suppliers) to do business with a firm having financial difficulties.
By hedging its risks, a firm can increase its value by reducing its probability of
facing financial distress in the future.
44
Risk Management
a.
Managers also may have an incentive to speculate when the firm would be better
off hedging. Managers may have an incentive to speculate if they are
compensated with executive stock options, which are worth more when stock
price volatility is higher. Longer-term considerations may provide managers with
even more incentives to take speculative risks and choose not to hedge.
Managers who realize a favorable outcome as a result of a risky strategy are
likely to receive an attractive bonus and, in addition, be promoted and have many
more opportunities in the future. As long as their upside potential exceeds their
downside risk, managers will want to speculate rather than hedge.
b.
A firms liability stream can be decomposed into two components: one that
reflects default-free interest rates and one that reflects the firms credit rating.
When a firm borrows at a fixed rate, both components are fixed. When it rolls
over short-term instruments, the liability streams fluctuate with both kinds of
risks. Derivative instruments allow firms to separate these two sources of risk: to
create liability streams that are sensitive to interest rates but not their credit
ratings, and to create liability streams that are sensitive to their credit ratings but
not interest rates.

A. Multiple Choice
1.
2.
3.
Managers are generally defined as ____________.

a.
Stockholders
b.
Agents
c.
Creditors
d.
Suppliers
e.
Customers.
Incentives for multinational company managers do not include the following

______.
a.
Stock options
b.
Bonuses
c.
Perquisites
d.
Salary increases
e.
Vacation.
Given below an Environmental factors affecting international operations

except________.
a.
International distances
b.
Foreign economic factors
c.
Foreign political situations
d.
Foreign legal aspect
e.
Foreign customs.
45
4.
5.
Which of the following is the primary objective of a firm?

a.
Employees benefits.
b.
Satisfaction of customers.
c.
Satisfaction of suppliers.
d.
Prompt payment to creditors.
e.
Maximize stockholder wealth.
Corporate governance is often narrowly defined as the prudent exercise of

ownership rights toward the goal of increased:
a.
Shareholder value
b.
Profit
c.
Profit margin on sales
d.
Asset turnover
e.
Sales volume.
B. Descriptive
1.
What are the sources of risk?
2.
Enumerate the different approaches to managing risks.
3.
Risk management is not a single step to manage, but it is a process. Explain the
logical sequence steps to manage risk.
practice only.
46
UNIT 19 ORGANIZATION
ARCHITECTURE, RISK
MANAGEMENT, AND
SECURITY DESIGN
Structure
19.1
Introduction
19.2
Objectives
19.3
Components of Organizational Architecture
19.4
Business Architecture
19.5
Financial Architecture
19.6
Security Design
19.7
Summary
19.8
Glossary
19.9

19.1 INTRODUCTION
A business organization is not an isolated one but a part of the society. It is included in
an environment that consists of various components. All the components can be termed
as architecture. It includes the environment, assets, and the operations that together
describe the situations under which the firm carries on its business and the various
sources of finance etc,. [v1]The structure of organizational architecture can be broken
down into two basic components viz., Business architecture and Financial architecture.
In this unit, you will learn about the structure of organizational architecture.
19.2 OBJECTIVES
Understand Organizational Architecture
Discuss the components of Business architecture;
Identify the various aspects of Financial architecture;
Recognize various financial instruments and financial markets; and
Develop securities design.
19.3 COMPONENTS OF ORGANIZATIONAL ARCHITECTURE

The structure of organizational architecture can be broken down into two basic
components:
i.
Business architecture.
ii.
Financial architecture.
Both these components can further be broken down into several elements. Let us now
focus our attention more on the basic components of the organizational architecture.
19.4 BUSINESS ARCHITECTURE

The firms business architecture refers to the environment, assets, and the operations
that together describe the situations under which the firm carries on its business. It also
states the manner in which in conducts the business with the only exception of its
financial agreements. The firms financial agreements together make up the financial
architecture of the firm. Let us now look into the different components or rather the
elements that constitutes the firms business architecture:
Macroeconomic environment
Financial market environment
Industry characteristics
Resources
Internal legal and governance structures
Business strategies and growth opportunities
Diversification versus focus
Firm size and capital intensity.
Let us now discuss about each of the above stated elements in more details.
MACROECONOMIC ENVIRONMENT
The macroeconomic component of the business architecture of the firm is composed of
three elements. They are:
a.
Economic growth projections, inflation and taxes.
b.
Legal environment.
c.
Macroeconomic growth factors.
Economic Growth Projections, Inflation and Taxes

It is to be always kept in mind that the firms expected profitability, its plans regarding
the capital expenditures and the risks associated with the financial distress is influenced
by the short-term as well as the long-term expectations of macroeconomic growth,
inflation and taxes. Let us now divide the recent American economic history into three
phases. The first spans from the year 1960-1973, second from 1974-1982, and the final
from 1983-2000. The first of these sub-periods experienced high GDP growth, low
interest rates and low levels of inflation rates. Along with this there were relatively high
rates of taxes, high productivity growth and moderate real returns on the stocks. The
second phase was featured with low real GDP, high interest rates and inflation, lower
taxes, weak productivity growth and low real returns on the stocks. The final period
saw high real GDP growth, lower levels of interest rates and inflation, lower taxes and
fairly high productivity growth and exorbitant high returns on the stocks. Taxes, is it
either corporate or personal, whether it is imposed on the ordinary income or the capital
gains can influence the capital structure decision of the firm as well as the dividend and
the stock repurchase schemes. It has been also observed that the taxes can also have an
effect on the efficacy of transactions such as leasing, acquisitions and the issuance of
targeted stocks and spin-off activities, and liquidation processes.
48
Organization Architecture,
Risk Management, and Security Desgin
Legal Environment
There are certain aspects of legal environment that are also important to the firms.
The basic aspect of this relates to the protection of the property rights, the enforcement
of the legal contracts, and the limited liabilities that pertains to the shareholders as the
owners of the company. Added to this there also lays the importance of the government
regulations on the conduct of the business. Although, of late there have been several
cases of deregulations of certain American industries, as a whole the firms of most of the
industries operate under regulation. It is the Federal government that regulates the issues
relating to the international trade, labor contracts, and the quality of the consumer
products. The merger and acquisition activities are subject to various reviews relating to
their compliance with the antitrust legislation. Finally, it can be said that the bankruptcy
law, including the filings under reorganization or liquidation of the US Bankruptcy
Code provides for the resolution of a firms financial claims in the event of default.
Macroeconomic Risk Factors
The financial as well as the business architecture of a firm can be affected by several
macroeconomic factors such as the interest rate risk, currency risk and the commodity
price volatility. The interest rate volatility that emerged during the late 1970s in the
American markets had resulted in revolutionizing the corporate bond market. During his
time, the firms decided to reduce upon their debt maturities and issue floating rate
securities. There was also the emergence of the interest rate derivatives so that firms
could cover their interest rate risk with such instruments. During the period of 1980s
and the 1990s, there was floating of some of the major currencies along with the
increased globalization. This has resulted in many firms getting exposed to currency
risks. In order to protect themselves from such currency risks, the firms resorted to the
currency derivatives. Added to this there was also an increased used for other forms of
derivatives that allowed the firms to hedge their commodity price risk.
FINANCIAL MARKET ENVIRONMENT
The Financial market environment can further be classified into five major elements.
They are:
a.
Regulations regarding the issuance and trading of securities.
b.
Operational efficiencies of the financial markets.
c.
Technological advancements of the financial markets.
d.
Investor preference.
e.
Market for corporate control.
Let us now try to understand each of these elements in details.

Regulations Regarding the Issuance and Trading of Securities
The regulations pertaining to the issuance and the trading of securities in the US are
governed by the Securities and Exchange Commission, state governments, and the
securities exchanges. These regulations may include the mandatory due diligence,
49
registration activities, and restrictions on the insider trading. Say for instance, for the
initial and continued listing of a stock, the exchanges may impose certain restrictions as
to the minimum number of share holders, minimum share price, and the minimum
volume of trading that is to be carried on. Such regulations may influence the firm in
taking decisions relating to the equity or private ownership of the firm, considering
which stock exchange to list its shares, the proportion of the shares to be placed in the
public market.
Operational and Informational Efficiencies of the Firm
This element can be related to both the primary as well as the secondary markets. As far
as the primary markets are concerned, the operational efficiency refers to the extent to
which a firm can issue securities more quickly, at a fair price and with low floatation
costs. It is to be noted that for both the stocks and the bond issues, the underwriters
spread are inversely related to the issue size. As far as the secondary markets are
concerned, the operational efficiencies relate to the liquidity of the market as the stocks
are traded on the exchanges. The extent to which the liquidity of the market is
concerned, it can be related to the quickness of the transactions, at a fair price coupled
with low transaction costs.
The information efficiency of a financial market relates to the various aspects of the
market efficiency. In other words it relates to the impact of the accuracy and quickness
of the market price on the relevant information reflected through them. For the purpose
of raising external debt or equity capital, both these forms of efficiency can come of
use. But for smaller firms and those firms that experiences high level of information
disparity, it becomes difficult to establish and maintain the liquidity and the efficiency
of the markets for the securities.
Technological Enhancements in the Financial Markets
This technological enhancement takes into account the swiftness of the information
flow. The operational and the informational efficiencies of any securities market the
speed at which the accurate, and value relevant information is carried on to both the
issuers and the investors. The technological advancements also relate to the degree to
which the more complex forms of securities and the transactions are available. Based on
the availability of such devices, the firms can develop a better financial architecture and
reduce their contracting problems. The banks and the finance companies offer debt
capital through private debt contracts. There are also other financial institutions that also
engage themselves in purchasing private as well as semi-private debt contracts. Another
alternative means of raising debt capital is done through the public issuance of debts and
bonds. For trading of these securities the public debt market provides a good avenue.
Further discussions relating to the advanced equity securities deals with the targeted
stocks and the dual class equity structures.
Investor Preference
Another important element that aids in shaping the financial architecture of the firm is
its preference of the investors. As an example, the desire of the investor to seek out for
liquidity may have an impact on the dividend policy of the firm. Added to this is the
50
planned investment horizons of the firms may influence the maturity of the corporate
debt issues, and the risk tolerance level of the investors may impinge on the capital
investment program of the firm and its leverage decisions.
Market for Corporate Control
The activist stockholders of any company seeks for taking part in the proxy contests in
an attempt to remove and replace the board members of a firm, as well as to reform the
firms governance. The external market for corporate control affects the firms
organizational architecture in many ways. Say for example, a smaller firm in the
industry may frame its development of the financial and the business architecture with
the intention of becoming an attractive acquisition target for any larger firm within
the industry. It may sometimes happen that the due to the existing threat of a
takeover, the firm may take certain actions that may be in the interest of the
stockholders rather than in the interest of the company as such. It may also happen, that
in order to avoid in any takeover attempt, the firm may resort to increasing its leverage,
purchase its own shares, bring a change in its ownership structure, resort to antitakeover devices and even arrange for buyout deals.
INDUSTRY CHARACTERISTICS
The two aspects that can affect the elements of the firms business and financial
architecture include the size and the growth potential of the industry, and the
competitiveness of the industry. As the former element is concerned, Myers theory of
investment problems states that the debt element can pose problem for affirm that has
substantial growth opportunities but at the same time the short term debt structures may
be posing less problems. Having internal capital may sound to be better, but this would
mean firms having high growth may stay away from paying dividends. As far as the
latter is considered, it has been stated that the existence of information asymmetry can
pose major problems in case of highly competitive industries. The business and
financial architecture of the firm may also be affected b the regulatory status of its
concerned industry. Those firms that are in a regulated industry are more likely to have
lesser profitable growth opportunities but at the same time are also less prone to risks,
as a result of which they will be having higher optimal leverage. Such regulated firms
will also be less prone to the conflicts arising between the principal and the agent, and
problems relating to the information asymmetry. So one can say that having diffusely
owned equity may be posing fewer problems to the firms. On the other hand, it can be
also said the issues relating to the deregulation in industries can also be of problems to a
firm. In such situations, the firm has to adjust to the severe competition by framing its
business strategies, changing its ownership structure, dividend policies and levels of
leverages. While framing such strategies in the competitive environment, the firm may
go for a higher level of leverage, which may act as a double edged sword. On one hand
such strategies may herald the intense competition that the firm is going for and on the
51
other hand it may act as a preventive barrier for other firms to enter into competition.
The firm may also look for a more conservative and low leverage strategy that may
enable it to squeeze out the more highly leveraged firms in the industry. (This is in fact
the crux of the long purse hypothesis as described earlier).
RESOURCES
This component of the firms business architecture deals with three primary elements.
They are:
a.
Natural resources.
b.
Production technologies.
c.
Human capital.
Let us now try to understand each of these components in detail.

Natural Resources, Utilities and Infrastructures
For any manufacturing firm, the location of the firm and its production efficiency is
determined by its availability of the natural resources that forms an integral part of its
production process. It is also to be remembered that the cost associated with the natural
resources forms an important element in determining the profitability of the firm, and
the overall feasibility of the production process. It is also the requirement of the firms
to have a reliable, low cost fuels as well as an efficient networking system.
Production Technologies, and Property Plant and Equipment (PP&E)
Any firm, by employing an up to date, cost effective production technology and
equipment can secure a firm competitive advantage in its industry. In this context, it can
be said that equipments can also be leased for many of the firms, the PP&E may
represent the single largest expenditure made but at the same time it can also be
financed with the mortgaged debt.
Human Capital
The importance of the human capital to a firm especially in the highly technological
information intensive economy needs no further emphasis. The extent to which a person
is capable in delivering his responsibilities depends on his education, work ethics and
compensation benefits. The cost at which such labor services are available is dependent
on the general level of income pertaining to that region. The recruitment and the
training process of the rank and the file employees tend to be very expensive as well as
risky. This may be due to the fact that such trainees may leave out of the training
programs before the optimum utilization of the investments made on such programs. So,
in order to retain, motivate and reward the key employees the firms can resort to
contracting devices.
INTERNAL LEGAL AND GOVERNANCE STRUCTURES
One of the important feature of a firms legal structure deals with taking decisions
relating to the number of divisions it should have and its parent subsidiary structures.
The firms internal governance structure includes the stockholders voting rights, the
52
board of directors of the firm, the management hierarchy and the operations of an
internal capital market. A firms legal structure is referred to its status as a single unit, a
multidivisional organization, or parent subsidiary structure. Studies conducted by Bodie
and Merton have tried to justify the establishments of subsidiaries by any firm for the
following reasons:
To have a better control over the risk exposure by either of the parent or the
subsidiary firm.
To increase its ability in order to evaluate the individual performance.
To create a different set of compensation system for the diverse set of business
activities.
To comply with the regulatory requirements customized to a particular business

environment.
In contrast, it can be also said that the conglomerate parent subsidiary structures are
often inefficient. It has been observed that many of the conglomerates that have been
developed during the 1960s and 1970s were mainly due to the inefficient external
capital markets. This have later on busted through takeover deeds or has even
voluntarily broken up through the issuance of the target stocks or equity curve outs that
are generally followed by the spin-off activities.
Internal Governance
The internal governance structure of the firm mainly deals with:
i.
The voting rights of the stockholders.
ii.
The board of directors of the firm.
iii.
The managerial hierarchy of the firm.
iv.
The internal capital market of the firm.
The stockholders of the firm are generally vested with the powers to take part in the
voting rights on major issues such as elections of the board members, decisions
concerning the merger and acquisition activities, and sales of major assets such as a
division of a firm. As it is earlier stated that the activist stockholders occasionally
attempt to garner sufficient number of proxy votes in order to bring a change in the
corporate governance structure of the firm, this may also lead to the termination of the
worn-out boards. The board of directors of a firm helps in providing an insight to the
senior management of the firm. Sometimes the board members also act as consultants to
the firm. The optimal structure of the board is said to have a proper blend of both the
insiders as well as the outsiders to a firm. The insiders to the firm have an advantage of
knowing more about the firms business strategies but at the same time they are
cautious of not challenging the CEO relating to any dubious plans and decisions. As far
as the outsiders are concerned they harbinger an independent opinion and a broader set
of experiences to the board. Further, the effectiveness of the board is also related to its
size. A smaller size means a more effective board. The managerial hierarchy in any
organization can range from steep to flat. In the former type of hierarchy, the
management takes the major decisions within the organization. Where as in a flat
53
hierarchical structure, the lower rung managers enjoys a greater autonomy and decision
making powers. The internal capital markets of a firm refers to the existing competition
among the divisional managers for the purpose of allocating the firms limited capital to
the different projects that are proposed by the different divisional managers. In spite of
having a lot of advantages the internal capital market of a firm is not free from its
shortcomings. There may be problems relating to the incentives as well as the cross
subsidization relating problems.
BUSINESS STRATEGY AND GROWTH OPPORTUNITIES
As we know that the business strategy of a firm is made up of three essential
components. They are:
i.
To establish goals in terms of market share and profits.
ii.
To develop a strategy that is effective as well as competitive to stand against its

rivals.
iii.
To target specific product and service markets.
The growth opportunities that are available to a firm may provide valuable real options,
but at the same time they can also bring along certain problems. Coming back to the
Myers theory of underinvestment problem, which states that a leverages firm with high
value growth opportunities may not always able to pursue them if a company has a
considerable portion of their benefits, accrues to its creditors. In order to avoid this
problem, the firm should limit the maturity of its debt or maintain financial slackness so
that the internal equity funds can be used to finance its projects. Apart from this the
problem relating to the information disparity can be of more severe nature to a firm that
has profitable opportunities. The existence of information asymmetry leads to the
increase in the firms cost of external financing. This compels the firms with growth
opportunities to rely more heavily on its internal capital to finance their projects. But it
is at the same time remembered that even in such situations it is important for the firm
to maintain financial slack.
DIVERSIFICATION VERSUS FOCUS
The issues relating to the diversification process has two extremes. At one end, we have
the conglomerates which have its interest in several different industries. Where as on the
other extreme, we have the focused firm that is more committed towards a narrow
product market in a single industry. One more aspect that needs to mention is the extent
to which the firm is vertically integrated. This vertical integration can help the firm in
getting a better supply of its raw materials, or even its customers. Such aspects of a
firms business architecture can influence on its financial architecture. Say for example,
reduction in the risk through vertical integration may result in the increase in the debt
capacity of the firm. In contrast, a firm that is diversified may be able to increase its
share value by engaging in divestment process.
54
FIRM SIZE AND CAPITAL INTENSITY

The financial architecture of the firm can be affected by both its absolute size as well as
its size relative to its industry competitors. As an example, firms that have a higher level
of leverage are more likely to raise short term and long term debt capital in the public
debt market vis--vis the private debt markets. In relation to the relative size of the firm,
let us go back to the Williams (1995) argument which characterizes the industry by a
few larger firms that are highly profitable, capital intensive, and more highly levered
and at the same time more smaller number of firms that are marginally profitable, labor
intensive and also enjoys a lesser level of leverage. Size does play an important part in
determining the economies of scale and the market power of firms. But if the senior
management of the firm does not have an effective organizational architecture, the
bureaucratic inefficiencies may act as a dominant factor over the economies of scale.
This may result in the overall inefficiencies of the firm. With relation to the capital
intensity structure, earlier mention has been made about the collateral hypothesis.
This hypothesis states that the debt capacity of a firm is only limited to the value of its
collateralized assets, which primarily is made up of the firms PP&E. For a firm that has
collateralized assets, there lies a lesser chance for the firm to incur losses if it defaults.
In contrast, the collateral value of the PP&E is limited if it is illiquid, which in turn
depends to some extent on whether the assets can be sold at their fair value in
circumstances that are depressing to the industry in which the firm operates.
a.
What are the elements included in legal environment of a business firm?
..
b.
How does Technological Enhancement take place in the Financial Markets?
19.5 FINANCIAL ARCHITECTURE

EQUITY
Equity forms the first component of the firms financial structure. This component can
further be divided into four elements. They are:
a.
Public versus the private ownership.
b.
Structure of the ownership.
c.
Ownership dynamics.
d.
Policies regarding the dividend and stock repurchase.
Let us now discuss each of these elements with respect to the equity capital of the firm.
55
PUBLIC VERSUS THE PRIVATE OWNERSHIP

In any firm, the basic trade off in relation to the separation and ownership and control
and specific trade offs involves in the decision of whether to keep a firm closely held as
against going public and letting the ownership control of the firm lose its importance. In
contrast to this, the stock-holders can reduce their risk of their privately held portfolios
by diversifying their equity investments across the firms. In addition to this, the
secondary market for the public equity develops naturally, which in turn increases the
liquidity of the equity shares. On the other hand, one of the results of a diffused
ownership structure is that none of the stock-holders of the firm has a sufficient
proportion of stake in the firm. This will lead the firm in incurring the agency cost
associated with the managerial discretion until the time that the contracting devices are
brought into the picture that can lessen the managements incentives from pursuing the
self serving activities, such as shirking, empire building and avoiding more profitable but
risky projects. The decisions involving going public may also be linked to the problems
associated with the information asymmetry. As an example, the issue relating public
equity may pose problems if a fair amount of the firms value is dependent on its strategic
information to such an extent that the firms insiders has to keep it confidential.
OWNERSHIP STRUCTURE AND OWNERSHIP DYNAMICS
The importance of the ownership structure of a firms equity goes beyond saying. Say for
example, the importance of the managements holding lies in lessening the cost associated
with the stock-holder management and the principal agent problem as well as problems
relating to the information asymmetry. It is rarely seen that the equity ownership of any
firm is static. There can be many ways by which the ownership of a firm can change
hands entirely. Some of these may be merger, acquisition, takeovers or buyout activities.
DIVIDENDS AND STOCK REPURCHASES
There can be several problems associated with the firms dividend policy decisions. Many of
these problems takes into account the element of dividend policy with the other elements
that are part of the firms financial architecture. The dividend income of the firm is
associated with the element of income tax, and the dividend payments are not deductible
expenses. Thus, it can be said that the policy of a firm to pay out its dividends may result
increase in its cost of equity capital and result in attracting a group of investors that prefer
such dividend policy of the firm. Further, it is also to be remembered that the firm has its
own incentives to retain the free cash flows that are available to it rather than distribute it as
dividends. Further, we can also say that for any firm that is highly leveraged, it has an
incentive to increase its dividends so as to increase its possibilities of expropriating more
wealth from its creditors. Finally, it can also be said that the underinvestment problem is
suggestive of the fact that a leveraged firm may pay out its dividends rather than pursue a
more profitable investment project if majority of the benefits of the project goes to its
creditors. In the last twenty years or so, the stock repurchase activities have greatly increased
among the publicly traded non-financial US companies. There can be several reasons that
can be attributed to the stock repurchases. They are:
56
i.
In case the firms shares are undervalued.
ii.
The repurchase compels the deployment of the free cash flows.
iii.
Reduction in the firms outstanding equity, results in the expropriation of

creditors wealth.
iv.
Repurchase of shares serves as a takeover defense.
FINANCIAL ARCHITECTURE: LIABILITIES

The liabilities of a firm can be further categorized into four basic elements. They are:
a.
Leverage
b.
Sources
c.
Terms
d.
Leases.
Let us now try to explain each of these elements in terms of the firms liability structure.
Leverage
If at all there exists any thing as the firms optimal leverage, it is dependent on a number
of aspects of a firms industry, its assets and its operations. The traditional trade off
theory states that for every firm there is an optimal debt-equity ratio structure. This ratio
is in turn a function of the trade off between the benefits of the debt and the present
value of the expected future costs of the issues relating to the financial distress and
bankruptcy. Both of these elements increases but not at the same rate with that of a
change in the leverage structure. An additional insight to the leverage decision is
provided by the agency theory. Sometimes, leverage can enhance the value of a firms
share holders by bringing discipline into the firms management. It forces the
management to disgorge its cash which would other wise been used for the purpose of
any inefficient investment. But in reality, the agency cost associated with debt may
prevent it from benefits. The management that acts in the interest of the share holders
has an incentive to take actions that can expropriate wealth from its bondholders.
The information asymmetry problem also has a bearing on the issues relating to
leverage. The most discussed theory relating to this is the pecking order hypothesis.
It is to be noted that under the conditions of information disparity, the cost of external
financing is more than that of the internal financing, and at the same time the cost of the
external equity finance is much more than the cost of external debt. The hypothesis
states that it is important for a firm to maintain a sufficient degree of financial slack so
as to avoid the necessity of external financing. If at all there is any need of external
financing, the cost of debt financing is less costlier than that of equity financing. It can
also be said that leverage can also be used as an effective tool for competition. A firm
can go in for aggressive competitive strategy by adopting a high degree of leverage or
may even go in for low level of leverage so as to squeeze out the highly levered
competitors when the industry profits are not well.
Sources of Debt Capital
While deciding on the sources of debt funding sources, especially when it concerns
private sources such as banks and financial corporations versus raising funds through
the issuance of debt in public, the firm takes into account of the principal agent
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conflicts as well as conflicts arising out of information asymmetry. The wide spread
use of the trade credit is because the seller may be in a better position as compared to
a financial institutions in matters of evaluating, monitoring, and controlling the buyers
credit risk. Banks can be considered to be in a better position than the public debt
markets in terms of,
a.
Maintaining strict confidentiality in information.
b.
Monitoring of the firms management.
It may be that for such reasons the banks are some times referred to as inside leaders, as
in contrast to the lenders in the credit market that are termed as the outside leaders
because they generally do not perform such functions. It is also to be noted that the
monitoring by a bank may enhance the banks ability to issue public debt. Further it can
also be seen in certain situations that a bank may provide protection to a firm against its
rivals which may otherwise be able to squeeze out the firm financially. As on the other
hand, those larger firms for which the existence of the principal agent conflict and the
information asymmetry problem is not that severe, the economies of scale that are
associated with the public debt market tends to dominate and as a result the firms can
issue the debt securities publicly.
Terms in Debt Contracts
The terms that are included in the corporate debt contracts, especially in the case of
publicly issued notes and the bonds, can help in lessening both the principal agent
conflict and problems relating to information asymmetry. Those traditional firms that
are taken into account regarding this deals with:
i.
The maturity of the debt.
ii.
The covenants that result in the managements activities.
iii.
Alternative retirement provisions.
Coupled with this there is also the innovation of the debt marker that has brought in
more responsibilities for the firms to issue debt in the public debt markets.
Leasing
The non-financial American markets make extensive use of leasing, particularly as an
alternate means of financing equipment. The process of leasing actually provides a
glaring example of the relationship between the firms business architecture and its
financial architecture. As per the lending theory of leasing is concerned, leasing can
create a tax arbitrage if the lessors tax rate is higher than that of the lesses tax rate.
With the help of leasing, a firm that has a low marginal tax rate, transfers the tax shield
associated with the tax instrument, especially its liquidity in the secondary market.
FINANCIAL ARCHITECTURE: CONTRACTS WITH OTHER
STAKEHOLDERS
The over all design of a firms organizational architecture can effectively done, only
when it incorporates all the contracts in which it engages itself. These other contracts
may include:
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a.
Contracts with board members.
b.
Executive compensation contracts.
c.
Contracts with other employees.
d.
Contracts with the suppliers and the customers.
Let us now discuss each of these contracts in details.

Contracts with Board Members
As far as the contracts with the board members are concerned, the major focus is given
to the tenure restrictions and issues relating to the board members. Added to this, there
also lays the importance to provide the board members with incentives contracts that are
commensurate to those provided to the firms executive. One more issue regarding the
contracts revolves round the director liability.
Executive Compensation Contracts
It is to be always borne in mind that the executive contracts are complex in nature. They
are associated with various incentive devices, so as to reduce the agency cost of
managerial discretion. it is also to be noted here that the compensation given to a firms
CEO is generally associated with the following components. They are:
i.
Basic salary.
ii.
Earnings-based bonus.
iii.
Long-term incentive pays.
iv.
Stock grants and stock options.
Contracts with other Employees

Of late, most of the American firms have established incentives such as the profit
sharing bonuses or the stock options for the purpose of their junior managers as well as
the rank and file employees. Another most popular stock ownership plan that has been
growing in importance for the rank and the file employees are the Employees Stock
Option Plans (ESOPs). These actually became popular during the period of 1980s and
they provide substantial tax benefit to both the employers as well as the employees.
Such instruments often lead to the recognition of the fact that the firms employees are
its actual stakeholders.
Contracts with the Suppliers and Customers
The contracts of the firm with its suppliers and customers may have an impact on the
following points:
i.
It can reduce the firms risk.
ii.
Provides some protection against its rivals.
iii.
Increases the firms debt capacity.
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FINANCIAL ARCHITECTURE: DERIVATIVES AND RELATED CONTRACTS

Let us now try to have a firm understanding on the following points relating to the
motive of the firm in connection with the:
a.
Hedges with derivatives.
b.
Purchase of insurance.
c.
The issuance of guarantees.
Let us now understand the basics of the derivatives instruments and their use as a tool
for hedging.
Forwards and Future Contracts
A forwards agreement is a private, customized and a bilateral agreement between two
parties in which one party agrees to purchase and the other tries to sell, a certain number
of units of a specified asset at a predetermined future date and at a specified price.
The forwards contracts are common in the case with the foreign currency and
commodities such as gold and oil. The price at which the forward contract is generally
written is called the fair price. It is relatively easier to determine the fair price of the
assets if they are trade don the active spot markets. Similar to the forward contract is the
future contract. Though there lays a lot of similarities between both the products, some
differences also do exist. The first point of difference being that the futures trade as
standardized products on exchanges such as the CBOT. The exchange takes care of
intermediation of each of the trades taking place. The second point of difference is
that, trading in the futures transaction involves daily settlement in cash as well as
marking to the market. At the end of each trading day, a settlement price is reached at
and the price of the contract is considered at this new settled price. At the same time,
based on whether this new price is higher or lower than the settlement price of the
previous day, those parties that are having a short positions will pay to those parties
that have longer positions or the other way round an amount of cash proportional to
this daily price.
Swaps
A swap transaction can be considered as a bilateral agreement that involves the periodic
exchange of cash flows in which one is variable and the other is fixed over a period of
time. Let us consider an example of interest rate swap. There are two counter parties
involved in our transaction. Counterparty A agrees to pay counterparty B Rs.100 at the
end of each year for the period of the next ten years. In exchange to this the
counterparty B has agreed to pay an amount that is equal to the product of 1000 times
the then going annual yields on 1-year American treasury bills. The T-bill rate is 10
percent, then the exchange will be neutral because in the process, the counterparty B, will
also be paying Rs.100 (1,000 x 0.1). On the other hand, if the yield on the 1-year T-bill is
more than the stated 10 percent, a net cash flow will flow from the counterparty B to the
counter party to the counterparty A, where as the opposite will be the case if the yield
on the T-bill is less than the 10 percent mark. The swap contract is basically a portfolio
or a series of forward contracts. This fact can be justified from the angle of a currency
60
swap. In case of a currency swap, the two counterparties that are involved in the process
swaps periodic cash flows that generally comprise of the interest and the principal
payments on a common amount of debt, over several years. The cash that is exchanged
is in two different currencies and the exchange rate is fixed in advance.
Options
Rather than going into the details of an option contract, let us try to focus more on the
pervasiveness of the option contract involved in corporate contracting:
i.
The equity of a levered firm can be viewed as a call option on the assets of the
firm
ii.
It is also to be remembered that the call and the conversion provisions in a bond
contract are also types of call options
iii.
The warrants that are sometimes included during the issue of stocks and bonds of
the company can also be viewed as call options
iv.
The stock options that are granted to the executives of the companies can also be
viewed as call options.
As a matter of fact, all of the above stated forms of the call options helps in lessening
the agency cost or problems relating to the information asymmetry in the company. The
put options that are available to the company can also help in reducing these problems
as well as hedging risk.
CORPORATE MOTIVES FOR HEDGING
In any sort of perfect market, where in the stockholders are well diversified, there
may not be any justification for hedging. Further, if we consider one market
imperfection, that the process of hedging and insurance entails transaction costs, those
transaction costs will be not of any good use. The question that arises is that why
firms do at all goes in for hedging or buying insurance products. Let us here try to
find an answer to it with the help of certain empirical evidences provide in several
research papers.
Measuring and Hedging Exchange Rate Exposures
As far as this is concerned, certain questions needs to be answered. How does one
determine that the firm is exposed to exchange risk? Is the exchange risk of the firm has
any relationship with the relative level of foreign exchange? Does the firm make use of
the currency derivatives as related to its exchange rate risk? There have been many
studies done so as to seek answers to the above mentioned questions. The first couple of
questions are answered by Jorian in his study conducted in the year 1990.
He started his study by developing a measure of a firms exchange rate risk using the
modified market model regression:
Ri,t = bo,i + b1,i RS,t + b2,i RM,t + ei,t
61
Where,
Ri,t denotes the firms monthly stock returns.
RS,t denotes the contemporaneous percentage change in a given exchange rate.
RM,t denotes the return on the market portfolio.
b1,i denotes the measure of the firms exchange rate risk.
The author also found out the cross sectional regression so as to determine whether the
firms exchange rate risk is related to its foreign business:
B1,i = go + g1FS/TSt + ui
Where,
FS/TSt denotes the ratio of the firm is foreign sales to its total sales.
The above two equations are derived by using the data of 287 publicly traded American
firms that varied in terms of their foreign sales over the period ranging from 1981 to
1987.
For the determination of the exchange rate variable in the first equation Jorian had used
a trade weighted measure of the value of the dollar derived from the weights in the
multilateral exchange rate model computed by the International Monetary Fund.
Tax Rate Convexity as an Incentive to Hedge
Smith and Stulz (1985) and Graham and Smith in their research paper has put forth the
following argument. Those firms that encounter a progressive or convex tax structure
has an incentive to hedge, because it can reduce the firms expected liability. In general
if a firm faces a convex tax structure and a risk factor affects income to the extent that
the marginal income tax rate are crossed depending on the outcome of the risk, the firm
can reduce its expected tax liability by hedging.
Reduction in the Underinvestment Problem through Hedging
In his argument, Basselbinder (1991) has stated that the issue of hedging can help in
bringing down the underinvestment problems. The theory states that with the use of
hedging with the forwards and future contracts, the firms can increase their values by
reducing the incentives available for underinvestment. This is due to the fact that the
process of hedging reduces the sensitivity of the senior claim value to incremental
investment that further allows the equity holders to gain a larger portion of the
incremental benefit from new investments. Hedging has another advantage. It ensures
the due meeting of the firms commitments and obligations in situations where it could
not other wise do. This increases the firms credibility of the firm towards its customers,
creditors and its managers. Studies conducted by Gay and Nam (1998) have found
empirical evidence of derivatives helping in reducing the problems of underinvestment.
The studies took into account a total of 486 publicly traded, American non financial
firms in the year 1995 out of 325 used derivatives products. The study conducted
focused on the importance on the internally generated cash flows, cash stocks and
investment opportunities on the firms use of derivatives.
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Reducing the Risk Shifting Problem through Hedging

In relation to the reduction in the risk shifting problem through hedging is concerned,
Kracaw and Campbell (1987) provided a theoretical analysis. It involved the dual issue
of the risk shifting incentives of a leveraged firm and hedging. Some times the element
of debt can entail huge costs if the creditors have the knowledge that the borrowers have
both the incentive as well as the opportunity to increase the risk of the firm so that they
can expropriate wealth from the creditors. A considerable commitment towards hedging
can reduce such problems.
Growth Opportunities and Hedging
In the year 1997, Geczy, Minton and Schrand conducted an analysis of 372 firms
among the eminent non financial firms that were listed in the fortune 500 companies.
The firms that were used in the sample, had a considerable exposure to foreign currency
risk from operations abroad, foreign denominated debt, or the high level of
concentration of foreign competitors existing within the industry. It was found that
approximately around 41 percent of these firms used the currency swaps, forwards,
futures, options or even a combination of these option instruments. Their findings can
be summarized as follows. They closely examined the use of the currency derivatives so
as to distinguish between the existing theories and the hedging behavior. Firms that
have higher growth opportunities and tighter financial constraints are the ones that are
more likely to use the currency derivatives. This result may be suggestive of the fact
that the derivatives instruments can be used as a means of reducing the cash flow variation
that might otherwise prevent the firms from investing in valuable growth opportunities.
Those firms that have extensive foreign exchange rate exposure and economies of scale in
hedging activities are the more likely users of the currency derivatives.
Hedging Reduces External Funding Needs and Increases the Debt
Capacity
There have been several papers that have studied on the avoidance of external financing
and increasing the debt capacity as motives for hedging. Some of the researches have
argued that if any firm resorts to hedging certain risks, it can reduce the probability in
engaging in costly external financing. Taking this into the picture one can safely say
that hedging helps in the increase in the value of the firm through the explicit and
implicit savings. Some also suggested that a firm can increase its debt capacity with the
help of hedging with derivatives instruments, and in the process it can also reduce its
cash flow volatility. The evidence of the fact is provided by an empirical analysis. One
of the studies was done on 100 oil companies from the period ranging from 1992 to
1994. The studies suggested that to the extent to which these firms hedge their risk is
related to their financing cost. It has also been observed that companies with greater
degree of financial leverage are able to manage their price risk more extensively.
Further there also lays a relation of hedging with that of the economies of scale. For
those larger companies which has their production facility located in hose regions where
the prices have a high level of correlation with the prices of the exchange traded
derivatives are based are more likely to reap the benefits of managing risks.
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Managements Risk Aversion and Corporate Hedging

In their research paper, Smith and Stulz had put forth the argument that the managerial
risk aversion is a motive for hedging. Their argument states that the risk averse manger
has got his personal incentives to invest in less risky projects even though there may be
the existence of more valuable high risk projects. If some of the risk that is involves in
the high risk projects can be hedged, the management may consider its acceptance and
the semi-hedged projects may be beneficial to the stockholders. In his study, Tufano in
1996 had studied several gold mining firms, and their motives and objectives to hedge
the gold price risk during the period of 1990 to 1993. He examines that over 85 percent
of the firms resorted to tools for hedging the gold price risk. His study was suggestive of
the fact that the managers tendency to hedge the risk is related to his risk aversion
rather than the motives that are commonly found in the literary text. But at the same
time it is also seen that managers who hold more of options are able to manage less
price risk, and those managers who hold more of the stocks are able to manage more
gold price risk. This in turn suggests that the managerial risk aversion may influence the
corporate risk policy. Another finding of the study is the negative correlation of the
managerial risk aversion with that of the tenure of the firms CEO.
Corporate Motives for Purchasing Insurance
As it has been stated earlier that an insurance contract is similar to a put option that is
bought by the insured from an insurer so as to protect the value of an asset. The corporate
insurance is an obvious and common example of a firms attempt to manage risk.
Hedging versus Insurance
It can be safely said that the process of hedging with derivatives and the purchase of
insurance products are some what closely related. As stated earlier that a firm can resort
to hedging a risk by purchasing a put option, and at the same time it can also be said
that mechanically, insurance is also a put option. But one important point of difference
has been pointed between the two products by Smith and Stulz. Their theory states that
the elements that determine the need for hedging is very different from that of the need
for an insurance product. As far as the insurance products are concerned, their purchase
provides a real service that can be attributed to the experts of the insurance companies
in the process of evaluating certain types of risks and administering the claim settlement
procedures. Where as no such real service is provided by the futures and the forwards
contracts. The intermediary role that is played by an insurance company can be
considered to be important from the point of view of both monitoring the assets that are
actually insured and lessening the asymmetric information problems by taking the
possession of secretive trade information. The use of the insurance products from the
viewpoint of the modern corporate finance has been studied by Myers and Smith. Their
argument states that firms engage in purchasing insurance products to reduce their
agency costs. It also states that the corporate form can provide an effective hedge as the
stockholders can eliminate the insurable risk through diversification. Thus any purchase
of the insurance by the firms at the actuarially unfair rates would give a negative net
present value of the project and there by reducing he stockholders wealth. It was
further suggested that the insurance firms had a comparative advantage over the outside
64
stockholders, bondholders and the customers in the process of monitoring certain

aspects of the firms real activities than those firms that does not. As far as the reduction
in the agency cost was involved, Myers and Smith made an extension to their argument.
They said that a casualty loss generates option like features in their assets because their
value in turn depends on the discretionary investments. With the presence of the risky
debt in the capital structure of the firm, the stock-holders can sacrifice the discretionary
investments even though it provides a positive net present value. So it can be firmly said
that there exists a potential conflict between the bondholders who want to go for the
investments and the stock-holders who do not. Well there can be two ways by which the
underinvestment problem can be controlled:
i.
To put a restriction on the amount of debt in the capital structure of the firm
ii.
The inclusion of covenant in the bond contract that requires insurance coverage.
Guarantees
The use of the guarantees is done in a variety of circumstances. Guarantees are
generally provided by both the manufacturer and the retailers on their products. Also a
parent company may guarantee its debt that is being used by one of its subsidiaries. As
far as the functional requirement is concerned, a guarantee can be thought as equivalent
to a put option. The buyers are in a position to realize at least a minimum amount of
value of the product, asset or security or it can be returned in exchange of cash. In their
discussion paper, Merton and Bodie has spoken about financial guarantees focusing on
the parent guarantee of a subsidiarys obligations. According to them, such guarantees
are often quite important to the subsidiary firms. It might also some times happen that
the suppliers and the customers are ready to do business with the subsidiary. In cases of
managing the guarantees of its subsidiaries, it might be useful for the parent to use those
management methods that might not be feasible for the external guarantor. The parent
company has the access to virtually all of the subsidiary companys information without
causing any harm to the same. Such availability of information greatly helps in the
reduction in problems relating to information asymmetry between that of the guarantor
and the guarantee. So it is apparent that the moral hazards and the other principal agent
problems are of a lesser degree than that would be with the outside guarantor.
19.6 SECURITY DESIGN

THE OPTIMAL DESIGN OF SECURITIES
It was Allen and Gale in 1994 who took the broadest view of corporate securities as risk
sharing devices. They have resorted to the financial markets the role of distributors of
risk throughout the economy. The financial markets develop continuously so as to
provide ever more advanced means of performing this task. Their work can be directly
related to that of the concept of organizational architecture. Say for example, the early
innovations took into account the development of the corporate form of business where
the establishment of the risk sharing among the firms owners, creditors and the society
takes place by the limited liability provision. The authors also pointed out the fact that
the primary objective of a security design process is maximizing the issuers proceeds.
65
Another study focuses on the assignment of both the cash flows as well as the voting
rights where in the latter is more concerned with the issues relating to corporate control.
It states that there is an existence of conflict of interest between that of the contestants
for control and the outside investors. The root cause of this conflict arises because the
private benefits of control gives the contestants an incentive to acquire the control even
when the fact leads to the reduction in the value of the firm. The applications of security
design helps in the reduction in the conflicts and at the same time increase upon the
share holders and firms value. Similar to the studies conducted by Allen and Gale,
Zender also focused on the problem of allocating the cash flows and thereby control
rights. His study in fact concentrates on the problem of information incentive, under the
conditions of information asymmetry provided that only one of the involved parties can
take part in the decision-making process. Given such conditions, the optimal securities
are the equities with the control rights and the debt securities with no control rights. In
another study, Boot and Thakor (1993) further stressed on the importance of security
design as a device of reducing the information asymmetry problem. They found out that
in an asymmetric information environment, the issuers expected revenue is increased
by such cash flows partitioning as it makes the informed trade more profitable. They
further said that splitting a security into two components, one that is informationally
insensitive and the other more informationally sensitive than the composite security
makes the informed trading more profitable. The reason behind this is that the informed
traders with constrained wealth endowments tend to earn a higher return on their
investments in matters of information by allocating their wealth to the information
sensitive security. As a consequence of the informed trading the equilibrium price of the
intrinsically more valuable security moves closer to its fundamental value. This in turn
increases the high valued issuers total expected revenue.
Examples of Security Design
Security design is nothing new. The existence of the convertible bonds has been there
for long. Due to a lot of innovations coming into the security design, there has been the
emergence of a lot of new features in the corporate bonds. This has resulted in the birth
of the financial engineering. Financial engineering has given birth of various products,
markets and strategies that has helped the investors and the issuers in:
i.
Reducing costs.
ii.
Managing risks.
iii.
Pursuing profitable opportunities.
Let us now try to explain some of the recently emerge corporate bond features and also
some other contracting innovations.
Floating Rate Notes
The floating rate notes gives a coupon interest at a particular rate that is variable with
the specific short-term interest rate. The development of the floating rate was basically
in response to the concerns about the price risk associated with the long-term fixed
coupon bonds in the period of the volatile interest rates. The floating rate bonds provide
a better degree of stability than the price of the fixed coupon bonds with respect to the
change in the interest rates. This is due to the reason that the floating rate notes always
66
pay the going short term interest rates. Some of the floating rate notes are callable where
as some others are not. But even in case that the floater is callable, the yield premium
that is needed for the call provision is likely to be lower than the one that is required on
the fixed coupon bond. The reason being, that keeping apart the substantial change in
the issuers default risk, the price of the bond should always be close to its par value.
This provides a fair advantage to the issuing firm because it can enjoy the flexibility of
the early retirement provision without going in for paying the price for it in terms of
higher coupon interest. The choice between the fixed or the floating rate may be
partially dependent on the correlation of the firms earnings and the rate of inflation. For
a company for which the earnings before the interest and taxes is highly positively
correlated with the rate of inflation, the floating rate bonds will tend to reduce the
earnings volatility. But on the other hand, if the EBIT is negatively correlated with the
rate of inflation, the floating rate debt will tend to worsen the earnings volatility.
Low Coupon, Zero Coupon and Deferred Coupon Bonds
The various kinds of zero coupon bonds that emerged in recent times are:
i.
Original Issue Discount (OID) Bonds.
ii.
Deferred Coupon Bonds.
iii.
Payment in Kind Bonds (PIK).
However, most of these innovations have not seen an overwhelming success in recent
years due to various reasons. Say for example, the zero coupon bonds were issued in
part so as to take the advantage of a tax loop hole that has since then been eliminated.
But at the same time, they can be also useful in special circumstances. One advantage
of a zero coupon debt is that for the issuing firm, there is minimum or even no cash
flow involvement until the maturity of the instrument takes place. Thus such type of
bonds would be useful in situations where the company is not expected to realize
substantial pay-offs on its investments made in the projects for a number of years.
Added to this there is also the possibility of the amortization of the interest expense
over the life of the bond due to the existence of the tax laws. This facilitates the firm
to take tax benefits on an annual basis but at the same time helps in deferring the
actual cash payments in the distant future. The usefulness of the deferring interest in
the form of PIK bond was explained by Opler in 1993. These forms of bonds are
generally associated with the leveraged buyout activities. The study says that these
leveraged buyout activities are funded by payment in kind bonds, that facilitates the
issuer to meet the interest payments by the issuance of additional debt. One advantage
of the PIK debt is that it can substantially reduce the financial distress costs. Without
the existence of the PIK debt, a firm that faces financial distress has to renegotiate the
allocation of rights to the cash flows. With PIK being in place, the firm does an
automatic workout by providing the debt-holders greater claims to the cash flows in
the form of new debt claims. So one can firmly say that the PIK debt avoids the cost
associated with the negotiation of some type of debt for equity swap which is a
typical feature of a workout.
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High-Yield Junk Bond

The high-yield or the junk bond constitutes the market for corporate bonds that enjoys a
speculative grade rating. The issuance of the high-yielding bonds actually started in the
year 1970, by smaller and financially weaker firms whose credit rating would fall well
into the speculative grade category. Prior to such issuance, these firms were prevented
from the public debt markets and were compelled to issue privately placed debt. It was
seen that over the time those firms that had originally issued the bonds with investment
grace ratings later on encountered financial distress and their bond rating fell into the
speculative grade rating category. Such bonds are actually referred to as the fallen
angels. The new issue high-yield bond market faced a temporary setback in the early
1990s that followed the recessionary period of the 1990-1991. But at the same time the
markets did recover steadily throughout the 1990s and appeared to be so for some time
at least.
a.
What are the problems associated with dividend policy?
..
..
..
b.
List a few contracts that are included in a firms organizational architecture.
Mandatory Convertibles
The traditional convertible bonds are convertible at the option of the bondholder. In
contrary to the traditional products, in the new type of the convertible bond, the date of
the conversion is predetermined. The generic name that is given to such form of
convertibles is mandatory convertibles. Though it is also a common practice for banks to
device such products and gives them the brand name. Some of the well known examples of
this kind include the Morgan Stanleys PERCS (Preferred Equity Redemption Cumulative
Stock), Merrill Lynchs PRIDES (Preferred Redeemable Increased Dividend Security), and
Salomon Brothers DECS (Debt Exchangeable for Common Stock or the Dividend
Enhanced Convertible Security). The mandatory convertibles have been successful since
their inception in 1988. The role of the mandatory convertibles is similar to that of the
larger, often highly levered firm that are in the look out for equity capital but at the
same time wants to avoid unnecessary dilution.
68
Reset Notes and Rating Sensitive Notes

In the high-yielding corporate debt markets, two of the most widely used instruments are
the reset notes and rating sensitive notes. Both these types of notes offer a variable coupon
rate of interest. As far as the reset note is considered, the coupon rate is changed
periodically so that in the estimation of the original underwriter, the new coupon rate
would be sufficient enough to render the market price of the note that is equal to its par
value. So that in case after the issuance of the note, the issuers financial position is
worsened the coupon rate on the note would be worsened. On the other hand if the
financial position is better of, then the rate on the coupon would fall. As far as the rating
sensitive note is concerned, the coupon rate on such instrument would be changed only
when the credit rating of the firm as measured by S&P or Moodys changes. Take for
instance, a firm may issue a rating sensitive note that has an original rating of B and a
coupon rate 14 percent. Now if the credit rating of the firm increases to BB, the resulting
coupon would be reduced to 13 percent, but if the credit rating of the firm falls to CCC,
the coupon rate automatically increase to 15.5 percent. The development of these notes
took place to mitigate the price risk associated with the high-yielding corporate notes.
Strip Financing
Strip financing can be defined as one in which the investors hold a firms debt and its
equities. Strip financing may be partial as well as complete. In the former case, only some
investors hold both the debt and the equity, where as in the latter case, all of the investors
hold both the debt and the equity. The explanation of the strip financing was done by
Opler in 1993. His theory states that by aligning the incentives of the bond holders and the
equity holders, the complete strip financing eliminates any need for restructuring the
financial claims in times of financial distress. Even when strip financing is partial, it will
result in the reduction in the negotiation costs due to greater confluence of interest among
the negotiating parties.
Asset Backed Commercial Papers
The importance of the commercial papers has increased in the last twenty years or so.
The success of this can be partly attributed to the increased innovations in the Asset
Backed Commercial Papers (ABCP). This particular commercial paper is issued by a
Special Purpose Corporation (SPC), and is backed by the receivables of several firms.
These firms receive the proceeds of the issuances excluding the fees of the SPC. The
instrument can provide the riskier firms an indirect access to the low cost commercial
paper market.
Leveraged Loan Syndication
The bank loans have also made access to the public through the recent developments in
the leveraged loan syndication markets. It has been observed that the bank loan market
has come more in terms of a capital market in which one or more of the underwriters
structure and price the loans for the purpose of syndication to the different groups of
investors. This market driven approach has been more significant in the leverage
lending segment. The key to the success of the leveraged syndicate loan market is the
69
increased liquidity provided with these instruments. This has provided the riskier
borrowers a greater access to the debt capital at a lower interest costs.
Strategic use of the put Provision
The put provision in a bond contract allows the bondholder to use the bond for the
payment of the principal before the maturity date of the bond. Companies have added
this provision mainly for two reasons. They are:
a.
Because of the importance of the put provision to the bondholder, the interest
cost on the bond is lower than it would other wise be.
b.
The manager of the issuing firm may resort to an event triggered put provision that
can be exercised by the bondholder in situations where the issuing firm is
threatened with the take over. So, it can be said that the event triggered put
provision is an anti-take-over device that the management uses to ward off any
takeover activities and also to retain their jobs to a certain extent.
Apparently, it may seem that the put provisions may be the ultimate protection to the
bondholders against the attempt of the firm to expropriate the bondholders value. But
at the same time, it also suffers from some limitations. One of such drawback
involves around the risk shifting agency problems. Say after the issuance of a
putable bond, the firm shifts to a high risk operating or a marketing strategy that
may either lead to a great success or utter bankruptcy. In the former case, there will
not be the need of the put provision and in the latter case the put provision will be
virtually worthless, because in the case of bankruptcy, the claim of the bondholder
is the same with or without the put provision.
The Clawback Provision
This can be considered as one of the most recent forms of innovations that has taken
place in the corporate bond market. It is so named because of the unique provision of
the bond contract. The clawback provision allows the issuer to redeem a part of the
bond issue within a specified time frame at a predetermined price but only by the use of
funds from a later equity offering. It is because of this reason that the claw back
provision is also some times called as the equity call provision. An empirical analysis
done by Goyal, Gollapudi and Ogden on clawback bonds has shown that almost onethird of the corporate bonds that has been issued in the US comprises of this kind of
call provision. The authors states that these kinds of provisions help to reduce the
deadweight losses that would other wise are incurred when equity is offered following
a debt offering. The birth of the clawback provision can also be associated with the
emergence of another important financial innovation. These are the public issuance of
the bonds by the young privately held companies. In the case of the private issuers of
the clawback bonds, the clawback provisions can be exercised using the funds from
the public offerings and as such these are also referred to as the IPO clawback.
70
The Make Whole Call Provision

In the early part of the 1990s a new type of call provision emerged in the corporate bond
market which was better known as the make whole call provision. By the time of the
late 1990s this type of call provision became the order of the day and comprised of
almost two-thirds of the total callable bond market of the US similar to the traditional
form of the call provisions the make whole call provision permits a firm to retire its
bonds prior to the stated date of maturity. But at the same time it is to be remembered
that the make whole call provision requires the firm to pay a call price that is set at the
time of the call and that is sufficient to provide the bond holders an ex-post return on the
life of the bond to date that is equal to the return that they would have received a noncallable treasury bond that had the same maturity period as the callable bond.
The Eurobond Market
The eurobonds are those bonds that are sold outside the country in whose currency they
are denominated. The eurobonds are generally geld by the investors in bearer form,
rather than on a registered basis. The Eurobonds can be considered to be similar to those
of the domestic corporate bonds. The market for Eurobond is almost entirely free of
official regulation by any agency that is comparable to the Securities Exchange
Commission. Rather the market for the Eurobond is regulated by the Association of
International Bond Dealers. It is observed that the borrowers of the eurobond market are
generally large. These firms are well to the mass and enjoy a considerable credit rating.
The major eurobond issuers in the year 2000 had been The enron Corporation, IBM
Corporation, LTV Steel Corporation and some other firms. Research studies has shown
that these firms are actually able to borrow at a lower cost in the Eurobond market than
it is possible to do in their own domestic market. This is partly due to the fact that the
market allows the firm to search the world for the location and the currency in which the
borrowing costs may be low. An added advantage of the Eurobond market is the speed
at which the firm can go in for issuing debt. This is done in few days as compared to the
lengthy delays that is associated with the regulated US public corporate bond market.
Project Finance
In the last section of the discussion, let us focus on the project financing aspect that has
become an important means of privately financing huge infrastructure projects.
Throughout the period in the industrialized world, most of the funding of the large scale
public works such as activities relating to the building of roads and canals has come
from the private sources of capital. It was only at the end of the nineteenth century that
the public financing of the large scale infrastructure projects began to dominate the
private finance. Some of the features of such type of project financing can be
categorized as following:
i.
Establishment of a project is done as a separate company that enjoys protection

of subsidies under the government.
ii.
The majority portion of the equity associated with the project financing is
provided by the project manager or the sponsor, which in turn ties-up the
provisions of the finance to the management of the project.
71
iii.
The project company enters into a contractual arrangement with the suppliers
and customers.
iv.
The project company enjoys a high debt-equity ratio with he lenders been offered
limited recourse to the government or the equity holders.
It can be said that the structure and the contracting features of project finance are means
through which the principal agent conflict among the various stake-holders can be
mitigated in a company. These stake-holders include the government, stake-holders,
suppliers, other investors, project sponsors, lenders and the financial customers that will
be served by the projects construction.
19.7 SUMMARY
A firms organizational architecture consists of business architecture and financial
architecture.
Business architecture includes all aspects of the firms its environment, assets and
operations that describes the circumstances under which and the manner in which
business is conducted by it, barring its financial contracts.
The firms financial contracts forms the financial architecture of a firm.
An efficient organizational architecture is built by recognizing and giving due
importance to the components and elements within the system. (architecture)
Components of financial architecture includes derivative [forward contracts, futures,
options, swaps] and contracts like insurance and guarantees to manage various types of
risk [currency risk, commodity price risk, interest rate risk etc.].
Security should be so designed by the firm so as to maximize stockholder wealth.
It should be targeted at the investor group that values them most. Debt and equity are
optimal generic securities.
19.8 GLOSSARY
Hedging is an act, in which an investor seeks to protect underlying or anticipated
position by using an opposite position in derivatives.
A firms business architecture is the environment, assets, and the operations that
together describe the situations under which the firm carries on its business.[v2]
Inflation is a continuous rise in the price of goods and services.
Interest Rate Risk is the possibility of a reduction in the value of a security, especially
a bond, resulting from a rise in interest rates.
Junk bond is a high-yield bond that enjoys a speculative grade rating.
72


a.
There are certain aspects of legal environment that are also important to the
firms. The basic aspect of this relates to the protection of the property rights, the
enforcement of the legal contracts, and the limited liabilities that pertains to the
shareholders as the owners of the company.
b.
This technological enhancement takes into account the swiftness of the

information flow. The operational and the informational efficiencies of any
securities market the speed at which the accurate, and value relevant information
is carried on to both the issuers and the investors. The technological
advancements also relate to the degree to which the more complex forms of
securities and the transactions are available.
a.
Many of the problems takes into account the element of dividend policy.
The dividend income of the firm is associated with the element of income tax,
and the dividend payments are not deductible expenses. Thus, it can be said that
the policy of a firm to pay out its dividends may result increase in its cost of
equity capital and result in attracting a group of investors that prefer such
dividend policy of the firm. Further, it is also to be remembered that the firm has
its own incentives to retain the free cash flows that are available to it rather than
distribute it as dividends. Further, we can also say that for any firm that is highly
leveraged, it has an incentive to increase its dividends so as to increase its
possibilities of expropriating more wealth from its creditors.
b.
The contracts may include are:

i.
Contracts with board members.
ii.
Executive compensation contracts.
iii.
Contracts with other employees.
iv.
Contracts with the suppliers and the customers.
73

A. Multiple Choice
1.
2.
3.
4.
74
Which of the following components that constitutes the firms business

architecture?
a.
Macroeconomic environment.
b.
Financial market environment.
c.
Internal legal and governance structures.
d.
Business strategies and growth opportunities.
e.
All of the above.
Which of the following is one of the primary elements that a firms business
architecture deals with?
a.
Human Capital.
b.
Product design.
c.
Plant layout.
d.
Factory Layout.
e.
Financial Capital.
What are the reason/s that can be attributed to the stock repurchases?
i.
In case the firms shares are undervalued.
ii.
The repurchase compels the deployment of the free cash flows.
iii.
Reduction in the firms outstanding equity, results in the expropriation of

creditors wealth.
iv.
Repurchase of shares serves as a takeover defense.
a.
Only (i) and (iv) of the above.
b.
Only (i) and (iii) of the above.
c.
Only (ii) and (iii) of the above.
d.
Only (ii), (iii) and (iv) of the above.
e.
All of the above.
Identify zero coupon bond/s that emerged in recent times from the followings.
i.
Original Issue Discount (OID) Bonds.
ii.
Deferred Coupon Bonds.
iii.
Payment in Kind Bonds (PIK).
a.
Only (i) of the above.
b.
Only (ii) of the above.
c.
Only (iii) of the above.
d.
Only (ii) and (iii) of the above.
e.
All of the above.
5.
Which of the following is one of the basic element that a firms Financial
architecture deals with?
a.
Wage Rate.
b.
Cost of Production.
c.
Leverage.
d.
Foreign Exchange Rates.
e.
Human Capital.
B. Descriptive
1.
What are the macroeconomic components that are included in the business
architecture of the firm?
2.
Differentiate Public ownership with Private Ownership.
3.
What is meant by junk bond?
4.
What are the features of project finance?
practice only.
75
UNIT 20 THE PRACTICE OF HEDGING

Structure
20.1
Introduction
20.2
Objectives
20.3
Factor Models Explained
20.4
Factor Betas
20.5
Measuring the Risk Exposure
20.6
Hedging with Convenience Yields
20.7
Summary
20.8
Glossary
20.9

20.1 INTRODUCTION
There are various types of risks that a firm faces. These are often termed as exposures.
Exposures are in relation to interest risk, business cycle risk, inflation risk, commodity
price risk, and industry risk. Let us here try to understand how a firm tries to mitigate each
of these risks. There are different types of risk exposures. [v1]For the reduction in the cash
flow risk exposure, one needs to resort to cash flow hedging. This is actually the
acquisition of the financial instrument in order to reduce the cash flow factor betas of the
firm. In order to minimize risk exposures, one acquires the financial instruments, that
when bundled with the assets of the firm, result in those factor betas that are more or less
close to zero.
20.2 OBJECTIVES
Understand the concept of hedging;
Identify the determinants of Factor Betas;
Analyze the Factor Models for portfolios;
Know the application of statistical tools to measure Risk Exposure; and
Learn hedging with Convenience Yields.
20.3 FACTOR MODELS EXPLAINED

A factor model is a breakdown of the returns of securities into two categories. They are:
i.
A set of components correlated across securities; and
ii.
A component that generates firm-specific risk and is uncorrelated across

securities.
The components that determine correlations across securities, that are the common
factors, are variables that represent some fundamental macroeconomic conditions.
The components that are uncorrelated across securities represent firm-specific
information. The firm-specific risk, but not the factor risk, is diversified away in most
large well-balanced portfolios. Through a judicious choice of portfolio weights,
however, it is possible to tailor portfolios with any factor beta configuration desired.
The arbitrage pricing theory is based on two ideas, they are:
a.
The returns of securities can be described by factor models.
b.
The arbitrage opportunities do not exist.
Using these two assumptions, it is possible to derive a multi-factor version of the

CAPM risk-expected return equation which expresses the expected returns of each
security as a function of its factor betas. To test and implement the model, one must first
identify the actual factors.
There are substantial differences between a multi-factor APT and the CAPM that favor
use of the APT in lieu of the CAPM. In contrast to the CAPM, the multi-factor APT
allows for the possibility that investors hold very different risky portfolios. In addition,
the assumptions behind the CAPM seem relatively artificial when compared with those
of the APT.
In choosing the multi-factor APT over the CAPM, one must recognize that the research
about what the factors are is still in its infancy. The three methods of implementing the
multi-factor APT are more successful than the CAPM in explaining historical returns.
However, it appears that firm characteristics such as size and market-to-book explain
average historical returns more successfully. Until we can better determine what the
factors are and which factors explain expected returns, the implications of APT will be
fraught with ambiguity and will likely be controversial. If the CAPM and the APT do
not hold in reality, the theories may be quite useful to portfolio managers. Recall that
according to the CAPM, the market compensate investors who bear systematic risk by
providing higher rates of return. If this hypothesis is false, then portfolio managers can
match the S&P 500 in terms of expected returns with a far less risky portfolio by
concentrating on stocks with low betas. The evidence in this chapter suggests that in
addition to buying low-beta stocks, investors should tilt their portfolio toward smaller
cap firms with low market-to-book ratios. However, we stress that these suggestions are
based on past evidence which may not be indicative of future events. As you know,
economists do reasonably well explaining the past, but are generally a bit shaky when it
comes to predicting the future. Despite any shortcomings these theories exhibit when
measured against historical data, the CAPM and APT have become increasingly
important tools for evaluating capital investment projects. They provide an increasingly
significant framework for corporate financial analysts who can use them appropriately
while understanding their limitations.
20.4 FACTOR BETAS

77
The magnitudes of a securitys factor betas describe the sensitivity of the securitys
return to changes in the common factors.
DETERMINANTS OF FACTOR BETAS
Let us here consider how the stock prices of smooth run, an automobile manufacturer,
and Entertainment Inc. a chain of movie theaters reacts differently to factors. The sales
of Auto are linked highly to overall economic activity. Therefore, the returns to holding
stock of smooth run should be very sensitive to changes in industrial production. In
contrast, movie attendance is not as related to the business cycle as car purchases, so the
stock Entertainment Inc. should prove less sensitive to this factor. Hence, smooth run
should have a larger factor beta on the industrial production factor than Entertainment
Inc. If consumers go to more movies during recessions than at other times, substituting
cheap theater entertainment for expensive vacations during tough times, Entertainment
Inc. might even have a negative factor beta on the industrial production factor.
FACTOR MODELS FOR PORTFOLIOS
Multi-factor betas, like single-factor betas, have the property that portfolio betas are the
portfolio-weighted averages of the betas of the securities in the portfolio. For example,
if stock As beta on the inflation factor is 2 and stock Bs is 3, a portfolio that has
weights of 0.5 on stock A and 0.5 on stock B has a factor beta of 2.5 on this factor.
Thus, it can be said that the factor beta of a portfolio on a given factor is the portfolioweighted average of the individual securities betas on that factor.
The algebraic expression of a multi-factor model, that is a factor model with more than
one common factor, is given in the following equation:
%
%
r%
1 = 1 + i1 + i2 F2 + ... = ik FK + %
i
The assumption that goes behind in framing the above equation is hat the securities
return are generated by a relatively small number of common factors, each of the factor
being resented by the factor F, for which the different stocks have different sensitivities,
or s, along with uncorrelated firm specific components, the s, which contributes
negligible variance in a well diversified portfolio.
Given the K-factor model (or factor model with K distinct factors) of the above equation
(multi-factor model) for each stock i, a portfolio of N securities with weights xi on stock
i and return, R p = x1%
r1 + x 2 r%
2 + ... + x N r%
N , , has a factor equation of
% %
R%p = p + p1F%
1 + pk FK +
i
Where,
78
p = x11 + x 2 2 + ... +x N N
p1 = x1 21 + ... +x N N1
p2 = x1 21 + x 2 22 + ... + X N N2
.
pk = x11K + x 2 2K + ... + X N NK
p = x11 + x N 2 + ... + x N %N
It is to be remembered that not only is the factor beta a portfolio-weighted average of
%
the factor betas of the stocks in the portfolio, but also the alphas (a) and the epsilons ()
of the portfolios are the portfolio-weighted averages of the alphas and epsilons of the
stocks. Let us now look at the following example.
COMPUTING FACTOR BETAS FOR PORTFOLIOS
Illustration 1
Let us now consider the following two-factor model for the returns of three securities:
Apple Computer (security A), Bell South (security B), and Citigroup (security C).
r%
A
% %
.03 + F%
1 4F2 +
N
r%
B
% %
.05 + 3F%
1 2F2 +
N
r%
C
% %
.10 + 1.5F%
1 0F2 +
C
Let us find out the factor equation for a portfolio that,

a.
Equally weights all three securities, and
b.
Has weights XA = -0.5, XB = 1.5, and Xc = 0.
Solution
a.
p =
1
1
1
(0.03) + (0.05) + (0.10) = 0.06
3
3
3
p1 =
1
1
1
(1) + (3) + (1.5)
3
3
3
=1.833
Thus,
P2 =
1
1
1
(-4) + (2) + (0) = 0.667
3
3
3
Where,
%p is an average of three s
b.
P1 = 0.5(1) +1.5(3) + 0(1.5) = 4
79
P2 = 0.5( 4) +1.5(2) + 0(0) = 5

Thus,
P1 = 0.5(1) +1.5(3) + 0(1.5) = 4

Where,
% %
R%P = 0.06 + 4F%
1 + 5F2 =
P
USING FACTOR
VARIANCES
MODELS
TO
COMPUTE
CO-VARIANCES
AND
Let us now discuss the correlation or co-variance between the returns of any pair of
securities is determined by the factor betas of the securities and how to use factor
betas to compute more accurate covariance estimates. When using mean-variance
analysis to identify the tangency and minimum variance investment portfolios, the
more accurate the covariance estimate, the better the estimate of the weights of these
critical portfolios.
COMPUTING CO-VARIANCE IN A ONE-FACTOR MODEL
Since the s in the factor equations (as described in the last section) are assumed to be
uncorrelated with each other and the factors, the only source of correlation between
securities has to come from the factors. The following example illustrates the
calculation of a co-variance in a one-factor model.
COMPUTING CO-VARIANCES FROM FACTOR BETAS
The following equations describe the annual returns for two stocks, Ram Electronics
and Sita Software, where F% is the change in the GDP growth rate and A and B
represent Ram and Sita, respectively.
% %
r%
A + 0.10 + 2F +
A
% %
r%
B + 0.15 + 3F +
B
The s are assumed to be uncorrelated with each other as well as with the GDP factor,
and the factor variance is assumed to be 0.0001. Let us compute the covariance between
the two stock returns.
% % + 3F%+ % )
AB + cov(0.10 + 2F,3F,15
B
% %+ 0+0+0
= cov(2F,3F)
Since constants do not affect covariances. Expanding this covariance, we get,
% %+ cov(2F,
%% ) + cov (% ,3F)
% + cov(% , % )
AB = cov(2F,3F
B
A
A B
% %+ 0+0+0
= cov(2F,3F)
80
Thus, the covariance between the returns is the covariance between 2 F% and 3 F%, which
is 6 var ( F%), or 0.0006.
The pair of equations for r%
A and r%
B in the above example represents a one-factor model
for stocks A and B. Notice the subscripts in this pair of equations. The %s has the same
subscripts as the returns, implying that they represent risks specific to either stock A or
B. The value each takes on provides no information about the value the other acquires.
For example, A , taking on the value 0.2, provides no information about the value of
B . The GDP factor, represented by F%, has no A or B subscript, implying that this
macroeconomic factor is a common factor affecting both stocks. Since the firm specific
components of these returns are determined independently, they have no effect on the
covariance of the returns of these stocks. The common factor provides the sole source of
covariation. As a result, the covariance between the stock returns is determined by the
variance of the factor and the sensitivity of each stocks return to the factor. The more
sensitive the stocks are to the common factor, the greater is the covariance between their
returns.
COMPUTING CO-VARIANCES FROM FACTOR BETAS IN A MULTIFACTOR MODEL
Illustrates 2
Calculation of Co-variances Return within a Two-factor Model
Consider the returns of three securities (Apple, Bell South, and Citigroup), given in the
above example let us compute the covariances between the returns of each pair of
securities, assuming that the two factors are uncorrelated with each other and both
factors have variances of 0.0001.
Solution
%
Since the two factors, denoted F%
1 and F2 , are uncorrelated with each other, and since the
s are uncorrelated with each of the two factors and with each other
%
cov(r%
rB ) = 3 var(F%
A,%
1 ) 8 var(F2 )
= 0.0005
%
cov(r%
A , r%
B ) = 1.5 var(F1 )
= 0.00015
%
cov(r%
B , r%
C ) = 4.5 var(F1 )
= 0.00045
In the above illustration, the covariances between the returns of any two securities are
determined by the sensitivities of their returns to factor realizations and the variances of
the factors. If some of the factors have high variances, or equivalently, if a number of
stock returns are particularly sensitive to the factors, then those factors will account for
a large portion of the covariance between the stocks returns.
81
More generally, covariances can be calculated as follows:

Let us assume that there are K factors uncorrelated with each other and that the returns
of securities i and j are respectively described by the factor models:
%
%
% %
r%
i = i + i1F1 + i2 F2 + ... + iK FK +
i
%
%
% %
r%
i = j + j1F1 + j2 F2 + ... + jK FK +
Then the covariance between and is:
%
%
ij = i1 j1 var(F%
1 ) + i2 j2 var(F2 ) + ... + iK jK var(FK )
The above result reveals that the covariances between securities returns are determined
entirely by the variances of the factors and the factor betas. The firm-specific
components, play no role in this calculation. If the factors are correlated, they still
irrelevant for covariance calculations. In this case, however, additional terms must be
appended to the above equation to account for the covariances between common
factors. Specifically, the formula becomes:
K
ij = im jn cov (F%m ,F%n )

m =1 n =1
a.
On which ideas, the arbitrage pricing theory is explained?
b.
What are the assumptions underlined in multi-factor model?
20.5 MEASURING THE RISK EXPOSURE

Let us start with the assumption that currency and the interest rate uncertainty contribute
to a firms risk of doing business in Japan. The exposure of the future cash flows to the
above two factors can be estimated by estimating a factor model. Let us now assume
that the estimation of the factor model results in the following equation.
c%= 30 + 2F%curr
%
4F
int
+ %
Where,
c%
denotes the cash flows in millions.
F%curr
denotes the percentage in the yen/rupees exchange rate in the coming year.
F%
int
denotes the percentage change in the short-term interest rate in the

coming year.
82
The absolute values of 2 and 4 are the sensitivities of the cash flow to the exchange
rate and the interest rate respectively, or the cash flow factor betas.
denotes the risk of the cash flows that is not captured by the two risk factors that is
stated above.
USING THE REGRESSION TO ESTIMATE THE RISK EXPOSURE
The regression method is one of the most popular tools for the purpose of analizing
risks and developing hedges. This actually examines the historical performance of the
unhedged cash flows in relation to the risk factor. More specifically, it estimates the
factor betas as slope co-efficients from the regression of the historical returns or cash
flows on the risk factors.
MEASURING RISK EXPOSURE WITH SIMULATIONS
This is more of a forward looking approach of estimating the risk exposure. In the
rapidly changing industries, the simulation method is superior to the regression
estimation, which is based on more of historical data and is thus considered to be
backward looking approach.
IMPLEMENTATION WITH SCENARIOS
The implementation of the scenario analysis calls for the forecasting of earnings or the
cash flows for a variety of factor realizations. Say for example, in the case of exchange
rate risk, the manager would implement the method by specifying a wide-range of
different exchange rate scenarios. Each of the scenarios will include an estimate of the
profits or the cash flows that would occur under a variety of assumptions about the
demand in the industry and about competitor and supplier responses.
SIMULATION VS REGRESSION
It is to be remembered that though the method of simulation calls for a lot of

judgments, it does not require that the historical performance of the company provides
the best estimate of its future potential. This aspect can be very important in a
changing environment.
MODIFYING THE INITIAL ESTIMATES OBTAINED FROM REGRESSION
The simulation method for the exchange rate risk calls for the estimation of the future
costs and revenues under the different exchange rate scenario in order to obtain profit.
The inputs for this may be well provided by the regression analysis, but the analyst is
not limited to the use of the regression results. He may make assumptions about the
sensitivity about the products demand to its price, as well as its expected competitor
responses to the exchange rate changes. Added to this, the regression analysis specifies
a linear relationship between the determinants of profits and the exchange rate changes
which in reality is not to be seen. It is important for the manager to modify the
regression based estimates in order to account for any non-linearity in the statistical
relationship.
83
An Example
Automobile giant general motors might assume that the Japanese automakers will
maintain the same American dollar prices for their cars when they are faced with a
small increase in the value of the yen. In this case, the company will benefit from a
small increase in the value of yen. But in case, the yen strengthens significantly, the
Japanese automakers may find it more beneficial to abandon certain US markets. This
action in fact would greatly benefit the Japanese auto making giant. Similarly, when the
yen weakens as relative to the dollar, a small waking may not have any impact on the
prices that the US dealers pay for the Japanese cars. One reason for this may be that the
Japanese car makers are concerned about a future appreciation in the price of their
products if the yen subsequently strengthens. On the other hand, if the yen weakens
considerably, providing the Japanese automakers with cost advantage, they might take
advantage of the situation to increase their market share, which would in turn result in a
significant decrease in the profit of general motors.
VOLATILITY AS A MEASURE OF RISK EXPOSURE
It has been observed in numerous occasions that the corporate managers often like to
represent the risk exposure with a single number. This is one of the reasons that the
standard deviation is used as a representative of the risk impact of a collection of factor
betas. The variance of the factor risk of an investment can be represented as:
k
2 = mn cov(F%m , F%n )
m =1 n =1
Where,
m denotes the factor beta on the factor m.

n denotes the factor beta on the factor n.
The volatility of the cash flow or the value owing to the factor risk is actually the square
root of the above expression. The following illustration shows how the above formula
can be implemented:
Illustration 3
Assume that a firm has a cash flow one year from now (in US$ millions) that follows
the factor model,
%= 30 + 2 F% 4F% + %
C
curr
int
Where the currency factor, F%
curr is the percentage change in the /US $ exchange rate
over the next year and the interest rate factor, F%
int' is the percentage change in
three-month LIBOR from now until one year from now. Assume that the variance of the
currency factor is estimated to be .011, the variance of the interest rate factor is
approximately .022, and the covariance between the two is .004. What is the
factor-based volatility of the cash flow?
84
Solution
Using the variance formula above, the factor based variance is
29.96 32.25
1.1
The square root of this number, the volatility, is 0.576 (expressed in US millions).
20.6 HEDGING WITH CONVENIENCE YIELDS

From the valuation point of view, most of the commodities can be considered as
dividend paying stocks because of the fact that there is a benefit of owning them apart
from their potential for price appreciation. The direct benefit that one can derive by
owning them is called convenience yield. This is actually the benefit from holding an
inventory of the commodity net of its direct storage costs that arises because it is much
more convenient to have the inventory at hand than having to purchase the commodity
every time it is needed. For the commodities with convenience yields, the number of the
future or the forward contracts that is used to hedge the commodity varies according to
the date of the future obligation.
CONVENIENCE YIELDS AFFECTING THE HEDGE RATIOS
Convenience yields does not have any effect on the future or the forward hedge ratios
when the maturity of the future obligations that one is trying to hedge matches the
maturity of the future or the forward contract which is used as a hedging instrument.
Whenever, the obligation is a forward contract and the risk therefore is eliminated with
an offsetting opposite forward contract, the future contract can generate the same
perfect hedge provided that it is tailed for the interest earned on the marked to market
cash. Whenever, there is the existence of a mismatch in the maturity of the hedging
instrument and the obligation to be hedged, the Convenience yield affect the hedge ratio
whether the hedge is executed with a forward contract or future contracts. Let us try to
focus on the determinants of a Convenience yield.
DETERMINANT OF CONVENIENCE YIELD
Let us consider the case of the petrol that is used to fill up our automobile tanks.
Whenever, we go to any filling station, we prefer to fill our vehicle tank to almost full
capacity, because it does not make any sense for us to stop for every half an hour and
get it filled whenever the tank gets empty. But for this convenience, there is also a small
cost attached to it. The petrol that is filled in the tank will not appreciate in value
(considering it is not stored for too long a period), but on the other hand, the money that
has been incurred on buying the petrol might have earned some interest it has been
invested anywhere else. Now say that in case the storage of petrol would have come for
free, one would even choose to store it for anytime use. Here the term free is use to
mean not only the direct cost of storage, but also free in the sense that the interest
earned on holding the petrol would be comparable from that earned if the money was
85
deposited in the bank. In other words it can be said that the demand and the supply of
the convenience which in turn depends on the cost of supplying the convenience is
determinant of the inventory of any commodity. For the supply to be equal to the
demand, the difference between the expected price appreciation of the commodity and
say any other investment having identical risk must be the difference in their net
convenience yields. For the sake of simplicity let us here refer to the net convenience
yield as, convenience yield.
HEDGING WITH CONVENIENCE YIELDS
The convenience yields tend to reduce the ratio of the forward price to the spot prices.
Let us here consider the forward price of crude oil. The refineries with the oil
inventories earn a convenience yield (that in fact exceeds the cost of storage), mainly
because they do not have the risk of having to shut down the refinery if there is an
interruption in the supplies. Let us here assume that the crude oil price has a
convenience yield of 2 percent per year. If the oil is selling at Rs.25 per barrel and the
risk-free rate is 10 percent per year, then the no arbitrage futures and the forward price
for the oil that is delivered one year from now is:
426.96 =
$25(1.1)
1.02
This can be generalized to a certain extent. If the commoditys convenience yield to the
forward commitments maturity date is taken to be y, and the no-arbitrage forward price
that would apply in the absence of any convenience yield is represented as Fo, the
forward price of the commodity would be:
Fo
1+ y
The above expression affects the hedge ratio because of the existence of the mismatch
between the maturity of the futures and the date of the position one is trying to hedge.
Say, when one is trying to use the forward or the future to perfectly hedge the price of
oil, by holding its inventory the convenience yield would affect the hedge ratio used.
As the following exhibit reveals, an increase in the current price of oil from its present
price of Rs.25 per barrel (column 1) to Rs.30 per barrel (column 2), which results in a
zero PV futures and forward price of Rs.32.35 would be offset by a short position in
1.02/1.1 future contracts (row a) or 1.02 forward contracts (row b).
Thus, it can be said that the two percent convenience yield results in the hedge ratio for
the oil to be different for that of gold, which is believed to have very little or no
convenience yield.
86

Position
Hold 1 barrel Oil
(1)
(2)
(3)
Position Value at Initial Oil

Price of $25/Barrel
( Zero PV Forward and
Futures price = $26.96)
Position Value if Oil price Rises

to $30/barrel
Mark to
Market Cash
$25
$30
$0
$5
( Zero PV Forward and

Futures Price = $32.35)
(4)
Gain from
Position
(2) + (3) (1)
Sell 1 futures contract
5.4
5.4
Sell 1.02/1.1 futures

contracts
-5
Sell 1 forward contract
4.9
4.9 =
26/96 - 32.25
1.1
Sell 1.02 forward contracts
5 = 1.02 (4.9)
sell 1 futures contract
25
$30
5.4
0.4
Hold 1 barrel of oil and sell

1 forward contract
25
25.1 = 30 4.9
a. Hold 1 barrel of oil and

sell 1.02/1.1 futures
contracts
25
$30
b. Hold 1 barrel of oil and

sell 1.02 forward
contracts
25
25 = 30 1.02 (4.9)
Table 1
Hedging a Decline in the Price of Oil with a two Percent Convenience
Yield-current Oil Position
It is important to recognize that this risk comparison has been oversimplified by our
assumption that the convenience yield of a commodity does not fluctuate with the
commoditys price. For most commodities, convenience yields tend to increase as the
price of the commodity increases and decrease as the price of the commodity decreases.
When this is the case, the forward price is even less volatile relative to the volatility of
the spot price.
Maturity, Risk and Hedging in the Presence of a Constant Convenience
Yield
In order to understand the hedging of the long-dated commodities with short-term

maturing futures and forwards, it is essential to link the risk of each commitment and
hedging instruments to the risk of holding the commodity. For example, let us here
assume that the price of oil has a convenience yield of two percent per year, the forward
commitment to buy one barrel of oil 10 years from now is equivalent in risk in position
in
1
(1.02)10
barrels of oils purchased today. On similar lines, the commitment to buy oil
one year from now is equivalent to risk to a position in
1
barrels of oil purchased
(1.02)
today. So, in order to perfectly hedge the obligation to buy a barrel of oil 10 years from
now by selling a forward contract to purchase oil one year from now, one should sell
87
(1.02) 9
1
(1.02)10
1
1.02
10
1
1.02
= 0.837
=
1
(1.02)9
1.02
= 0.837
Forward contracts maturing one year from now.

ROLLOVERS AT THE FORWARD MATURITY DATE
With each day passing, it is unnecessary to change the position in the one year forward
contact. Say for example, one half year from now, the obligation to buy oil long-term
would be 9.5 years from now, while the short-term forward would be 0.5 years from
maturity. Hence, the proper number of short-term forward contract being sold would be
10
1
1
1
=
9
10
1
(1.02)
(1.02)
1.02
= 0.837
=
= 0.837
1
1
(1.02)9
1.02
1.02
However, as the tear further elapses, and the short term forward contract matures, it
becomes essential to rollover the old contract and enter into a new one year forward
contract. For this contract, the obligation would be nine years from out. At this point,
selling of the new one year forward contract perfectly hedges the risk of the nine year
old obligation. Offsetting the forward contracts at the maturity date of the short term
hedging instrument is a form of tailing the hedge.
9
1
1.02 = 0.853
=
1
(1.02)8
1.02
FUTURE HEDGES
It is to be noted that a one year future contract is more risky than a one year forward
contract because of the marked-to-market features. With a 10% risk-free rate, each one
year future contract is equivalent in risk to 1/1.11 one year forward contract. Hence, for
the example that is shown above, a perfect futures hedge would involve selling one year
future contract at the outset.
1
(1.02)9 (1.1)
= 0.761
However, as each of the day elapses in that first year, it is necessary to tail the future
hedge because it is getting closer to the forward contract in terms of its risk. For
example, one half year from now, the obligation to buy oil long-term would be 9.5 years
away, implying that the number of short-term future contracts being sold would have to
equal to
9.5
1
1.02
=
9
5
1
(1.02) (1.1)
1.02.5
88
= 1.15 = 0.789
HEDGING OIL PRICE RISK WITH SHORT-DATED FUTURES AND

FORWARDS
Illustration 4
Assume that ABC Company has an obligation to deliver 1.25 million barrels of oil one
year from now at a fixed price of $25 per barrel.
a.
How can it hedge this obligation in the forward or futures markets, using
forwards and futures maturing one month from now and then rolling over into
new one-month forwards and futures as these mature?
b.
Assume that the convenience yield is 5 percent year and the risk-free interest rate
is 10 percent per year, both compounded annually.
Solution
a.
The sum of 1 plus the on-month convenience yield per dollar invested in
1.051/12. Hence, the forward hedge would buy 1.25 million/1.0511/12 barrels of oil
one-month forward. In the futures market, one would buy futures to acquire
1.25 million/[(1.0511/12) (1.11/12)] barrels of oil.
b.
The convenience yield makes the risk from holding 1.25 million barrels of oil
greater than the risk associated with the present value of the obligation to receive
1.25 million barrels in one year. The risk-minimizing hedge would be to sell
1.051/12 x 1.25 million barrels of oil for one-month forward delivery. A futures
position to sell (1.05/1.1)1/12 x 1.25 million barrels of oil also eliminates the oil
price risk.
Quantitative Estimates of the Oil Futures Stack Hedge Error
Mello and Parsons (1995) constructed a simulation model for Metallegescellschafts

(a company) hedging problem. Their model assumes that Metallgesellschaft has an
obligation to deliver 1.25 million barrels of oil at a fixed price on a monthly basis for
the next 10 years.
This amounts to delivery obligations of 150 million barrels of oil at a fixed price. Mello
and Parsons reported that Metallgesellschaft used what is known as a rolling stack of
short-term futures contracts to undertake this hedge. With a rolling stack. The obligation
to sell (buy) a commodity is offset with a series of short-term futures or forward
contracts to buy (sell) the same amount of the commodity. Metallegesellschafts
commitment to sell 150 million barrels of oil at a preset price is hedged (although
imperfectly) with a rolling stack that takes a position in short-term futures contracts to
buy 150 million barrels of oil. As the futures contracts expire, they are replaced with
futures contracts in amounts that maintain a one-to-one relation between the futures
contracts to buy oil and the forward commitment to sell oil. Mello and Parsons
assumed that the convenience yield of oil is 0.565 percent per month and the risk-free
rate is 0.5656 percent per month. Based on the analysis above, the obligation to sell
1.25 million barrels of oil at month t could be perfectly hedged by purchasing
89
one-month futures contracts that are rolled over. If the convenience yield is constant,
the number of futures contracts should be
1.25 million
1.00565
1.25 million
(1.005656 t 1 )(1.00565)
For the obligation at each of the 120 months, the annuity formula gives a futures
position (in barrels of oil) of
108.7 million =
1.25 million 1.25 million

1.25 million 1.25 million
+
+ ... +
+
1.00565
1.005652
1.00565t
1.00565120
Hence, a rolling stack of 150 million barrels in futures positions over hedges the risky
obligation of Metallgesellschaft by a considerable degree.
Intuition for Hedging with a Maturity Mismatch in the Presence of a
Constant Convenience Yield
Thus in a nut shell we can say that long-dated obligations hedged with short-term
forward agreements need to be tailed if the underlying commitment has a convenience
yield. The degree of the tail depends on the convenience yield earned between the
maturity date of the forward instrument used to hedge and the date of the long-term
obligation. When hedging with futures, a greater degree of tailing is needed.
The above result derives from the fact that a convenience yield makes the receipt of a
commodity at a future date less risky than receiving the same commodity now. Just as
50 percent of an investors risk disappears when he sells 50 percent of his shares of
stock in a company or if the stock has a dividend equal to 50 percent of its value, so
does a 50 percent convenience yield reduce the risk of a commodity received in the
future by 50 percent. Because y percent of risk disappears with a y percent convenience
yield, eliminating the risk of a forward commitment by taking on a position in a (more
risky) underlying (spot) commodity requires less than a one-to-one hedge ratio when the
commodity has a convenience yield.
Perfect hedging of long-dated obligations with short-term forwards (or futures) has a
less than one-to-one hedge ratio because perfect hedging is a matter of matching up
risks. The short-dated forward (or futures) contract is more like the underlying
commodity, which has more risk than the long-term obligation. The closer the maturity
date of the forward, the closer the hedge ratio (in a perfect hedge) is to the less-thanone ratio for hedging the obligation by holding the underlying commodity. The longer
the maturity of the forward contract, the more the forward contract looks like the
forward commitment and the closer the hedge ratio is to one.
Convenience Yield Risk Generated by Correlation between Spot Prices
and Convenience Yields
The analysis up to this point has assumed that the convenience yield is constant.
Generally, however, the convenience yield is uncertain and correlated with the price of
the commodity. This subsection examines the effect of the correlation on the hedge
90
ratios. It is not difficult to see that convenience yields are generally positively related to
the price of the underlying commodity. In the late spring of 2000, for example, gasoline
prices in the United States rose over a matter of weeks by close to 50 percent. Industry
forecasters suggested that this was caused by a temporary shortage of gasoline and
higher than expected demand, but that gasoline prices would be coming down by the
end of the summer.
Earlier, it was argued that petrol consumers fill up their tanks for the convenience of not
having to stop again. However, when petrol prices rose in the summer of 2000, some
motorists did not fill up their tanks when they were empty. Instead, they put in because
petrol prices were expected to depreciate, the cost of convenience went up. After all,
storing an inventory is not very profitable when the inventory value is declining. Note,
however, that the convenience yield of gasoline also went up at this time because the
convenience benefit of that last gallon in a 5-gallon fill up is a little higher than the
convenience of the last gallon in a 15-gallon fill up.
Generally, the size of a commoditys convenience yield fluctuates inversely with the
aggregate inventory of a commodity, which, in turn, is driven by supply and demand
shocks. A necessary ingredient for a convenience yield, that is, for there to be a benefit
from holding inventory, is that there must be some transaction cost, above and beyond
the ordinary cost of the commodity, to acquire the commodity at certain times.
A gasoline station may pay the ordinary price for gasoline when the suppliers tanker
truck shows up on its weekly route. However, if between its regular deliveries the
gasoline situation requires a special delivery of gasoline because demand is
exceptionally high, the supplier may impose a surcharge. This surcharge reflects the
tanker truck drivers inability to deliver gasoline using the most efficient route possible.
At times of low aggregate inventory nationwide, for example, the summer driving
season, the benefit of a large inventory of gasoline gasolines convenience yield is high.
Hedge ratios are further reduced by convenience yields that tend to increase whenever
the price of the commodity increases. The intuition for this insight, is based on a
comparison of the risk of the commoditys present value at different dates. In particular,
the following result suggests that a convenience yield that increases a lot as spot prices
increase tend to dampen the change in the longterm forward prices more than when the
convenience yield exhibits only a mild increase in response to a spot price increase.
Thus one can say that the greater the sensitivity of the convenience yield to the
commoditys pot price, the less risky is the long-dated obligation is to buy or sell a
commodity.
The positive correlation between the convenience yield and the commoditys spot price
means that the convenience yield is high when the commodity price is high and vice
versa. Usually, the convenience yield is high when the commodity price high and vice
versa. Thus, a more realistic picture of the convenience yield suggests that in hedging
long-dated commitments with short-term forwards or futures, the hedge ratio should be
smaller than the ratio computed for a convenience yield that is assumed to be certain.
91
The exact computation of the hedge ratio cases where the convenience yields changes
depends on the process that generates the underlying commoditys spot price, which is
tied to the fluctuating convenience yield.
Thus it can now be safely said that the greater the sensitivity of the convenience yield to
the price of the underlying commodity, the lower is the hedge ratio when hedging longdated obligations with short-term forward agreements.
In simple models, sensitivity as used in results 22.3 and 22.4 can be thought of as the
covariance between changes in the convenience yield and changes in the commoditys
price. Alternatively, one can view sensitivity as the slope coefficient from regressing
changes in the convenience yield on changes in the commoditys price.
BASIS RISK
When hedging an obligation with a rollover position, there is an additional

consideration known as basis risk. The basis at date t of a futures contract, B, is the
difference between the futures (or forward) price and the spot price.
Bt = Ft St
Basis risk is the degree to which fluctuations in the basis are unpredictable given perfect
foresight about the path the price takes in the future. Since the basis is simply the
difference between the futures 9 or forward price and the spot price, basis risk is also
the degree to which the futures 9 or forward price is unpredictable, given perfect
foresight about the path the spot price will take.
SOURCES OF BASIS RISK
Basis risk may arise because investors are irrational or face market frictions that prevent
them from arbitraging a mispriced futures or forward contract. We are somewhat
skeptical about this as a cause of basis risk, especially as it applies to financial markets
from about the late 1980s on. Basis risk may also arise because changes in interest rates
are unpredictable. While this eliminates the ability to arbitrage any deviation from the
futures-spot pricing relation, the effect on the pricing arbitrage any deviation from the
futures-spot pricing relation, the effect on the pricing relation and on hedge ratios has to
be negligible. [Reference Grinblatt and Jegadeesh (1996), for example.] Finally, basis
risk may arise because of variability in convenience yields that is not determined by
changes in the spot price of the commodity. Convenience yield risk of this type is
unhedgeable and eliminates not only the ability to perfectly hedge long-term obligations
with short-term forwards, but also the ability to arbitrage deviations from the forward
spot pricing relation. It is largely this unhedgeable convenience yield risk that the
analyst needs to be concerned about when estimating hedge ratios.
a.
Explain the use of Regression model to Estimate the Risk Exposure.
b.
What is the effect of Convenience yields on hedging ratio?
92
How Unhedgeable Convenience Yield Risk Affects Hedge Ratios
Thinking about convenience yields in the same way one thinks about dividend yields
aids in understanding the effect of unhedgeable convenience yield risk on the variance
minimizing hedge ratio. The stock price is the present value of future dividends. Hence,
the stock price 10 years in the future is the present value (PV) of the dividends from
year 10 onward, while the stock price 1 year in the future is the PV of the dividends
from year 1 onward. The difference is the PV of the dividends paid from years 1
through 10. Now, consider the hedge of a forward obligation to pay the year 10 stock
price offset with a 1 year forward contract on the stock and examine how variable the
PVs of the two hedge components are over time. The variability of the PV of the 1-year
forward contract, which is entirely due to changes in PV of the stock price 1 year in the
future, exceeds the variability in the PV of the 10-year forward obligation, which stems
entirely from the PV of the year 10 stock price. The difference in variability is the
variability in the PV of the dividends paid from years 1 through 10. There is a portion of
this that cannot be hedged because it is unrelated to the stock price. So it can be said
that the greater the unhedgeable convenience yield risk, the lower is the hedge ratio for
hedging a long-term obligation with a short-term forward or futures contract. When
hedging with a rollover strategy, the largest risk arises at the rollover dates of the shortterm contracts. At these dates, the benefit of convenience embedded in the value of the
hedging instrument drops abruptly as a result of the change in the forward maturity date.
By contrast, the risk from changes in the convenience yield over small intervals of time
between rollover dates is orders of magnitude smaller.
Situation Where Basis Risk Does Not Affect Hedge Ratios
Basis risk does not affect the size of the minimum variance hedge ratio when hedging a
long-dated commitment with a comparably long-dated forward contract on the same
underlying commodity or asset. In this case, the forward contract and the forward
obligation are essentially the same investment, implying a hedge ratio of one. As long
as there is no arbitrage at the maturity date, FT = ST, hence, any basis risk before the
maturity date is irrelevant.
20.7 SUMMARY
The managerial focus must be more on risk management than on risk elimination which
comes at a very high cost.
Future hedges must be linked to the interest earned on due amount of cash that is
exchanged because of mark to market feature.
The long dated obligations which are hedged with short-term forwards needs to be
linked if the underlying commodity has a convenience yield. The degree of link depends
upon the convenience yield earned between the maturity date of the forward instrument
used to hedge and the date of the long-term obligation.
The greater is the sensitivity of convenience yield to the commodity spot price, the less
risky is the long dated obligation to buy/sell a commodity.
93
The greater is the sensitivity of the convenience yield to the price of the underlying
commodity, the lower is the hedge ratio when a long dated obligation is hedged with a
short-term forward agreement.
For hedging a long-term obligation with a short-term forward or futures contract, the
greater the unhedgeable convenience yield risk, due lower is the hedge ratio.
If a companys exposure to a risk factor is eliminated by acquiring f forward contract
then the firm can eliminate that risk exposure by acquiring f/ options, where is the
forward delta of the option.
The factor risk of a cash flow is eliminated by acquiring a portfolio of financial
instruments whose factor beta stands exactly opposite to the cash flow factor beta.
The regression co-efficient represent the hedge ratio that minimizes the variance given
that there are no capital constraints on the use of costless financial instruments for
hedging.
20.8 GLOSSARY
Alpha is a measure of the difference between a securitys expected return and its
expected equilibrium.
Arbitrage is the simultaneous purchase and sale of the same financial asset in an
attempt to profit by exploiting price differences on different markets or in different

forms.
Beta is a statistical measurement of risk associated with an individual stock or a
portfolio of stocks. It is the ratio of the covariance of the security return and market
return to that of the variance of the market return.

Cross Hedging strategy is taken to hedge the adverse price of a commodity with
respect to its related commodity (in terms of price movements).

In Delta Hedge, to achieve complete cover against the exposure, an options strategy is
taken in which the number of contracts is ratioed up by the reciprocal of the option
delta.
Hedge is a technique by which the adverse price risk which is inherent to any cash
market is managed by taking a risk management instrument such as forward or futures

or options contract.
Hedge Ratio is the minimum number of units of a hedging instrument needed to be
held in order to minimize the overall portfolio, which is a combination of a cash

position and a hedge position.
Hedged Portfolio is a portfolio which has been hedged by using a long stock, short call
or long stock, long put in such a way that the hedge ratio can be continuously adjusted
to achieve a risk-free portfolio.
94
Hedging is a risk management strategy that is done through the following steps:
a.
The amount of necessary exposure is to be estimated.
b.
Suitable derivative instruments need to be chosen in such a way that it will create
another type of risk which is equal but opposite to that of earlier one.
Donald De Pamphillis. Mergers, Acquisitions and other Restructuring Activities,

a.
b.
The arbitrage pricing theory is based on two ideas, they are:

i.
The returns of securities can be described by factor models.
ii.
The arbitrage opportunities do not exist.
The assumption that goes behind in framing the multi-factor model equation is
hat the securities return are generated by a relatively small number of common
factors, each of the factor being resented by the factor F, for which the
different stocks have different sensitivities, or s, along with uncorrelated firm
specific components, the s, which contributes negligible variance in a well
diversified portfolio.
a.
The regression method is one of the most popular tools for the purpose of
analizing risks and developing hedges. This actually examines the historical
performance of the unhedged cash flows in relation to the risk factor. More
specifically, it estimates the factor betas as slope co-efficients from the
regression of the historical returns or cash flows on the risk factors.
b.
Convenience yields does not have any effect on the future or the forward hedge
ratios when the maturity of the future obligations that one is trying to hedge
matches the maturity of the future or the forward contract which is used as a
hedging instrument. Whenever, the obligation is a forward contract and the risk
therefore is eliminated with an offsetting opposite forward contract, the future
contract can generate the same perfect hedge provided that it is tailed for the
interest earned on the marked to market cash. Whenever, there is the existence
of a mismatch in the maturity of the hedging instrument and the obligation to be
hedged, the Convenience yield affect the hedge ratio whether the hedge is
executed with a forward contract or future contracts.
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A. Multiple Choice
1.
2.
The presence of risk means that ________.

a.
More than one outcome is possible
b.
Investors will lose money
c.
The standard deviation of the payoff is larger than its expected value
d.
Final wealth will be greater than initial wealth
e.
Terminal wealth will be less than initial wealth.
Adding a home insurance policy to your portfolio of assets is an example of

_____.
3.
4.
5.
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a.
Speculating
b.
Asset dominance
c.
Risk neutrality
d.
Aversion to risk
e.
Hedging.
One reason swaps are desirable is that _______.

a.
They are free of credit risk
b.
They have no transactions costs
c.
They offer participants easy ways to restructure their balance sheets
d.
They increase interest rate risk
e.
They increase interest rate volatility.
The open interest on silver futures at a particular time is the ________.

a.
Number of all silver futures outstanding contracts
b.
Number of all silver futures outstanding contracts
c.
Number of silver futures contracts traded the previous day
d.
Number of silver futures contracts traded during the day
e.
Both (b) and (c) of the above.
Financial futures contracts are actively traded on the following indices except
________.
a.
The Dow Jones Industrial Index
b.
The New York Stock Exchange Index
c.
The Nikkei Index
d.
The S&P 500 Index
e.
All of the above indices have actively traded futures contracts.
B. Descriptive
1.
What is meant by Basis risk? Explain basis risk.
2.
Explain Factor Models for Portfolios
3.
What are the Determinant of Convenience Yield?
practice only.
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UNIT 21 ENTERPRISE RISK

MANAGEMENT
Structure
21.1
Introduction
21.2
Objectives
21.3
Risk Management
21.4
Various Types of Risks
21.5
Technological Risks
21.6
Anti-Trust Risks
21.7
Environmental Risks
21.8
Legal and Ethical Risks
21.9
Financial Risks
21.10 Human Resources Risk

21.11 Marketing Risks
21.12 Political Risks
21.13 Enterprise Risk Management Framework
21.14 Summary
21.15 Glossary
21.16 Suggested Readings/Reference Material
21.1 INTRODUCTION
The importance of risk management is being increasingly felt in the financial world
today. Though the most firms are awared the need for risk management, they are unable
to implement the techniques of risk management properly. [v1]For all the sophistication
in the burgeoning techniques of risk management, recent events suggest that there are
plenty of other risks that need to be monitored and managed. In this unit, meaning of
enterprise risk, its management and various types of risks are discussed.
21.2 OBJECTIVES
Understand meaning of risk Management;
Know the types of risks;
Identify the ways to minimize risks; and
Understand the risk management framework.
21.3 RISK MANAGEMENT

Now a days Financial Institutions have started to embed risk management
throughout the organization, taking risk appreciation beyond immediate and
quantifiable concerns. For example, J P Morgan Chase is one of a number of banks
to have combined the role of chief risk officer and chief financial officer, thereby
ensuring that risk management is both taken into account at a strategic level and
also factored into financial decision-making. When all probable and plausible
developments are factored into decision-making, it implies that a firm knows how
to react to evolving situations and also when to accept and when to reject
opportunities.
Financial or otherwise, institutions do not always look beyond immediate concerns. As
expected, they are weak at taking into account high impact but low probability events
such as the World Trade Center crash. Identifying and understanding individual risks is
not enough. The WTC terrorist outrage made the insurers realize that they had lost sight
of interlinked risks that could result in long-term, as in this case, business disruption. An
important point is not merely to take a step back from the immediate risks, but to review
that interlinked, and worst-case, scenarios. The banking industry also has been criticized
for its inability to take into account high-impact but low-probability events. Though
aware of immediate risks involving credit quality and market volatility, other equally
important risks tend to get overlooked. In an environment where risks permeate every
aspect of the enterprise and where low probability, high impact events are not of
infrequent occurrence, failing to take a holistic view of risk management can have
extremely serious consequences. Bankers do not disagree on the fact that risks
encountered are not merely relating to credit quality and market volatility, but that
capital ought to be set aside to cover operational risks. Basel II defines operational risk
as the risk of loss resulting from inadequate or failed internal processes, people and
systems or from external events. Of course, this definition is not exhaustive enough to
include all the potentially big risks. Reputation risk is a case in point. While it can be
argued that reputation risk is not a separate category of risk but rather the outcome of
other risks arising due to frauds or incompetence. Reputation risk stems from a decision
that makes economic sense in the short-term, but may damage the long-term prospects
of the enterprise. Legal reputation risk is the risk that the media or others might as part
of an investigation evaluate any observed aggression in corporate attitude, though
within the legal boundaries in the country of domicile. Whether an adverse judgment is
later handed down or not, the initial publicity causes grave damage in itself. A keen
awareness of this type of risk implies real benefits in an environment where corporate
reporting is viewed as circumspect. Needless to say, a purer reputation for going beyond
regulatory requirements in terms of corporate governance shall have a favorable effect
in the capital markets. Business strategic risk is another type of risk, which is faced by
organizations operating in a complex economic environment an outcome of their
structure, product range, pricing approach and customer selection/preference.
The unforeseen concentrations of risks are further heightened by the disparity of the
organizational and geographical spread of modern economic entities. Value creation to
stakeholders of the firm is not merely the outcome of growth in revenues but more from
the trade-offs between the required rates of growth and the prospective effects of the
concomitant associated risks undertaken with it. It has become more important for
managers to understand these trade-offs instead of targeting only at revenue
enhancements. Such trade-offs between returns and risks spread across the businesses
can be clearly and completely evaluated by the managers only when the corporate
culture incorporates the right framework of risk management and imbibes the right risk
awareness. This scientific understanding and logical evaluation stems from the art and
science of risk management. An enterprise-wide risk management culture encompasses
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several features, some of the principal attributes of which, as discerned in practice, are
indicated here:
100
An awareness of risk pervades the enterprise. Performance measurement and

pricing are risk-adjusted. The priorities of risk management are reflected in the
compensation schemes thereby encouraging risk-taking behavior that is aligned
with the capacity to bear risk. The analysts and the stakeholders obtain a more
complete understanding of the risks undertaken with the help of risk-adjusted
forecasts and returns.
Risks are identified, reported and quantified to the greatest possible extent. This
means setting up extensive historical risk and loss databases, and identifying
risks precisely. Some risks can be quantified while some risks elude
quantification. Nevertheless, both quantifiable and unquantifiable risks are
bestowed equal attention. The temptation to ignore risks that cannot be
quantified is avoided. The risk charter of the United Bank of Switzerland
typically lists reputation protection or reputation risk, generally avoided in
reporting, as one of its five risk factors.
The risk culture is defined and enshrined within the organization. The risk
appetite of the enterprise is clearly understood in all its spheres. Risk
management is aligned with that culture to give managers and employees the
desired freedom for taking the right course of action irrespective of the
entrepreneurial or conservative culture of the firm.
The firm does not venture into those products and/or businesses that are not
comprehended by the enterprise with regard to commercial feasibility. To know
enough so as to understand the adversities involved with reasonable levels of
estimation is proper risk management. A product/business that delivers excellent
profits, is nevertheless found by the management to have inherent risks beyond
the accepted level of complexity and is kept aside. Not to do what is not
understood is the general prescription.
Uncertainty is neither shirked nor avoided but is considered and accepted. As

assumptions no longer remain fixed, all possible developments are attempted to
be factored into decision-making by leading risk managers. Some, for instance,
employ scenario planning so that the firms strategy embraces uncertainty
without concealment or elimination, and which makes it possible to consider
future developments, examining options and knowledge sharing.
The managers who are entrusted with the responsibility of effectively managing
risks of the organization have to regularly monitor. Risk management has gained
enough paramount importance not to be left to risk managers alone. The ubiquity
of risk management necessitates other features such as internal audit procedures
and management control systems to ensure the proper running of systems and the
consequent achievement of the right results.
Risk management delivers value. It is not designed to stop people from taking
risks but rather to create value, by enhancing the chances of a project or product
succeeding and by enabling managers and shareholders to understand the level of
risk they run and to manage accordingly.
Risk management is everyones responsibility. Risk is not fragmented into

compartments and silos risk management shouldnt be either. People from IT,
legal, compliance and even communications departments are involved in
decision-making to inform senior managers of non-financial risks associated
with the launch of new businesses and products.
UNDERSTANDING RISK MANAGEMENT

Risk is all about vulnerability and taking steps to reduce it. Several factors contribute to
this vulnerability. Fluctuations in financial parameters such as interest rates, exchange
rates or stock indices are only one part of the story. Unfortunately, most organizations
are obsessed with financial risks. Just as IT companies have dominated the field of
knowledge management, risk management has been strongly associated with the finance
function. Investment bankers, corporate treasurers and insurance companies, have
hijacked the risk management agenda. It is simplistic to focus only on those risks for
which insurance cover or derivatives are available. Managers and boards too often
regard risk management as a matter for financial experts in the corporate treasury
department rather than as an integral part of corporate strategy. Quite clearly, risk
management is much wider in scope. Failure to appreciate this simple fact can land
companies in trouble by missing the woods for the trees.
Many organizations also make the mistake of dealing with risk in piecemeal fashion.
Within the same company, the finance, treasury, human resources and legal departments
could be covering risks independently. An organization-wide view of risk management
can greatly improve efficiencies and generate synergies. That is why many companies
are taking a serious look at Enterprise Risk Management (ERM), which addresses some
fundamental questions:
What are the various risks faced by the company?
What is the magnitude of each of these risks?
What is the frequency of each of these risks?
What is the relationship between the different risks?
How can the risks be managed to maximize shareholders wealth?
21.4 VARIOUS TYPES OF RISKS

There are many important risks faced by companies. Some of them are ongoing or
recurring while others are more sporadic. Some make a tremendous impact while others
have a low impact. Strategic risks arise from the companys core strategies like capacity
expansion, vertical integration and diversification. Capacity expansion has associated
risks. After adding capacity, if the demand does not arise, the company may find itself
burdened with overheads. At the same time, if capacity is not built in time, competitors
may move ahead and grab market share. Arvind Mills that built up huge capacity for
Denim production ran into serious problems when demand tapered-off. Vertical
integration gives a company control over additional stages of the value chain. Yet, there
are risks involved as the competencies required to compete across different segments of
the value chain are different. In the computer industry, for example, focused players like
Microsoft and Intel have done much better than vertically integrated companies like
Apple. Excessive dependence on a single or few products, or a single or few regions for
generating revenues results in risk. Many companies look at a diversified product
portfolio or geographical base as a means to stabilize revenues and profits. At the same
time, diversification also makes management tasks more complex. In India, the
packaging company, Metal Box went bankrupt when it diversified into bearings. On the
other hand, GE has successfully built up a portfolio of businesses ranging from financial
services to aircraft engines.
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Technology risk has become a major factor these days. Innovation cycles have become
shorter. Consequently, companies that do not have a strategy to cope with changing
technology may find themselves at a disadvantage. The key decision involved is
whether to move early or adopt a wait-and-watch policy, when a new technology is
emerging. In the disk drive industry, many of the established players were completely
taken by surprise when smaller disk drives emerged. In the earthmoving industries,
hydraulics technology unseated many of the industry leaders.
Mergers and acquisitions, generally considered a strategy to generate fast growth and
quick access to the marketplace are also fraught with major risks. Many companies have
paid unrealistic prices for their acquisitions and the projected synergies have later failed
to materialize. Moreover, integration of the pre-merger entities can run into big
problems because of cultural differences. Some of the deals which have run into
problems include AT&Ts acquisition of NCR, Kimberly Clarks purchase of Scott
Paper and the acquisition of Republic Airlines by Northwest Airlines.
The most commonly discussed form of risk is financial risk. When interest or foreign
exchange rates fluctuate, there is an impact on cash flows and profits. Risk also
increases as the debt component in the capital structure increases. This is because debt
involves mandatory cash outflows while dividends can be paid at the discretion of the
company depending on the profits generated. Today, sophisticated hedging tools like
derivatives are available to manage financial risk. Among the companies that have
failed to manage financial risk well in recent times are Barings, Procter & Gamble and
Sumitomo.
Another type of risk is environment risk. If companies do not take steps to protect the
environment in which they operate, they face the risk of resistance and hostility from
society and the local government. In some cases, this could even threaten the very
existence of the company, as is well illustrated by the example of Union Carbide in
Bhopal. Similarly, oil companies like Exxon have faced major crises due to oil spills
from their tankers.
Political risk arises from the possibility that political decisions or events may adversely
affect a companys profitability. It covers actions of governments that interfere with
business transactions resulting in loss of profit potential. In extreme cases, political risk
results in confiscation of property. The more common scenario is one in which
government imposes constraints on the conduct of business. Enron has encountered
various problems since its entry into India.
More and more importance is also being paid to high standards of legal compliance,
ethics and corporate governance. Illegal and unethical practices and low standards of
corporate governance can bring down the reputation of a company in the eyes of its
shareholders, and severely erode market capitalization. A good example of a company,
which has seen a severe decline in its business owing to unethical and illegal disclosure
practices is the famous insurance company, Lloyds of London. Class action suits by
employees or shareholders can pose grave concerns. Similarly, anti-trust proceedings by
the government can distract a company so much that it may not have enough time for its
core business. Microsoft has been heavily burdened in this respect. On the other hand,
Intel is generally credited with having dealt with anti-trust issues much more
professionally.
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21.5 TECHNOLOGICAL RISKS

Technological changes are responsible for both the creation and destruction of
industries. In the face of sweeping changes in technology, some industries die while
others are born. Quite clearly, a firms competitiveness is significantly influenced by its
ability to understand and embrace new product or process technologies. Introducing
technological change is risky because it brings with it a high degree of uncertainty.
Understanding the nature of this uncertainty, especially the obstacles to the acceptance
of the new technology, is a tricky issue. Between technical feasibility and commercial
viability is a period of suspense. Excessive caution and haste is both undesirable in the
context of new technologies. Sometimes, companies commit themselves to a new
technology too fast and burn their fingers. In other cases, they wait and watch while
another company comes up with a new technology that puts them out of business. So,
even the most seasoned managers have problems evaluating the potential of a new
technology.
THE GROWING PACE OF INNOVATION
Innovation cycles have become shorter in the present day unlike in the past, when they
were long. Probably the most important reason is the growing importance of software
and knowledge inputs as opposed to hardware and physical capital. People with good
ideas and creative capabilities can innovate, as the need for huge amounts of physical
capital has been obviated. A related factor is the availability of venture capital. Unlike
banks, Venture Capitalists (VCs) give less importance to things like collateral and more
to the business potential. So, it has become easier for first generation entrepreneurs to
convert their ideas into up and running businesses. Another important reason for the
faster pace of innovation is the speed at which information is being disseminated, due to
information technology in general, and the Internet in particular. This enables ideas to
flow freely and encourages new entrepreneurial initiatives.
MANAGING INNOVATIONS
There are broadly two types of innovations product and process. Product innovation
refers to work done to improve the product. Some product innovations are truly radical,
such as the Sony Walkman. Others are incremental, such as adding new features to a
color television set. Process innovations aim to make the manufacturing process more
efficient through automation, simplification, better process control and lower energy
consumption. Normally, the product and the process innovations are interdependent. In
the early stages of the product life cycle, product innovations tend to be rapid. As the
rate of product innovation decreases, it is common to observe a faster rate of process
innovation. But the relative importance of product and process innovation depends on
the nature of the industry. Peter Drucker has listed seven sources of opportunity for
innovative organizations. In order of increasing difficulty and uncertainty, they are:
The unexpected success that makes a company happy, but is rarely dissected to
see why it occurred.
The incongruity between what actually happens and what was supposed to
happen.
The inadequacy in an underlying process that is taken for granted.
The changes in industry or market structure that catch everyone by surprise.

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The demographic changes caused by wars, medical improvements and even

superstition.
The changes in perception, mood and fashion due to the ups and downs of the
economy.
The changes in awareness caused by new knowledge.
Successful technology management is all about bringing a new concept to the market in
the most efficient way. To commercialize an idea successfully, a number of different
stages must be completed, each more difficult than its predecessor. Not only must each of
these stages be completed successfully, but also adequate resources be mobilized to
facilitate transition from one stage to the next.
Imagining: Developing the initial insight about the market opportunity for a
particular technical development.
Incubating: Nurturing the technology sufficiently to gauge whether it can be

commercialized.
Demonstrating: Building prototypes and getting feedback from potential

investors and customers.
Promoting: Persuading the market to adopt the innovation.
Sustaining: Ensuring that the product or process has a long life in the market.
The first three stages obviously cannot be managed like an ordinary business with tight
controls. So they have to be fostered and nurtured in an environment that is culturally
quite different from normal corporate settings.
In order to develop a useful framework for commercializing technological innovations,
organizations must address three important issues.
What is the likelihood that customers will be attracted to the new technology?
What is the price that will attract the largest number of customers?
Will the new technology evolve into or help in building a profitable business?
Successful innovators focus on how the new product or service will affect customers.
They look at the various stages of customer experience like purchase, delivery, use,
maintenance and disposal. They also consider the utility of the product in terms of
environmental friendliness, convenience, simplicity and customer productivity. In other
words, they orient product development activities towards the customer rather than the
technology. The price chosen by the innovator has to attract and retain a sufficiently
large number of customers. Innovations very often compete with other products that
may look quite dissimilar but perform the same function. What is important here is how
people will compare the new product with other very different-looking products and
services. The price level will also depend on the ease of imitation. If the product is
difficult to imitate or well protected by patents, a high price is possible. On the other
hand, if imitation is easy, a low price becomes essential. Successful innovators
understand the importance of generating positive cash flows as quickly as possible.
They generate profits not by raising price but by keeping costs tightly under control,
consistent with the chosen price level. They improve materials selection, simplify
design processes and improve manufacturing efficiencies to cut costs. They may also
consider strategic outsourcing of non-core activities. Moreover, innovators compensate
for their lack of technological capabilities in some areas by partnering and forming
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alliances. In spite of all these moves, if the price is still high and beyond the reach of
target customers, they look at options such as leasing or renting the product on a timeshare basis, which are more appealing to customers.
21.6 ANTI-TRUST RISKS

Anti-trust laws aim to protect economic freedom and opportunity and provide a better
deal to the customers by promoting competition in the market place. The basic premise
of anti-trust laws is that increased competition leads to lower prices, better quality and
more choice for customers. Anti-trust laws also aim at creating a level playing field and
encouraging new entrants into the industry. Most countries have laws that prohibit
restrictions on entry into specific industries or markets; price-fixing agreements;
concerted practices (whereby firms rig markets through their behaviour but without
entering into explicit agreements); exclusive distribution arrangements; and mergers and
acquisitions that result in excessive market power. Different countries have put in place
various measures to restrict anti competitive practices:
Many countries are giving their anti-trust authorities the power to dismember
quasi-monopoly groupings with retrospective effect.
Some countries have imposed specific quantified limits on business activity.

French law, for example, prohibits any concentration of businesses that
controls more than 25 percent of the sales, purchases or other transactions in a
given market. A concentration is defined as any situation in which a company or
group can directly or indirectly exercise a decisive influence on another
company.
In some countries, there is an automatic investigation of any company or group

with a market share exceeding what is considered reasonable.
In many developed countries, the anti-trust authorities must approve all

large-scale distribution agreements.
BASIC CONCEPTS OF FAIR COMPETITION

Competition laws define market power, market dominance, and abuse of a dominant
market position. Market power means the ability of businesses to increase
significantly the prices of their output without a decline in sales. Abuse of a dominant
position occurs when a firm actually raises its prices to unjustifiably high levels. Market
power may not necessarily damage economic welfare, especially if it offsets other
distortions in the economic structure of a country, for example a monopoly investing its
excessive profits in a nation where the capital markets cannot provide the funds
necessary for major new ventures. Assessment of market power also requires the
definition of a relevant market, since a given level of sales will represent a larger
proportion of a narrowly demarcated market than of one that is liberally defined. This
has been an important issue in the Microsoft anti-trust case. Practical problems with the
actual measurement of a relevant market include:
a.
defining substitutable products.
b.
separating price movements attributable to market power from those attributable

to inflation.
c.
uncertainty about the entry of new firms into the market.
Different countries deal with the issue of relevant market differently. The US, for
example, describes a relevant market as the narrowest combination of a set of products
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and a geographic area such that if all the production capacity in that product set were
owned by a single firm, that could profitably raise price by (usually) at least five percent
above a benchmark price for a significant non-transitory period. In contrast, the
European Commission defines the relevant market very broadly, as the market for
those products which are regarded as interchangeable or substitutable by the consumer,
by reason of the products characteristics and their intended use. This allows the
Commission to be as flexible as possible in its interpretation. Intuitively, the number of
firms within a specific industry sector and the market shares of each of these companies
should indicate whether it is a case of market dominance. While the existence of a large
number of competing firms with an even distribution of market shares gives prima facie
evidence of the absence of a dominant position, a small number of competing firms with
a few having large market shares does not necessarily imply dominance. Firms may
have captured a large market share unintentionally, with competitors having the
potential to increase their (initially low) market shares with a little more investment and
effort.
21.7 ENVIRONMENTAL RISK

Environmental risk is the possibility of harm to people and the environment owing to
human activities. A good example is the Bhopal gas tragedy of 1984, which exposed the
tremendous risks associated with poor safety and environmental management practices.
Thousands of people lost their lives after Methyl isocyanide gas leaked from the plant
and several thousands more were injured and left homeless. Memories of Bhopal Gas
Tragedy are still alive in the minds of most Indians. This incident served as a warning to
corporations that they need to take their environmental responsibilities far more
seriously than they had been doing till then. Environmental disasters have however,
continued to occur subsequently at regular intervals like the Chernobyl Nuclear disaster
of 1986, the Valdez oil spill of 1989 and the Tokaimura (Japan) nuclear accident of
1999. And in developing countries like India, environmental issues often take back seat
and accidents are quite common.
Many companies equate environmental risk management with regulatory compliance.
In actual practice, there is much more control and discretion when it comes to
environment related expenditures, than commonly assumed. Not only is regulation
subject to numerous interpretations but also what constitutes compliance is often not
very precise. Over designing products and processes to eliminate risk may often not be
the optimum solution. At the same time, a carefree non-caring attitude is dangerous, as
events like Bhopal Gas Tragedy have highlighted. In short, time has come to integrate
environmental performance into business strategy.
THE NEED FOR A NEW APPROACH
Many companies have realized the need for a proactive approach towards
environmental issues instead of passive regulatory compliance. Take the case of
Canadian paper company Alberta Pacific Forest Industries (AP). When AP faced
opposition from farmers, aboriginal residents and other activists, following concerns
about the environmental impact of a proposed pulp mill, it decided to take specific
measures to mitigate the impact. The company designed its plant to keep pollution
levels well below what the government specified. It also announced plans for
afforestation. AP also communicated clearly from time to time about the environmental
impact of its operations. As a result of all these measures, the company successfully
improved its relationship with the local community and eliminated costs that could have
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resulted from potential business disruption. AP is however more an exception than the
rule. Most companies show a high degree of adhocism and reactiveness to
environmental issues. Many companies also believe that command and control
mechanisms, and formal procedures and rules will automatically take care of
environmental risk. The right way to manage environmental risk is to integrate it within
the companys overall risk management strategy. So companies must collect and store
information about environmental issues systematically, and deal with environmental
risks just like other business risks. Those responsible for managing environmental risk
must be clear about the potential benefits of their investments and should be able to
justify the level and type of investment they have chosen.
Many companies fail to appreciate how investments in improving environmental
performance will affect their competitive position. Environmental costs normally do not
affect all competitors equally and tend to vary with location, size of the facility,
technology used and age of the plant. Unfortunately, many companies do not appreciate
these differences and in the process forgo opportunities to put competitors at a
disadvantage. To take an example, vertically integrated and non-vertically integrated
players in the same industry may be affected in quite different ways by a new
environmental regulation. Through suitable sourcing strategies or location decisions, a
firm can put competitors to a severe disadvantage and even prompt them to quit the
market. Due to poor cost benefit analysis, most companies fail to get the best returns
from their environmental investments. They undertake grandiose projects that do not
yield commensurate benefits. Instead, they would do well to concentrate on liabilities
which are small today but may escalate in future and where efficient solutions to the
problem are available. Sometimes, companies close plants in a hurry without
considering the implications. Regulators may intervene and demand expensive clean up
operations, because there is no concern about further job losses. Very often, managers
spend a lot of money on environmental improvement but, do not involve nearby
stakeholders before taking major decisions. Due to poor communication and a failure to
take the local community along, they run into problems.
a.
When will Political risk arise?
b.
What are the stages of Innovations?
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MANAGING ENVIRONMENTAL ISSUES

In general, corporate environmental policies may serve one or more of the following
objectives:
Reduction of costs through measures such as recycling or energy conservation.
Improvement of the companys reputation.
Motivation of employees by providing a better environment.
Improvement of relationships with regulatory authorities in general and the

government in particular.
Minimizing the possibility of accidents.
Conforming to a code of ethics.
The following are the different approaches to managing environmental issues:
The first involves a strong commitment to environment friendly processes or

products through heavy investments. The additional costs are recovered from
customers through a clear differentiation and product positioning that allows the
firm to charge a premium.
In a slightly modified form of the first approach, the firm can influence
environmental regulations, invest in environment protection and force other
firms to make similar investments and still stay ahead of them in terms of costs
incurred.
In the third approach, the firm may be able to invest in environmental

performance improvement, without any reduction in profits. This may happen
for example, if input consumption comes down because of effective recycling.
Then, there is no need to impose higher prices on customers to recover the
investments made.
A fourth approach, which is much more sophisticated involves combining

product differentiation, competition management and cost savings to change the
basis for competition and redefine the market so that both the firm and the
environment can benefit.
The fifth approach looks at environmental issues from a risk management

perspective, calling for a systematic method to deal with risks such as accidents
and activist attacks.
The approach to dealing with environmental issues would vary from firm to firm. It
would depend on the industry structure, the firms competitive positioning, its organizational
capabilities and its perceptions about how regulatory and activist forces in the environment
are evolving. We now examine the approaches in greater detail.
ENVIRONMENTAL PRODUCT DIFFERENTIATION
Industrial customers are often prepared to pay a premium for products with improved
environmental performance if their own costs can be reduced. Such customers may also
be prepared to foot the premium if they perceive that the superior product through better
environmental performance can be a hedge against stringent regulations in the future.
Ciba Specialty Chemicals special dyes have helped consumers to cut expenditure on
salt and water treatment and improve quality. This has enabled Ciba to charge more for
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its environment friendly dyes. In the case of consumer goods, retail customers may be
prepared to pay more if the environmental benefits can be bundled suitably. More
generally, for such products to command a higher price in the market, the companys
concern about the environment must be consistent with the other signals it is sending to
customers. If the improved environmental performance is not well integrated with the
overall product positioning or corporate strategy, it may fail to capture the value
created.
ENVIRONMENTAL RISK MANAGEMENT
Risk managers have identified four different elements of environment risk.
Probability of occurrence of an adverse event such as an accident.
Probability distribution of the total costs if the event occurs.
Allocation of the responsibility if an accident occurs.
Certainty of the assessment.
In other words, four different tasks have to be performed by management while

managing environmental risks. They must minimize the probability of occurrence of the
adverse event. They must cut losses when an accident occurs. They should be able to
shift responsibility to other parties to the extent possible, when the event occurs. They
must obtain more information to make the risk assessment methodology as robust as
possible. Managers have to use the right mix of risk reduction, risk shifting and
information acquisition to put in place an appropriate environmental strategy.
For many organizations, managing environmental issues means avoiding the costs
associated with accidents, catastrophes and other environmental mishaps. The simplest
way of managing environmental risk is to buy an insurance policy. This measure shifts
risk to the insurance company. The approach makes sense if the company is confident
that the premium being paid is small compared to the huge risks involved. A second
approach relies on maintenance of disaster management cells that can respond quickly
when an accident occurs. A third approach involves clear guidelines, including dos and
donts for the operating units in the form of various documents and manuals. A fourth
mechanism is to link promotions of managers with their contribution to risk
management. Behavioral issues need to be carefully examined so that environmental
risk is managed systematically. For example, reward systems normally favor mangers
who reduce costs or increase profits. Consequently, there may be a tendency to under
invest in environmental performance improvement measures. Inbuilt mechanisms are
necessary to check such undesirable tendencies. Environmental problems should be
analyzed as business problems. A rigorous analysis is necessary to understand which
investments generate value for shareholders. It is not desirable to do just the bare
minimum to stay on the right side of the law nor is it correct to pour huge amounts of
money into environmental projects, in the name of discharging social responsibility.
Managers should also look at better environmental performance as an opportunity rather
than as a threat. Many companies allow environmental issues to be handled by lawyers
and consultants who tend to focus on compliance rather than innovation. To correct this
situation, environmental strategies must become the direct concern of general
management and environmental impact should be incorporated in the overall process of
improving productivity and competitiveness. Managers should go beyond currently
regulated areas and also understand the opportunity cost of underutilized resources.
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21.8 LEGAL AND ETHICAL RISKS

Organizations have to develop a good understanding of the legal and ethical
environment in which they operate. Violation of laws may result not only in penalties
and other forms of government intervention but also damage the reputation of the
company. The dividing line between illegal and ethical activities is very thin. So, it
makes sense to cover them together. And whatever be the differences between them,
both can cause severe damage to a companys reputation. Protecting the companys
image is the task all CEOs have to take seriously. In todays competitive environment,
any adverse impact on the companys image can lead to a sharp decline in its
competitive position. Hence, antitrust issues, public litigation/class action suits, product
recalls, to name a few which have the potential to damage the companys reputation
must be handled carefully. This calls for a systematic, well-planned approach that
avoids knee jerk reactions and crisis management.
Management of ethical and legal risks is not merely about conforming to rules and
regulations. The regulation of business and risk management are closely related. Yet, it
may not always be clear what constitutes compliance. Regulatory laws often give a lot
of discretionary powers to officials who form an opinion based on the organizations
commitment to regulatory objectives, its record of compliance, the quality of
management and its capacity to comply. These are the considerations, which influence
the decision to intervene in the companys affairs. A proactive approach by companies
based on a good understanding of how government officials tend to view things is very
important in risk management. A distinction is drawn between government intervention
on the basis of statutes and laws and that based on political considerations. In this
article, only the first type of risk is covered. This article does not aim to explain various
legal provisions, nor will it cover the principles of business ethics in detail. Rather, it
aims at sensitizing the senior management to a special category of risks and to highlight
the key strategic issues involved in managing them.
THE GROWING IMPORTANCE OF ETHICS
Business Ethics is rapidly emerging as one of the most important disciplines of
management. In simple terms, it is coming to know whats right or wrong in the
workplace and doing what is right with regard to products/services, relations with
employees, relations with external stakeholders, etc. Most well managed companies
have codes of conduct to guide the decision-making processes of employees. Yet, many
ethical dilemmas have to be resolved on a case-to-case basis and no general prescription
can be offered. More and more organizations are realizing that adopting an ethical
approach has many advantages. Indeed, acting ethically may make the difference
between survival and closure of an organization.
Consider Manville, the asbestos company which filed bankruptcy in 1992. Manville had
known for years that asbestos inhalation resulted in lung diseases. But it concealed the
information from affected employees and customers. Justice finally caught up and the
company found itself facing 17,000 lawsuits. Around 80% of the companys equity was
eventually used to compensate the victims Manville had paid dearly for fooling itself
into believing that it was cheaper to kill people than admit the dangers associated with
asbestos. Contrast this with Johnson & Johnson, which faced a major ethical dilemma in
1982, when its Tylenol capsules, contaminated with cyanide led to several deaths in the
Chicago area. Although the standard procedure would have been to recall only the
contaminated lot, Vice Chairman David Collins felt the right thing to do was to recall
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the entire product line. Ultimately, the company was absolved of blame. To this day, the
Tylenol recall remains a classic case study in business ethics. Johnson & Johnson was
guided by one of its core values that was to remain responsible to the communities in
which we live and work and to the world community as well.
THE GROWING IMPORTANCE OF CORPORATE GOVERNANCE
Ethics and corporate governance are closely related. Good governance implies that a
corporation is run for the benefit of stakeholders. This requires accountability at all
levels of the organization. The CEO should not have such unbridled authority that he
can take major decisions without consulting the major shareholders. The board is the
ultimate authority for decision-making within a corporation. Unfortunately, many
boards, especially in India act like rubber stamps. They tend to endorse whatever the
CEO decides. So, the composition of the board is very important. Luminaries, who have
professional expertise in their respective fields, must be invited as external directors.
Board members, especially the non-executive directors should come well prepared and
take part actively in meetings. To attract good people, companies must compensate their
external directors well. They must also pay attention to disclosures. A strong grievance
redressal mechanism for employees and customers is necessary. When whistle blowing
takes place, companies should not react in a hostile way. They must try to understand why
whistle blowing has taken place and put in place structural remedies. The rewards for
accepting high standards of corporate governance are handsome. This is reflected in the
success of Infosys. Ultimately, good corporate governance cannot be enforced only by
systems and procedures alone. Strong core values are also necessary.
21.9 FINANCIAL RISKS

A firm is exposed to financial risk when the value of its assets, liabilities, operating
incomes and cash flows is affected by changes in financial parameters such as interest
rates, exchange rates, stock indices, etc. Financial risk management aims to reduce the
volatility of earnings and boost the confidence of investors in the company. Since the
1970s, following the deregulation of financial markets in many countries, the
importance of financial risk management has grown considerably. In its earliest form,
financial risk management concentrated on foreign exchange risk. The stability of
currencies under the Bretton Woods Exchange rate system ensured that this risk was not
serious. Following the breakdown of Bretton Woods by the mid1970s, the scenario
had changed dramatically as currency volatility increased. Also, with US interest rates
touching double digits, interest rate risk management became more relevant. Gradually,
the financial markets responded by coming up with a variety of over-the-counter as well
as exchange-traded instruments. Today, financial risk management has become quite
sophisticated. Many companies are moving away from ad hoc transaction driven
financial risk management towards business process risk management, which considers
the interconnectivity of risks and the way risks affect important business decisions and
processes. The real benefits of financial risk management must be understood in terms
of what it tries to avoid than what it tries to do. By preventing undesirable situations, it
ensures that management is not distracted from its core purpose of running its business
efficiently. Financial risk management aims to maximize shareholders wealth by
avoiding costs associated with re-negotiation of debt, restructuring of capital, litigation
expenses, loss of bargaining power vis--vis suppliers due to delayed payments, loss of
reputation in the financial markets due to failure to meet obligations.
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BROAD ISSUES IN FINANCIAL RISK MANAGEMENT
What kind of internal expertise/experience is available to monitor risk?
How frequently should positions be marked-to-market?
What are the acceptable counterparty credit limits?
What is the approach to stress testing and how frequently should stress testing be
done?
What are the variables that can result in large changes in positions, and which
need to be carefully monitored?
What are the variables which are most likely to change?
Which of the variables will move but offset each other?
TYPES OF FINANCIAL RISK

Credit Risk
In simple terms, credit risk refers to the possibility of default by the borrower. More
generally, it refers to the failure of the counterparty to honor its side of the contract.
Credit risk is, by far, the biggest risk that financial institutions take and has been the
root cause of many banking failures. A partner may not fulfil his obligations partially or
fully on the due date. In day-to-day commercial transactions, a customer may not pay
up. In derivative transactions, the counterparty may fail to honor the contract and a cost
may be incurred for replacing the existing contract with a fresh contract. Similarly,
losses may occur due to defaults in the case of letters of credit and loan guarantees.
Credit risk comes in two forms Traditional credit (loans) risk and Trading credit risk.
Traditional credit risk arises when a bank makes a loan and there is uncertainty about
the borrowers ability to repay. Credit risk from trading involves both pre-settlement
and settlement risks. Pre-settlement risk is the probability of loss due to a trading
counterparty defaulting before the settlement date. The risk is the sum of the
replacement cost of the position and the potential future exposure as a result of market
movements. Settlement risk is the risk of loss due to a party defaulting at the time of
settlement of the deal. On settlement day, the exposure is the value of cash flows to be
received on the securities.
The degree of credit risk varies depending on the stage of financial distress. For
example, even if there is no default, the price of a bond may fall if the credit rating is
downgraded. The next stage is a default by the borrower. Then, there could be
bankruptcy if the borrower declares his inability to meet his obligations. The last stage
is liquidation when receivers are called in to dispose off the asset. The traditional
approach to credit risk measurement consisted of making credit checks on the party
before the deal, setting limits on loans and passing risk to third parties through factoring
and credit insurance. Today, the approach has become more sophisticated, thanks to the
availability of credit derivatives. Banks can analyze credit exposure in terms of
concentration by sector, geographical region or a group of clients and optimize their
portfolio accordingly. Trading credit risks have to be handled differently. Corporations
are not the major players in the trading market. Most trading deals involve banks and
securities firms. These entities are unlikely to default, but when things go wrong, many
parties may default simultaneously. In the case of traditional loans, the exposure is stable.
So the focus shifts to the probability of default and recovery. In the case of credit risk for
trading, the exposure is variable. Here, ongoing measurement of the risk becomes very
important.
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Market Risk
This is the risk, which results from adverse movements in the prices of interest rate
instruments, stock indices, commodities, currencies, etc.
Interest rate risk arises when the income of a company is sensitive to interest rate
fluctuations. Consider a company that is going to need funds, after a few months. If
interest rates go up in the intervening period, the firm will be at a disadvantage.
Similarly, if the company is going to have surplus funds a couple of months from now
and interest rates fall, the firm will incur a loss.
Commodity risk is the uncertainty about the value of widely used commodities such as
gold, silver, etc.
Currency risk is the uncertainty about the value of foreign currency assets, liabilities and
operating incomes due to fluctuations in exchange rates. Consider an Indian importer
who has to make a dollar payment a few weeks from now. If the dollar appreciates
during the intervening period, the importer will incur a loss.
Equity risk is the uncertainty about the value of the ownership stakes a firm has in other
companies, real estate, etc.
Market risk is typically measured using Value at Risk (VaR) which quantifies the
potential loss/gain in a position or a portfolio that is associated with a given confidence
level for a specified time horizon. Conventional VaR models have the following
limitations:
They assume a normal distribution.
They use past data to predict future returns.
They use estimates based on end-of-day positions and do not take into account
intra-day risk.
They do not take into account risk arising due to exceptional circumstances.
Liquidity Risk
When there is a mismatch in the maturity of assets and liabilities, liquidity problems
arise. Say, the company has invested heavily in long-term assets but has several shortterm liabilities. It runs the risk of failing to meet its liabilities, even though it may be
profitable in the long run. Many small units are profitable if conventional accounting
norms are applied. But, often they have their funds blocked in receivables and are
unable to pay their suppliers. This working capital squeeze leads to their bankruptcy.
Borge argues that liquidity risk is the least understood and most dangerous financial
risk. If a trader has difficulty in finding buyers when he wants to sell or a borrower has
difficulty in finding a lender, then liquidity risk is encountered. This risk arises because
even with a large number of buyers and sellers operating, the markets are not perfect, as
is commonly assumed. While some markets are very liquid, others are not. Liquidity
risk is dangerous because it reduces the control the companies have over existing risks
and forces them to assume other risks which normally they would not like to hold.
STEPS IN FINANCIAL RISK MANAGEMENT
Four steps are involved in financial risk management:
Identification of risks.
Quantification of risks.
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Framing of policies to transform the risk into a form, with which the company is
comfortable.
Implementation and control.
Companies can deal with financial risks in various ways:

Avoidance: The firm can avoid holding financial assets or liabilities whose values are
uncertain.
Loss Control: When risks cannot be avoided, efforts can be made to limit the loss.
Diversification: Instead of concentrating assets in one place, the firm can distribute
them across several locations or markets.
Transfer: Transferring the asset/liability to another party can eliminate the risk.
Alternatively, the company can retain the asset/liability but the risk can be transferred.
Or the company may retain the risk but in the event of a loss, a third party assumes the
liability.
USING DERIVATIVES TO TRANSFER RISK
Derivatives, as the name suggests, are derived from underlying instruments. Thus an
interest rate future is derived from a bond, treasury bill, a deposit, etc. A stock index
future is derived from a stock index. Similarly, foreign currency futures are derived
from the underlying spot market for that currency. Derivatives have been around for
quite some time now. Flemish traders used forward contracts in the 12th century. Less
sophisticated versions of todays futures and options contracts were widely used in
Amsterdam in the 17th century. Commodity futures exchanges came up in Chicago and
New York in the middle of the 19th century. In fact, money whose value comes from
gold, is also a type of derivative. In recent times, the use of derivatives has increased,
following the freeing of currency and capital markets in the 1970s and the development
of the Black & Scholes option-pricing model. In 1994, the total outstanding value of
derivative contracts was about $20 billion. Derivatives have become a cheap and
efficient way of transferring risk from a party that does not want to retain it, to one that
does not mind holding it. Though derivatives may look very complicated instruments, it
is this simple risk-transfer function that they serve.
The distinguishing characteristic of derivatives is the leverage they offer. The value of a
position, which a derivative represents, is far greater than the down payment made by
the trader. This leverage makes derivatives cost effective in a positive sense and risky in
a negative sense. Controls are necessary to ensure that derivatives are not misused.
Besides, companies should understand the inherent limitations of derivatives. Many
business risks cannot be hedged by using derivatives. The value of the derivative can
change due to market influences. There can be basis risk if the derivative does not move
as much as the underlying asset. There is also counterparty risk, when the counterparty
defaults and a cost is incurred in replacing the position.
Barings, the famous investment bank collapsed after risky derivative trading due to the
lack of effective control systems. The Orange County crisis in California was the result
of poor risk measurement as well as ineffective communication of the risks involved to
the investors. Hedge funds like Long Term Capital Management (LTCM) and
corporates like Procter & Gamble have burnt their fingers as the potential for large
profits tempted their managers to take unwarranted risks in derivative trades. But it is
the stories, which do not get reported, where derivatives reduce risk that are more
typical. More often than not, derivative disasters have been the result of fraud or
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misuse. Derivatives can also create problems if they are used in a piecemeal fashion,
without an integrated perspective. Consider the German airline Lufthansa, which
signed a $3 billion contract to purchase aircraft from Boeing. To protect itself from the
appreciation of the dollar, the company booked a forward contract. Lufthansa generated
much of its revenues in dollars and consequently had a natural hedge. It ended up
making a big loss when the dollar instead of going up, moved down against the DM. In
this case, Lufthansa pursued a hedge that was unnecessary. To minimize the misuse of
derivatives, regulators in various parts of the world now insist on proper disclosure of
derivative transactions on the balance sheet, instead of treating them as off-balance
sheet transactions. But treasurers and traders have invented new ways of getting around
accounting rules. Moreover, the prices of some derivatives can change so fast that the
value indicated on the balance sheet may be completely different from the market value.
So, many regulators now insist on marking to market, i.e., showing derivatives on the
balance sheet at market value. But this method has its drawbacks. Let us say the value
of the underlying asset moves favorably and we incur a loss on the derivative used to
hedge the position. If the derivative is marked-to-market, but not the underlying hedge,
the picture would get completely distorted. This is exactly what happened in the case of
Metallgesellschaft.
Since derivatives can be dangerous weapons in the hands of inexperienced or reckless
traders, companies must establish a framework for effectively managing and controlling
derivatives trading activities. The various issues to be considered are the role of senior
management, risk measurement, operating guidelines and control systems and
accounting and disclosures. The use of derivative instruments should be guided by the
companys risk strategy and after undertaking necessary market simulation exercises
and stress tests. When using financial derivatives, organizations must be careful to use
only those instruments that they understand and which are consistent with their
corporate risk management philosophy. Exotic instruments should be avoided without
having a good appreciation of the risk return trade-offs involved. Proper safeguards
should be built into trading practices. Appropriate incentives must be provided so that
corporate traders do not take disproportionate risks.
Credit Derivatives
Developed in the early 1990s, credit derivatives are used to separate and transfer the
credit risk of underlying instruments such as loans and bonds. In spite of their best
efforts to diversify risk, banks are often heavily exposed to specific geographical
regions or industries. If a particular region or industry is going through a bad phase,
widespread defaults may occur. While the mechanics of a credit swap can be quite
complicated, the objective is fairly simple. The bank, which is trying to transfer risk,
pays a small fee to its counterparty at regular intervals. In case of a default, the
counterparty compensates the bank for its losses. Credit derivatives have created
interesting possibilities. Consider an American bank wanting to diversify its portfolio
by lending to clients in Europe. It can tie up with a French bank, which has a much
better understanding of local customers. While the French bank does the actual lending,
the American bank can be the counterparty in a credit swap. The increasing
sophistication of banks approach to credit risk management has created tremendous
potential for credit derivatives. Today, banks can quantify their exposures and use credit
derivatives to make potentially illiquid loans more liquid.
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Using Insurance to Transfer Risk

Insurance is a powerful and efficient technique for managing a wide-range of risks. In
general, a risk must meet the following requirements before it can be insured:
There must be many independent and identically distributed exposure units. The
person or entity exposed to the loss is the exposure unit.
The premium should be economically feasible, significantly less than the

expected loss for the client and must offer reasonable returns for the insurer.
Only accidental or unintentional losses must be covered. Losses that occur

overtime, like the wear and tear to an automobile are not insurable.
Losses should be easily verifiable and quantifiable.

verifying the loss details should be reasonably low.
This means the cost of
Though finance and insurance are considered to be separate fields, they have much in
common. They both look at risk in terms of variations in future cash flows. They use
similar valuation techniques. Both depend on risk pooling and risk transfer. Moreover,
the linkage between finance and insurance has strengthened in recent times. For
example, options and futures have been developed to deal with catastrophe risk. Life
insurers have developed products with embedded options on stock portfolios. While
life insurers have taken on investment risks traditionally managed by banks, some banks
have assumed mortality risk. Swiss life insurers for example offer a savings-oriented
product where the principal grows at the higher of a pre-defined fixed rate or the stock
index. This is effectively an embedded call option. There has also been integration of
financial and insurance products because of securitization.
In this age of deregulated financial markets, companies have to manage their financial
risks carefully. While the ways of managing risk have multiplied, thanks to the
availability of a plethora of derivative instruments, life has also become more
complicated for treasurers. Treasurers have to invest a lot of time and effort in
understanding the pros and cons of different instruments and choosing the right one in a
given situation. Derivatives, in particular, are double-edged swords. If used well, they
can mitigate risk but if used indiscriminately, they can land the company in trouble. In
India, the range of financial instruments available is still limited and markets lack depth.
But, in the near future, we can expect to see more and more instruments. Already,
trading of options and futures on stock exchanges has taken off. Restrictions on
currency swaps have also been removed. Corporate treasurers in India are truly headed
for exciting times in the years to come.
a.
When will interest rate risk arises?

.
.
.
b.
What are the steps in financial risk management?

.
.
.
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21.10 HUMAN RESOURCES RISK

In todays knowledge driven business environment it is the quality of people that
ultimately determines the competitiveness of an organization. Great companies attract
good people and have mechanisms for retaining and nurturing them. In such
companies, there is never a leadership vacuum. On the other hand, in poorly managed
companies, good people hesitate to join. Those who do join, lose motivation, get
frustrated quickly and leave. Due to a shortage of talented managers, such companies
find it difficult to grow fast and exploit the opportunities in the market place. Over a
period of time, they lose their competitive edge. In short, human resources management
has become more critical than ever before.
SUCCESSION PLANNING
At a strategic level, succession planning is probably the most important Human
Resources (HR) risk. The consequences of appointing the wrong successor can be
disastrous. Take the case of Westinghouse. A series of wrong CEOs virtually drove the
company that was once rated on par with General Electric, into bankruptcy. Though all
CEOs want to avoid a wrong successor, their track record, in this regard is
disappointing. Consider the legendary CEO, of Coke, Roberto Goizueta. The
aristocratic Cuban had trained his successor, Doug Ivester well and had nominated him
as his successor well before his death. When Goizueta died of cancer, Ivester took
charge in what the markets perceived to be one of the smoothest transitions ever in a
Fortune 500 company. Yet, a couple of years later, Ivester was found unfit for the task
and had to resign. An accountant by training, Ivester had a flair for numbers and had the
reputation of a street fighter, unlike Goizueta, who had been a charismatic leader,
strategic thinker and delegator. When they were together, Ivester complemented
Goizueta well. But after becoming the CEO, Ivester found it difficult to manage some
sensitive issues. Looking back, Ivesters number crunching, financial engineering and
technical skills were exceptional but his people orientation and leadership skills were
inadequate. Following an incident in Belgium, when hundreds of people became sick
after drinking Coke, Ivester did not go there for a week. This reflected his inability to
appreciate the magnitude of the crisis. Similarly, Cokes failed merger deal with
Orangina was mostly due to Ivesters failure in dealing with anti-American sentiments
in France. Ivester also seemed somewhat out of place while handling a racial
discrimination suit. Quite clearly, Goizueta had trained his successor well but had
chosen the wrong successor in the first place.
The problems associated with succession planning are particularly acute in India, where
family managed businesses proliferate. Such companies throw discretion to the winds
and often spend more time on dividing the family silver among the next generation than
in grooming the right person to takeover the top job. Family managed companies would
do well to remember that the chosen successor should have the necessary education,
skills and grooming to appreciate the privileges, responsibilities and challenges
involved. They should also be bold enough to appoint a professional manager from
outside the family, when there is no suitable candidate within. Some of the more
progressive Indian business houses like Ranbaxy, the Murugappa group and the Eicher
group have demonstrated a high degree of professionalism in this regard. Many Indian
companies are now beginning to take succession planning more seriously. At Larsen &
Toubro (L&T), one of Indias leading engineering companies, many of the companys
senior managers are expected to retire in the first few years of the new millennium. CEO
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A. M. Naik has named the top 10% of his executives as stars and chalked out a fast track
career path for them. Before initiating the program, L&T employed the services of a HR
consulting firm to list the positions falling vacant and the required competencies. L&T
now fills vacant posts with internal candidates, wherever possible. In some cases,
however, it compares the internal candidate with an external applicant to judge the internal
candidates readiness to move into the new job.
ROLE OF THE BOARD
The board should play an active role in the succession planning exercise. Indeed,
choosing the CEO is probably the most important decision the board makes.
Unfortunately, many boards do not take succession planning seriously. The directors
either due to their cosy relations with the incumbent CEO, lack of concern or simply
inertia, are reluctant to broach the subject. It is not simply a matter of chance that many
CEOs in major US companies have failed to last even three years in recent times. These
include Douglas Ivester of Coke, Durk Jaeger of Procter & Gamble, Dale Morrison of
Campbell Soup and Jill Barad of Mattel. In India, companies like Thermax have faced
crises because of poor succession planning. Identifying and specifying the attributes the
next CEO should have are challenging tasks. But many boards do not invest sufficient
time and effort in this regard. They confine themselves to generalities such as teambuilding skills or the ability to manage change. Other boards concentrate on technical
capabilities to the point of completely overlooking leadership skills. In many cases,
future CEOs are judged by their past track record in delivering measurable performance
like increase in market capitalization. Quite clearly, a balanced approach, which takes
into account the different dimensions of the job in a holistic manner, is necessary.
Leadership is something which is difficult to quantify. But, boards should still identify
some parameters for measuring the leadership qualities of a potential CEO. The Board
could assess the soft qualities of the future CEO by asking the candidates peers,
subordinates and superiors a series of questions to get an idea about consistency in the
way the candidate inspires trust in others, ability to introduce a high degree of
accountability, ability to delegate, amount of time and effort the candidate spends in
developing others, amount of time the candidate spends in communicating the
companys purpose and values down the line, comfort level in sharing information,
resources, praise and credit, ability to energize others, demonstration of respect for
followers and listening skills.
ATTRACTING AND RETAINING EMPLOYEES
Turnover of key employees is another big HR risk that companies face today.
The increasingly knowledge-intensive nature of many businesses creates serious problems
when talented employees leave. So, companies must do what is necessary to retain their
best managers. Attracting and retaining talent is not just a matter of higher salaries and
more perks. It involves shaping the whole organization, its vision, values, strategy,
leadership, rewards and recognition. Thus, companies must look at retention as an
exercise that ensures long-term employee commitment rather than as a knee jerk response
to hold back employees after they resign. An effective retention strategy must be built
around the following:
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Taking note of the companys culture, designing and building the ideal culture.
Assessing potential candidates for hiring, following careful hiring practices.
Measuring and understanding the issues driving retention.
Putting in place well-designed career-development plans.
Designing an attractive and transparent reward system.
ALIGNING INDIVIDUAL ASPIRATIONS WITH ORGANIZATIONAL GOALS

Many talented employees leave their organization not because they are unsuccessful in
their jobs but because they become fatigued and burnt out, due to long hours on the job.
Managers have to help employees find the balance between work and their personal life.
Good managers clarify the job responsibilities and ask employees to define their
personal priorities. By defining goals very clearly and by being focused on the results
than the process, they succeed in giving employees a lot of autonomy. Good managers
also recognize and support the full range of the peoples life roles. This deep interest
strengthens the bond with the employees who learn how to establish boundaries and
stay focused on the job. In good companies, managers regularly examine whether
conflicts between work and personal priorities are due to work place inefficiencies.
They regularly experiment with work processes to improve the organizations
performance and the lives of its people. They question basic assumptions and develop
innovative workplace processes, to facilitate the achievement of goals without
compromising in any way the personal interests and priorities of employees. They have
an open mind towards modern day work practices such as flexi working hours and
allowing employees to work from their homes or from the location of their choice.
Consulting and computer software companies tend to fall in this category. Todays
knowledge oriented business environment is characterized by ever-rising employee
aspirations. Employees are ambitious and want to achieve a lot in very little time.
At the same time, they want to maintain a balance between work life and family life.
Innovative techniques are hence needed to understand the inner motivations of
employees and manage them intelligently. Many people leave their organizations
because of a wrong assumption on the part of senior managers that people who are
doing well in their current jobs are also happy. The activities that make people happy
are determined by their deeply embedded life interests. Such interests are displayed
during childhood and remain stable thereafter but manifest themselves in different ways
at different points in a persons life. Indeed, many people do not know at least till they
are midway through their career, the kind of work that will make them happy.
21.11 MARKETING RISKS

To retain their competitive edge, companies have to offer products that provide value to
customers. If a company does not have a product to sell or if it has a product, which is
inferior to what competitors are offering, it cannot survive in the long run. Each new
product launch involves risk. Similarly, dependence on a few customers also results in
risk. Wrong communication strategies can dilute or harm the image of a brand. An
organization is also exposed to risk when its distribution channels wield high bargaining
power. In short, marketing risks refer to the uncertainties involved in designing and
implementing the marketing mix. Effective marketing implies balanced and informed
decisions that lead to long-term profitability. Quite often, strategies that focus on shortterm objectives may look attractive but may turn out to be risky in the long run. For
example, reckless brand extension may yield immediate benefits, but in the long run
may dilute the brand image. The same argument applies to sales promotion. Similarly,
advertising without a fundamental understanding of the customers decision-making
process may throw money down the drain. So, it is important to understand the risks
associated with different marketing activities. The pitfalls in marketing are best
illustrated by the failure of many dot coms in recent times. Focused totally on
generating traffic, they failed to realize that products have to be sold and profits
generated to sustain operations. In their anxiety to get to the market first, they did not
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pay enough attention to understanding customer needs. The few dot coms, who have
understood customer needs, have been able to offer suitable products and services and
more importantly have been able to charge a remunerative price.
The inability to control market forces and the difficulty in predicting these forces make
marketing more of an art than a science. However, marketing decisions need not be
taken purely on the basis of intuition. A systematic approach to formulation and
implementation of marketing plans can definitely minimize risks. A good understanding
of supply and demand conditions, an appreciation of the costs involved and insights into
the customer segment being targeted, are the building blocks of a successful marketing
plan. A systematic approach to managing marketing risks builds discipline into
managerial actions. The best marketing plan can fail in the absence of discipline. Take
the issue of pricing. Many companies let emotions rule and squeeze more from the
market when prices rise and panic unnecessarily when prices fall. Instead of this knee
jerk approach, companies must ask themselves the question: What do we need to do to
ensure that we can retain customers, charge a reasonable price and remain profitable
throughout the business cycle?
THE CHALLENGE FOR MARKETERS
The challenge for marketers is to ensure sustained demand for their products. Though
most marketers are wary of a fall in demand for their products, they approach the
problem in a fairly ad hoc manner. Marketers have to understand consumer behavior on
an ongoing basis, challenge existing business assumptions and reposition themselves
from time-to-time to attract new customers and increase the consumption of existing
customers. They need to keep asking themselves some basic questions such as who are
the customers, who are most loyal or those customers who may buy less if there is a
recession or those customers who are most likely to switch over to a cheaper product or
those customers who can be weaned away, etc. A companys customers must be
examined on the basis of various criteria: size, profitability, resilience to a recession and
loyalty. During times of uncertainty, watching competition is critical. But firms should
never forget that sustainable competitive advantages come not from imitation but by
doing things in a different way. Todays unprofitable or small customer segments may
well turn out to be the most important segments of tomorrow. Thus, a twin-pronged
strategy is essential. Companies should stay tuned to the needs of their existing
customers and at the same time should keep experimenting with new products, making
low cost investments for hitherto untapped segments. Along with customers, companies
also need to understand how the bargaining power of channels is shifting and the
potential conflicts that may result due to this shift. At the end of the day, the product
has to reach the customer. So, problems in the distribution network must be anticipated
and tackled in a proactive way.
BUILDING CUSTOMER LOYALTY
The success of any marketing effort ultimately depends on the ability to create a base of
loyal customers. Indeed, customer loyalty is the key driver of profitability of businesses
in general and online businesses in particular. Research by Bain & Co. and Mainstream
indicates that the average repeat customer for apparel spends 67% more during the third
year of the relationship than in the first six months. For online grocers, this figure is as
high as 75%. In fact, an average online apparel shopper is not profitable until he has
shopped at the site at least four times. Loyal customers are more willing to purchase
new product categories and generate valuable word-of-mouth publicity that attracts new
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customers. In the wake of intense competition and the availability of a wide array of
choices for customers, companies have to be innovative in retaining them. One such
technique is experience-based selling, which engages the customers and creates an
interactive selling process. A deep understanding of what customers look for when they
go shopping is an important input in experience-based selling. One of the important
reasons for the failure of the online fashion retailer Boo.com was its inability to
understand the kind of shopping experience sought by its customers. Its target segment,
women under 30, looked at shopping as a social experience. These women did buy
certain goods online and were quite familiar with the Internet. But when it came to
fashion shopping, social enjoyment took pride of place. So, the comfort of shopping
from home became an irrelevant factor. The way companies are positioning their
products also reflects this trend. Today, many companies wrap a story or emotion or an
appealing idea around their service or product to turn a routine purchase into a more
exciting experience. They do this by exploiting the latent needs of people. Nike for
instance wants its customers to Just-do-it and Coca-Cola wants customers to enjoy.
However, lifestyle marketing, while facilitating product differentiation, may also put off
some consumers. Indeed, consumers may get put off by a wrong lifestyle faster than
by a not-so-good product. So, lifestyle positioning requires a deep understanding of
human psychology, a far more difficult task than understanding the functionality
required in the product.
THE PITFALLS OF LISTENING TO CUSTOMERS
Understanding customer requirements through periodic market-surveys is important.
But beyond a point, this can be counter-productive. Indeed, some of the greatest new
product successes have not been achieved on the basis of market research. They have
been influenced strongly by managerial intuition. In recent times, Customer
Relationship Management (CRM) has been touted as the mantra for the success of
marketers. CRM implies listening to customers, capturing all the relevant information
in a computerized database and using tools such as data- warehousing and data mining
to understand and serve customers better. While the logic of CRM is sound, the dangers
involved need to be understood. Established companies often fail when a radical
innovation emerges. They are so much caught up with the needs of existing customers
that they totally overlook the entirely different needs of small but fast-growing
segments. So, successful products are built not just by listening to customers but also
by going ahead with what the company thinks are great products, which will be
profitable in the long run.
BRANDING RISKS
Today, brands are considered to be among the most valuable assets of a company.
The Coke brand accounts for 95% of the value of the Coca-Cola Companys total
corporate assets. Similarly, for most FMCG companies like Philip Morris, Unilever and
Procter & Gamble, brands are indeed the most precious assets. The same holds true
even for technology companies like Microsoft. The importance and power of corporate
brands has also increased significantly in recent times. IBM, Sony, Nokia and BMW
have all successfully leveraged their corporate brands. But brands are also vulnerable.
A failed advertising campaign or a perceived drop in quality can erode customer loyalty
in no time. Brands are also vulnerable to changes in customer tastes. Another risk,
which brands face, is the wrath of the anti globalization activists. Here, we look at
some of the strategic issues in brand management.
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ADVERTISING RISKS
Companies often spend huge amounts of money on advertising without realizing
commensurate benefits. In the first quarter of 2000, Drugstore.com spent $29.9 million
on marketing or $101 for every new customer. Its customers however spent on an
average only $23 per person. Beyond.com, frustrated by the inability of ads to stimulate
customer spending, spent a reported $11 million to cancel advertising contracts worth
$24 million during 1999. Companies like Procter & Gamble are realizing the need to
squeeze more out of their advertising expenses. Effective advertising should begin with
an understanding of the customers decision-making cycle. It must ask some
fundamental questions: How do people realize that they need the service or the
product? How do they make the purchase decision? Then ads can be designed to reach
prospects at the right point in the decision cycle and persuade them to purchase the
companys product. Very often, advertising is ineffective because it targets the wrong
customers. Pets.com spent millions of dollars on Super Bowl advertisements, totally
overlooking the fact that for one of its main customer segments, elderly women, the
Super Bowl was irrelevant. Instead, the company might have been better off, creating a
database and running an e-mail campaign targeted at potential customers. Online
advertising, in particular poses big risks, and has contributed to the downfall of many a
dot com. This is because for most dot coms, advertising is the biggest expense head.
Results from online advertising have been disappointing due to various reasons. Some
advertisements have been far too complicated with many visuals. Since the space in a
banner is limited, advertisements should be kept simple. Using too many visuals may
give a cluttered look. Most people do not log on to the Net to watch ads. So, if the
target customer has to click to get the message, the targeting will be very poor. Brand
awareness increases as the target audience repeatedly sees the ad but increasing the
frequency beyond a point through techniques such as pop-ups is also not advisable.
People may get put off if they keep seeing the same ad again and again. So the right
questions to be asked before a new ad campaign are: Is it making a solid offer to the
customer? Is it giving sound reasons to the customer to buy from the company? The ad
should get the prospects attention, foster the customers interest in the offer, build
desire for the product or service and generate a favorable action by the customer. Key
performance indicators must be used to track the effectiveness of advertising.
Especially in the dot com business, where ad spending makes up a big chunk of the
total expenditure, realistic communication objectives must be spelt out: awareness of
the site, the number of visitors, the rate at which visitors are converted into customers
and infrequent customers become regular ones. Advertisement tracking surveys, which
measure the impact of the ad campaign on the brand image, generally cost only a small
fraction of the ad outlay. Yet, many dot coms do not do this type of monitoring
systematically.
INSPIRING TRUST
A brand evokes distinct associations, stands for certain personality traits and builds
emotional attachments. Above all, a brand is supposed to inspire trust. A brand
provided a guarantee of reliability and quality. Its owner had a powerful incentive to
ensure that each unit of the product concerned was as good as the previous one, because
that would persuade people to come back for more. Even in todays digital economy,
things have not changed one bit. Consumer trust continues to form the core of the value
of a brand. Branding efforts should never forget this point. Take the example of
e-business. Customers may not disclose their credit card details if they do not trust the
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e-tailer. It is the trust that the Amazon brand inspires that attracts shoppers to its site.
Good brands are said to invite trust, earn trust, honor trust and reward trust. It is the
element of trust that has made HDFC one of Indias most well-known brands. It has
also been a peculiar brand in the sense that it has been built with virtually no ad spend.
In fact, its looked upon as a classic brand management case study, as a brand thats
evolved by word of mouth, through customer care and trust built up over the past two
decades. The failure of New Coke has adequately brought out the importance of customer
trust. In 1985, Coke faced a major challenge from Pepsi and changed the formulation of
its flagship Coca-Cola brand to give it a sweeter taste. Consumers revolted and the old
formulation had to be brought back almost immediately. Quite clearly, consumers felt
that by changing the formulation, Coca-Cola had breached their trust.
Keeping a brand trustworthy implies maintaining a degree of consistency in what the
brand has to offer. However, in their obsession with trust and consequently
consistency, companies should not overlook changing customer priorities. Brands
should be revitalized and repositioned from time-to-time to retain their sparkle.
Successful brands must constantly evolve, adapt to changes in consumers needs and
aspirations. There are several examples to illustrate the importance of revitalizing the
brand. Motorolas persistence with its rich technology heritage proved to be a handicap
when it faced competition from Nokias user friendly, hip, relaxed image. Today,
Nokia is far ahead of Motorola in the mobile handsets business. While traditional
brands such as Maxwell House emphasized the product Starbucks decided to convert a
functional coffee shop into a place with a rich ambience that made coffee drinking an
experience to savour. Brand repositioning was the key theme in the turnaround efforts
of Harley Davidson, the famous American motorcycle manufacturer, which faced
bankruptcy in the early 1980s. The company quickly realized that its motorcycles were
more than just products and represented American romance and prestige. It decided to
reposition the product based on a Harley lifestyle that conveyed the exciting experience
of riding on the roads. While repositioning a brand, a long-term orientation is desirable.
Managers must ask how relevant their brand position will be three years from now, as
the priorities of their target customers change or the target customers themselves
change. Anticipating which brand patterns are likely to unfold, gives managers a
critical head start in crafting the next winning moves for the brand.
DEALING WITH COMMODITIZATION
The profits, which a brand can generate depend heavily on the premium it commands in
the market. Commoditization is the lowering of the premium that a brand commands.
Today, many brands face competition from cheaper products that are perceived by
customers to be functionally on par. The reluctance of customers to pay a high
premium for brands is not in good taste to brand managers. The first hint of
commoditization came in April 1993, when Philip Morris announced it was cutting
prices of its cigarettes by 20%. Soon, the stocks of Heinz, Quaker Oats, Coca-Cola,
Pepsi Co, Procter & Gamble and R J R Nabisco, all of which had powerful brands, took
a severe beating. The incident, which is commonly referred to as Marlboro. Friday,
highlighted the vulnerability of brands. In India, Hindustan Lever executives recently
used the term down-trading to describe the phenomenon of people moving away from
premium brands to cheaper products. Many of the brands in the market place look alike
and differentiation has become a tough proposition. With an ever-expanding choice for
customers and little by way of differences in physical characteristics, marketing
managers face the challenge of making their brands look unique. Unfortunately,
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attempts by most companies to highlight the uniqueness of their brands have lacked
imagination. Given that proprietary technology is a diminishing competitive advantage,
companies have to conceive of a brand idea, which is big, simple, true and unique What is
important is to find an idea that is relevant to the markets. If one were to look at
organizations with relatively similar products, the key differentiator is the idea on which
the brand rests. Take for instance, the emotional appeal of Orange with the functional
appeal of Vodafone, or Nikes aspiration based advertising (Just do it) with Adidas focus
on the technology of sport and perfection. Advertisements with emotional appeal often
have a better impact and are more successful in creating top of the mind awareness.
STRETCHING THE BRAND
The profit potential of a brand is heavily dependent on the companys ability to leverage
the name in new categories. The exorbitant costs of launching an altogether new brand
and increasingly competitive markets make brand extension an important strategic
weapon in the marketers armor. Unfortunately, due to their restricted vision, many
marketers fail to leverage the brand fully and limit the extension to a few products. By
not launching new categories under an existing brand name, they also forgo
opportunities to modernize the brand and capture more shelf space at retail outlets.
Having said that, the risks associated with brand extension should not be
underestimated. While brand extension facilitates quick launch and acceptance of a
product by leveraging the strengths of an existing brand, it may also end up weakening
the motherbrand. In general, brand extension succeeds if the new category is seen as
compatible with the personality of the parent brand and the expertize it represents. In
addition, there must be consistency in the value perception of the brand in the new
category as compared to its parentbrand. Another point to be noted is that a highly
successful brand almost owns the category. Indeed, very successful brands like Xerox
became almost generic in their categories. This advantage may be lost if the brand
name is extended to other categories. Brand extension into lower quality products is
risky because of the possibility of losing the legitimacy and power of the original brand
in the existing market. Similarly, the complementary nature of the new product does not
guarantee its success. More than the nature of the products, what is important is a
coherent identity. Many extensions fail because the original marketing mix is not
modified to meet the needs of the new product or category.
DISCHARGING SOCIAL RESPONSIBILITY
The success of brands and the riches they have brought to their companies have given
them a high visibility and put them at the center of public attention. So, companies that
own powerful brands are being closely watched by governments, NGOs and social
activists. As a result, the way brands are perceived to be discharging their social
responsibilities has become an important issue. Benetton, the famous Italian apparel
company launched an advertising campaign in Europe in early 2000, featuring inmates
condemned to death, waiting in US prisons. The campaign was in line with Benettons
earlier efforts which focused on war, AIDS and racism. Unfortunately, for Benetton,
the campaign boomeranged in some markets. And worst of all, it led to the
cancellation of a contract by Sears, one of Benettons most important customers.
Similarly BPs corporate branding campaign, Beyond Petroleum backfired when
customers felt that the company was exaggerating its achievements. As we mentioned
earlier, powerful brands are built around great ideas and emotions rather than functional
attributes. But brands with strong emotional appeal also face threats from activists who
feel that making the brand more important than the underlying product is unethical.
When activists feel that the company has behaved in an irresponsible way and take to
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the streets, the brand image takes a severe beating. So the more aggressive the
companys branding efforts, the more it must do to be perceived as being ethically
correct. Unfortunately, not many marketers seem to be managing the issue of social
responsibility very proactively. Hindustan Lever recently had to withdraw an ad Surf
Excel Hai Na after it was perceived to be damaging the environment. A Fiat Uno ad
which showed several kids piling into the car seemed to show scant respect for safety.
Social responsibility is important to a brand because it has a significant impact on
customer perception. Quite clearly, there must not be any incongruity between the core
values of the brand and those of the company owning the brand. With brands having
such an impact on a companys fortunes, the responsibility for brand reputation lies as
much with the top management as with the brand managers.
PRODUCT DEVELOPMENT RISKS
New product launches are expensive and risky. New products may fail due to several
reasons such as overestimation of market size, poor product design, wrong positioning,
overpricing, uninspiring advertisements, higher than expected costs of product
development, aggressive competitor response. Strong new-product planning is needed
to improve the probability of success. The top management must define the markets
and product categories that the company wants to target. It must set specific criteria for
newproduct idea acceptance, based on the specific strategic role the product is expected
to play. A new product can help the company to remain an innovator, to defend its
market-share position, to get a foothold in a new market to take advantage of its special
strengths or to exploit technology in a new way. The amount of investment is a major
decision in product development. Outcomes are so uncertain that it is difficult to use
normal investment criteria for budgeting. Some companies encourage as many projects
as possible, hoping that a few will click. Others set their R&D budgets as a percentage
of sales or by looking at how much the competition spends. Alternately, companies can
decide how many successful new products they need and work backwards to estimate
the required R&D investment. Successful product development requires crossfunctional coordination and involves a consistent commitment of resources. It also
implies the establishment of suitable organizational arrangements that facilitate the
integration of the product development process into the strategic planning process.
Many companies are revamping their organizational mechanisms and processes to
improve the chances of success in product development. The use of cross-functional
teams is now a standard practice. By having executives from marketing, production and
design together right from the start, the product development cycle time can be cut
down, leading to major cost savings. When several product development efforts are
going on simultaneously, the costs incurred can be significantly reduced if there is a
constant transfer of knowledge across projects. This eliminates redundancies and cuts
the time taken to complete the project. For a company like Microsoft, which develops
products like MS office, this is extremely important. Microsoft has to constantly
transfer knowledge across software like Word, Excel, and Power Point, which are parts
of MS Office.
PRICING RISKS
Pricing strategies and tactics form an important element of a companys marketing mix.
Companies must carefully evaluate the various internal and external factors involved
before choosing a price that will give them the greatest competitive advantage in the
target markets. Most products tend to have a pricing indifference band. Within this
band, pricing changes do not have much impact on a customers willingness to buy.
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A products specific location within this band will have a significant impact on
profitability. Delineating the band is more expensive in the brick and mortar world.
On the web, cost effective means of determining the band are available by changing
prices and measuring the elasticity of demand. A price-cut or hike will affect customers,
competitors, distributors, and suppliers. A price-cut can be risky as customers may view
it negatively. Is the product faulty and not selling well? Has quality been reduced?
Will price come down further? Similarly, a price increase can also create a negative
customer perception. Is the company greedy and charging what the market will bear?
How can the firm figure out the likely reactions of its competitors? Just like the
customer, the competitor can interpret a price cut in many ways the company is trying to
grab a larger market share, it is doing poorly and trying to boost its sales, or it wants
others to join in cutting prices to increase the market size. Competitors are most likely
to react when the number of firms involved is small, when the scope to differentiate is
less and when the buyers are well informed. Uncertainty is less when there is one
large competitor, who tends to react in a predictable way to price changes. When there
are several competitors, the company must guess each competitors likely reaction. If
all competitors behave alike, there is no problem. But if competitors do not behave alike
perhaps because of differences in size, market share, or strategy separate analyses
are necessary. Also, if competitors treat each price change as a fresh challenge and
react according to their self-interest, the company will have to figure out their game
plan each time.
How does a company deal with price cuts by competitors? If the company feels price
reduction is likely to erode profits, it might simply decide to hold its current price and
protect its profit margin. Similarly, if it thinks it will not lose too much market share, it
may maintain its price and wait till it is clear about the impact of the competitors price
change. Or, the company may decide that effective action should be taken immediately.
It can reduce its price to match the competitors price. It may undercut the competitor if
it feels that recapturing lost market share later would be too hard. Or, the company
might improve quality and increase price, moving its brand upmarket. In general,
responding to competitive pressures by cutting prices is a strategy that clever marketers
avoid. This is a game, which does not stop with one round of price cuts. Each cut leads
to more cuts typically, leaving everyone worse off. Moreover, repeated price reduction
may lead to cost cutting, a deterioration in quality or a perceived dilution of brand
image. In the long run, price-cutting is a self-defeating strategy and is unsustainable as
some competitor can always quote a lower price. The web has created the possibility of
adjusting prices flexibly and fast in response to market forces. Indeed, when demand
fluctuates sharply, flexible pricing can be an effective risk-mitigation mechanism. A
mix of offline and online selling strategies can be very effective. For example, if
products have little demand and prices have to be cut drastically, the Internet can come
in handy because a large number of customers can be tapped quickly online. Some
consumers are prepared to pay more than others as they attach greater value to the
benefits. In the brick-and-mortar world, segmenting customers on this basis is difficult
if not impossible. However, the Internet offers exciting opportunities to understand and
segment customers by collecting and processing a variety of information. Thus, loyal
customers can be charged a lower price while a premium can be collected from
occasional buyers, who approach the company only during a crisis. Charging different
prices for different customers is however, not entirely risk-free. When Amazon.com
offered DVD buyers three different discount structures, 30%, 40% and 50%, customers
getting the lower discount complained. If consistency and trustworthiness are a
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products core values, changing prices from segment-to-segment can be a very risky
strategy. In October 1999, Coke sparked off a major controversy when it announced
that it was seriously looking at using a technology that would enable vending machines
to change prices according to atmospheric temperature. The move backfired and Coke
had to cancel the initiative.
SUPPLY CHAIN RISKS
The ability to manage the supply chain is undoubtedly one of the key requirements for
staying ahead of competitors. It does not matter whether a company is vertically
integrated or operates in a small segment of the value chain. The need for co-ordination
with supply chain partners and ensuring that orders are efficiently executed is important
in both the cases. Supply chain risks arise because one or more of the companys
partners may fail to deliver, leading to delayed delivery or canceled orders or lost
customers. Such risks have become more potent because of the dramatic transformation
of supply chains in recent times. In the past, the supply chain was more or less linear,
collecting raw materials at one end, passing it through the processing stages and finally
sending out finished products to the customers. Due to developments in communication
and information technology, the shape of the supply chain has not only become nonlinear but in some cases even indeterminate. Materials can flow in all directions. So,
understanding and coordination have become much more difficult. In the evolving
supply chain the information flow is facilitated through an Intelligent Information
Processor (IIP). The IIP interacts with the channel members and ensures the smooth
flow of goods and information across the chain. Physical goods and information flows
take place in a non-linear manner, unlike the traditional supply chain. The evolving
supply chain has been referred to in the literature as amorphous, since structures are
difficult to map and keep changing depending on the strategies of the company and its
partners. The same company may directly market its products to customers through its
website and also execute some orders through its traditional channels consisting of
distributors, wholesalers and retailers. For some activities, the company may reduce the
number of partners to improve integration and give them the volumes needed for
generating economies of scale. In the process, the companys vulnerability may
increase.
Two types of expertise: Information Technology and Relationship Management, are
absolutely vital in mitigating supply chain risks. Information has to flow in a seamless
manner across partners and must be made available to them online. The type of
dedicated investments, which todays supply chains demand, imply that a relationship
of trust and reciprocity must exist among the different entities. Indeed, without good
relations, the effectiveness of the supply chain will fall drastically. The importance of a
well-oiled distribution system cannot be overemphasized. Often, companies spend
heavily on advertising and promotion without paying adequate attention to distribution.
The importance of supply chain risk management has been highlighted by the
difficulties faced by dot coms in order fulfillment, a critical success factor in online
businesses. In the US, during the 2000 Christmas season, in spite of booking orders at
least a week before December 25, 8% of the packages failed to arrive on time. For most
e-business operations, the key decision involved in order fulfillment is whether to build
or outsource distribution infrastructure. e-Toys started off by outsourcing but later
invested heavily in modern warehousing facilities. It went bankrupt in the process.
Webvan, the online grocer has invested heavily in 26 high tech warehouses to facilitate
same day delivery. Webvan hopes that this investment will pay-off if business expands
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and it can widen its product range. Some analysts, however, estimate that Webvan will
have to attract 5% of the US households to break even. Faced with this Herculean task,
the companys stock price crashed while losses mounted. Webvan will quite likely, run
out of cash in the near future. In contrast, UK grocer, Tesco has pursued a low tech
strategy involving order pickers at local stores who fill a customers basket manually.
This approach, though clumsy at first sight, has enabled Tesco to go online without
making heavy upfront investments. Similarly, Wal-Mart, in spite of its huge resources
decided to start off by outsourcing order fulfilment. Wal-Mart wanted to get to the
market fast and learn the intricacies of online order execution. Now, it has decided to
handle delivery inhouse.
Channel management is a key issue driving Supply Chain Management. Ideally,
individual channel members, whose success depends on overall channel success, should
understand and accept their roles, coordinate their goals and activities, and cooperate to
attain overall channel goals. But this implies giving up individual goals. Channel
members rarely take such a broad view and are usually more concerned with their own
short-term goals and their dealings with firms closest to them in the channel. Channel
members typically act alone and often disagree on the roles each should play and the
rewards. Such disagreements over goals and roles generate channel conflict. Horizontal
conflict occurs among firms at the same level of the channel. A dispute between two
dealers in a city over the territory they should handle is a good example. Vertical
Conflict refers to conflicts between different levels of the same channel. A dispute
between a distributor and a retailer would fall in this category. Channel conflict is not a
new phenomenon but has gained importance in recent times, with the growth of ebusiness. Many consumer goods manufacturers cite channel conflict as the main
obstacle to selling goods online. Channel conflict was an important issue when Toys R
Us set up its website Toysrus.com for doing business online. Bob Moog, who joined as
CEO of Toys R Us e-Business operations, resigned after he found that there was
confusion over the role of the Internet and the traditional distribution channels. When
Levi Strauss launched its websites Levi.com and Dockers.com, it resulted in friction
with dealers. Levi later decided not to sell through its website and instead decided to
direct site visitors to the online retailing arms of J C Penny and Macys. Even for higher
involvement products like cars, channel conflicts may arise. When General Motors
announced that it would buy-back some dealer franchises and start direct selling through
the Internet, it faced strong protests from dealers. The web has eliminated layers of
traditional intermediaries, while encouraging new intermediaries with specialized
capabilities in the movement and handling of small parcels. Managers may sometimes
placate existing channel members, knowing fully well that these traditional relationships
will have to be severed one day. Resolution of channel conflicts by pampering the
traditional dealer network may not always be the right strategy. Customers decide how
to buy and may well shift their loyalty to competitors if channel members do not respect
their decision. So a clear and transparent communication to channel members about
changes in channel strategy is the need of the hour. Sometimes, channel conflicts can
seriously impair customer relationships. Consider a customer who logs onto a website
to procure a PC of a particular configuration. If the site does not accept the order due to
a bug, the customer may contact the call center to report the problem. Instead of dealing
with the customers concern, the call centre staff may book the order to earn
commission and not even bother to report the bug to the department concerned.
Consequently, the customer concern would remain unattended and lead to a marked
deterioration in relationship with customers over time. The main challenge for both
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established companies and start-ups is to integrate web initiatives with the traditional
channels. Accordingly, sales order fulfilment and service processes have to be reengineered to create a seamless customer experience that allows customers to choose the
method of interaction depending on the situation. If companies are unable to identify the
channels their customers prefer and do not gear up to facilitate these seamless
transactions, they run the risk of losing customers. Many companies are dealing with
channel conflicts intelligently. Banana Republic sells apparel over the internet but
dissatisfied customers can visit the nearby store for an exchange or a refund. CUS, the
largest drug store chain in the US, allows customers to place online orders and choose
between a same day pick-up at the nearest CUS store or home delivery the next day.
Sourcing activities along the supply chain need to be managed carefully. Fluctuations in
raw material prices pose an important risk for marketers, especially in industries where
the inputs used are commodities and the amount of value addition in the manufacturing
process is not very significant. To protect itself from this risk, a company can use a
variety of techniques: hedging through forward or futures contracts, technological
advancements, commodity substitution and just-in-time sourcing. Technological
advancement can cut the consumption of an input, facilitate substitution of one
commodity with another and in some cases, even enable complete switch over from one
commodity to another depending on the prevailing prices. By releasing requisition
orders just before the raw materials inventory gets depleted, the time period during
which volatility occurs can be reduced. This will ensure that suppliers do not pad up
their price. Dell is a good example of the build to order model. In todays customer
driven environment, marketing risks need to be managed effectively. The marketing
mix has to be carefully studied to examine the scope for providing a better value
proposition to customers. Product launch, promotion, pricing and distribution are all
activities, which need to be managed carefully after considering the various risks
involved. In the online world, marketers face special challenges.
21.12 POLITICAL RISKS

Political decisions or events often have an adverse impact on a companys operations.
Political risk covers actions of governments and political groups that restrict business
transactions, resulting in loss of profit or profit potential. In extreme cases, political risk
may include confiscation of property. Usually, however, political risk arises due to
various restrictions imposed by the government. Political risk analysis is quite common
in the case of foreign investments. This may also be necessary in some domestic
situations. Political risk may take different forms. Government policies may change
after elections. A new leadership with a different ideology may emerge within the same
political party and reverse earlier policies. More extreme events are civil strife and war.
Even issues such as kidnapping, sudden tax hikes, hyper-inflation and currency crises
come under the broad category of political risk. At a macro level, political risk arises
due to external factors such as fractionalization of the political system, societal divisions
on the lines of language, caste, ethnic groups and religion, dependence on a major
political power, and political instability in the neighboring region. At a micro level,
risks may result from change in policies in areas such as taxation and import duties,
controls on repatriation of dividends, convertibility of currency, etc. Most managers
take political risk seriously, especially while making overseas investments. Yet, the
degree of sophistication of political risk assessment mechanisms often leaves a lot to be
desired. Like with other risks, decisions related to political risk should not be based
entirely on gut feeling. Intuition needs to be backed by more rigorous analysis.
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EVOLUTION OF POLITICAL RISK MANAGEMENT

In modern corporate history, the large oil companies, which faced political risk as they
expanded their operations across the world, first mastered the art of political risk
management. They found themselves helpless when political upheavals took place, like
the communist takeover of the oil fields in the Caspian Sea, expropriation in Mexico
and the growth of nationalism in Venezuela, Saudi Arabia and Iran. The initial reaction
of these oil companies was to enlist the support of their governments and demand
retaliatory measures. Gradually however, they realized the need to be more proactive
and to reduce their dependence on government support. Multinationals in other
industries also realized the importance of dealing with political risk in a systematic and
structured way. Companies like Ford, General Electric and Unilever developed inhouse
capabilities for political risk analysis. Early attempts by MNCs to manage political risk
consisted largely of sending senior executives to different countries on what came to be
known as grand tours to strengthen ties with the local political leadership. After
making an assessment of the political situation over several days or even weeks, the
executives would return home to file their reports. The main drawback with this
technique was that the executives were unable to understand the hard realities that lay
below the surface. Also, many of their conclusions were highly subjective. The
drawbacks with the Grand Tours approach became evident when the Cuban revolution
took place in 1959. Fidel Castros communist regime nationalized all foreign
investments. Most US firms were taken unawares and few had taken insurance covers.
US firms lost an estimated $1.5 billion following the Cuban revolution. Gradually,
MNCs realized that in spite of their efforts to manage political risk, they were being
viewed with hostility by many Third World governments. The risk was highest in
resource intensive industries and in countries where revolutionary regimes had seized
power. To strengthen their capabilities in managing political risk, many MNCs began
to take the help of experts, including former diplomats, consultants, academics,
journalists and government officials. Some were recruited on a full-time basis, while
others were invited from time-to-time to examine the risk profiles of countries they
were familiar with. This method came to be known as the old hands method.
Over time, however, the limitations of these methods became evident. Managers began
to view them more as academic exercises. Also, by the 1990s, with more and more
experience, MNCs became more comfortable with running international operations and
managing the associated political risks. Moreover, liberalization in many countries had
reduced political risk to some extent. Most MNCs have devised ways of reducing
vulnerability by following appropriate business strategies such as not concentrating
assets and resources in one particular country. By the mid-1990s, companies providing
political risk management services were seeing a sharp decline in business. Two large
service providers, International Country Risk Guide and Political Risk Services merged.
Multi-National Strategies and International Reporting Information Systems reoriented
their activities. In 1994, the Association of Political Risk Analysts, whose membership
had crossed 400 in 1982, was disbanded. MNCs began to employ new tactics to manage
political risk. They formed partnerships that allowed risk to be shared with local
entities. Local partners made MNCs look more like insiders. The partners brought to the
table, their deep insights about the local political conditions. Also by a more broad
based participation of financial intermediaries, the investment risks were being shared
among several entities. Various forms of insurance cover also emerged. It would be an
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exaggeration to say that political risk has completely disappeared. The experience of
Enron in India illustrates that even in liberalizing economies, political risk is always
present. Another good example is Suzuki, which faced considerable hostility from the
Indian government in the late 1990s. Large American companies have to take into
account political risks while making acquisitions in Europe. All global companies
usually face some form of political risk or the other. So, identifying political risks and
understanding how to deal with them must be an integral part of any strategic planning
exercise. But, as in the case of environmental risks, well-managed companies have
begun to include political risks in a general commercial assessment of the risks faced
rather than treat them as a separate category.
IDENTIFICATION AND ANALYSIS OF POLITICAL RISKS
Broadly speaking, there are three types of political risks Transfer risk, Operational
risk and Ownership control risk. Transfer risks arise due to government restrictions on
transfer of capital, people, technology and other resources in and out of the country.
Operational risks result when government policies constrain the firms operations and
decision-making processes. These include pricing and financing restrictions, export
commitments, taxes and local sourcing requirements. Ownership control risks are due to
government policies or actions that impose restrictions on the ownership or control of
local operations. These include limits on foreign equity stakes.
MACRO POLITICAL RISK ANALYSIS
At a macro-level, MNCs should review major political decisions or events that could
affect enterprises across the country on an ongoing basis. One important event which
business leaders monitor closely is elections. Political swings to the left are normally
bad for business. Some companies closely align themselves with the ruling party. When
the opposition comes to power, they face problems. The M A Chidambaram group in
the south Indian state of Tamil Nadu is a good example. The group, which supports a
local political party runs into problems when the other main political grouping returns to
power. Regions where political unrest is common are best avoided by MNCs. This is
especially applicable to parts of the Middle East, Eastern Europe and Africa and more
recently, countries like Indonesia. In Islamic countries, the probability of moderate
governments being supplanted by extremist regimes must be carefully evaluated.
MICRO POLITICAL RISK ANALYSIS
Companies need to understand how government policies will influence certain sectors
of the economy. Examples include specific regulations, taxes, local content laws and
media restrictions. Businesses may be given preferential treatment based on the
priorities of the government. It is a good idea to understand these priorities and explain
to the government how the companys policies are consistent with these priorities. The
C P group in China is a good example. Its expansion of poultry operations in China has
been consistent with the governments policies of improving protein off-take and
general health among the population and generating rural employment opportunities.
Similarly PepsiCo, while entering India gave an assurance to the government that it
would develop processed food industries in Punjab, along with its core beverages
business. This was a decisive factor in getting the approval for entry into a crucial
emerging market.
A country analysis examines three different areas, namely economic and social
performance, the countrys goals and policies and the political, institutional, ideological,
physical and international context.
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Under economic performance, the important parameters are generally Balance of

Payments, Currency Movements, GDP Growth, Inflation, Savings Rates,
Unemployment, Wage Costs. Under social performance, the factors usually considered
are Distribution of income, Educational achievements (literacy percentage and number
of average years of schooling), Life expectancy, Migration, Nutrition standards,
Population growth and Public health. The goals of a country have to be understood by
analyzing the behavior of political leaders including their decisions. The government
policies such as Fiscal policy, Foreign policy, Foreign trade and investment policies,
Industrial policy, Monetary policy, Social policies must be examined in detail.
In the political context, the following are the important factors: Mechanisms for
transition of power, Key power blocs, Extent of popular support for the government,
Degree of consensus in policy making, and the processes through which political
differences are resolved. In the institutional context, the important parameters to be
considered include Independence of the judiciary and the executive, Competence and
honesty of bureaucrats and senior government officials, Importance of informal power
networks outside the government, Structure, technology, management practices and
financial strength of business institutions and Labor conditions, including pattern of
unionization and collective bargaining practices. In the ideological context, one must
consider the rights and duties of the members of society, whether there is a broad
consensus and/or serious ideological tensions.
COUNTRY ASSESSMENT
The countrys performance must be measured, against its own past performance, the
performance of other countries and the goals of the government. A performance that
falls short of goals and is poor in relation to the performance of competing countries
will result in demand for changes in policies. It will also produce tensions in the
political leadership. Analysts must also look for inconsistencies between strategy and
context and examine the quality of political leadership in the country. If the
performance of the political leadership is poor, the key factors behind the poor
performance must be identified.
A good way of assessing the degree of political risk is by trying to understand how the
government perceives the companys operations. MNCs can consider the following
scenarios, and their implications when they establish operations in an overseas market:
The government views them as a threat to the nations independence. This is

especially applicable in situations where MNCs gain control of strategic national
assets or resources such as oil, gas, metals, forests, etc.
The government views them as a threat to domestic firms. In particular, the host
government might be concerned about domestic firms engaged in declining
industries and those in promising industries, that need hand-holding.
The government perceives them to be hiding value, by depressing profits to

reduce tax liability or through transfer pricing policies. Sometimes, the
government may also suspect that the firm is deliberately keeping the best
technology out of the country.
The government perceives them as being socially irresponsible, with no longterm commitment to raising the standard of living of citizens.
Governments usually do a social cost-benefit analysis to examine whether a project is

adding value for the society. They value economic costs and benefits at their
opportunity cost to the society, which may be quite different from the market prices.
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They may also use a different discount rate that reflects the marginal productivity of
capital in the economy. Companies should be aware of the methods used by overseas
governments to appraise projects and rework their strategies suitably. By their actions
and through constant communication with the government and various local
stakeholders, companies can also demonstrate that their goals are consistent with those
of the host country.
DIFFERENT APPROACHES TO DEALING WITH POLITICAL RISK
Like other risks, political risk can be managed using financial techniques such as
insurance or by modifying the operations suitably. Various forms of political risk
insurance are now available. Earlier, political risk insurance cover was available only
from governments in developed countries, through their agencies. A good example is
the US Overseas Private Investment Corporation (OPIC). These agencies had the strong
backing of their national governments. Later, multilateral agencies such as the World
Banks Multilateral Investment Guarantee Agency also began to offer insurance cover.
Now, there are private insurance providers who view political risk as just another kind
of risk and integrate it with a more general commercial assessment of the uncertainties
involved. Political risk management techniques can be aligned with business strategy in
different ways. Involvement of local partners in foreign ventures is one such strategy.
Local partners are more aware of the political situation and can be useful because of
their contacts. McDonalds in India is a good example. Another strategy is to ensure
continued dependence of the country on the MNC for new technology. Yet, another
approach is the use of local debt. In case of confiscation or expropriation, local creditors
are affected. This makes the government think carefully before resorting to extreme
steps. Quite a bit of the debt in the Dabhol power project executed by Enron in India has
been financed by Indian financial institutions.
There are two broad ways of managing political risk Relative bargaining power and
integrative, protective and defensive techniques. In the first approach, the company tries
to dictate terms. A strong bargaining position is achieved when the local government
begins to feel it has more to lose than to gain by taking action against the company.
A good example is the use of proprietary technology. Suzuki has used its gearbox
technology as a powerful weapon in its negotiations with the Indian government. A firm
can use integrative techniques to help the overseas operations become a part of the host
countrys infrastructure. In other words, the firm can attempt to use the social and
economic fabric of the host country, which makes it difficult for the government to
discriminate against it. Local sourcing, joint ventures, local R&D activities, the use of
locals to manage operations and good relations with the local government are all
examples of integrative techniques. Hindustan Lever in India is an outstanding example
of the latter kind. Protective and defensive techniques aim to discourage the government
from interfering in the companys operations or to insulate the firm from potential
interference. Raising capital in the host country, reducing dependence on local
personnel, setting up production networks across countries and limiting R&D efforts in
the host country are all a part of this approach. Dynamic, high technology companies
often rely on protective and defensive techniques. Low or stable technology firms may
depend more on integrative techniques. When the Ispat group entered Kazakhstan, it
took various measures to win the goodwill of both the local political leaders and the
public at large. The manner in which a firm handles political risk ultimately depends on
its technology, management skills, logistics, nature of the industry, and the local
conditions in the host country.
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Another way of categorizing the different approaches to political risk management is

based on Observational data techniques and Expert-based techniques. Observational
data techniques collect data and extrapolate them to make forecasts. Indices can also be
constructed to facilitate cross-country comparisons. The main problem with this method
is that the past may not always be a reliable indication of the future. Expert-based
techniques rely largely on the conceptual and intuitive skills of a group of experts. An
important point is that past and future political instability may not always be positively
correlated. There tends to be a positive relationship between past and future instability
during the early stages of economic development. During the middle stages of
development, there is an inconsistent relationship. During the advanced stages of
development, the relationship is negative. As the gap between economic expectations
and reality increases, political instability also increases. The ability of the government to
control the manner in which people express dissatisfaction with this gap determines the
actual pattern of instability. Political instability may not necessarily create political risk.
Sometimes, major political upheavals, including the replacement of a democracy by an
autocratic leader can actually benefit companies. In general, not all politically
destabilizing events have direct economic relevance to a firm. Also, different firms can
be affected by political events in different ways, depending on their unique mix of
inputs, outputs, goals and strategies.
POLITICAL RISK INSURANCE
Insurance cover is available from multi lateral organizations, governments and privatesector players. The Multinational Investment Guarantee Agency (MIGA) (mentioned
earlier), set up in 1985, covers risks arising from political violence, expropriation,
nationalization, currency inconvertibility and breach of contract. MIGA also acts as a
reinsurer. The US Overseas Private Insurance Corporation (OPIC) has been providing
insurance cover since the second world war. Among the risks it covers are currency
inconvertibility, insurrection and war. The maturity of the policies can be up to 25
years. The US Exim Bank also provides insurance cover. In Europe, agencies like
Exports Credit Guarantee Department (UK), BFCE, COFACE (France) and Trevarbiet
(Germany) offer political risk insurance cover. EU countries have also established the
European Investment Guarantee Agency. Political risk insurance cover in Japan is
limited to Japanese companies. Supported by Ministry of International Trade and
Industry (MITI), political risk insurance has been an integral part of the Japanese
strategy of globalization. In 1997, all the G-7 nations had national insurance agencies
providing political risk cover. Private insurance providers are in general more flexible
but they are also more expensive and typically give covers for periods ranging from one
to three years. Among the leading players in the US are A.I.G, CIGNA, the Chubb
group and Continental. The important private sector insurance providers in Europe
include Lloyds (UK), Skandia (Sweden) and Pohjola (Finland).
SPECIFIC RISKS IN INTERNATIONAL BUSINESS
Kidnapping The annual number of kidnappings worldwide is estimated to be about
22,000. Kidnappings can be for cash or for religious/political reasons. They are usually
well planned. Some of the steps that can be taken to deal with this risk include avoiding
a predictable daily routine, avoiding a high media profile, using security guards,
installing alarm systems in office and residence, using insurance to cover employees,
spouse and children, undergoing a kidnap survival course, taking the help of specialized
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agencies/consulting companies when kidnapping events take place, using professional

counseling to reduce the mental trauma after the victim is released.
Terrorism The statistical probability of a terrorist attack is not very high. However,
terrorists do single out companies for attack, often on the basis of their country of
origin. While terrorist attacks are becoming less frequent, they seem to be causing more
casualties, probably because terrorist attacks these days are typically made by fanatic,
religious bigots, with non-economic motives. Such people are highly motivated to
complete the mission they undertake. They complete the task given to them without
worrying about their own lives. Terrorism may also target business property and disrupt
business activities by aiming at strategic locations. The risks arising due to terrorism
have to be managed according to specific circumstances. Oil companies, for instance,
have been known to fly their employees by helicopters directly to the work sites. In
other cases, armed bodyguards are provided for the employees. Companies must be
vigilant and monitor the methods and tactics of potential attackers. They have to assess
potential threats and put in place appropriate security measures.
Crime Crime can be a big problem in some places. To help expatriates cope with the
problem, a detailed city map showing high-risk areas may be useful. Appropriate
security devices can be installed at the workplace as well as residences. Most travellers
face the highest risk when they arrive fatigued in an unfamiliar city. So, travellers to
unfamiliar locations must be properly briefed and received by a known person at the
airport. Relevant information, both outsourced and internally generated must be
supplied to travellers as a matter of routine to make them familiar with the new place.
Corruption and Bribery In many parts of the world, companies are asked to pay
bribes. Studies by Transparency International (TI), a think-tank based in Berlin, reveal
that requests for bribes have now become widespread. The TI Corruption Perception
Index gives a score of 10 to clean countries and 0 to the most corrupt countries. In 1989,
out of the 99 countries surveyed, 66 scored 5.0 or lower. In the late 1990s, McDonalds
in China had to pay various fees towards river dredging, flower displays on public
holidays and President Jiang Zemins spiritual well-being program. There was no
legislation to this effect city bureaucrats were using their discretion to collect these
fees. In 1994, when Merrill Lynch was appointed the lead underwriter for the global
IPO of the Indonesian state telecommunications giant, Indostat, the agreement stipulated
that Merrill had to share 20% of its worldwide underwriting fees with its joint venture
partner for advisory, management and other related services. Establishing the joint
venture seemed to be a prerequisite for getting the underwriting contract. Bribes can
severely hurt a companys reputation. Once a bribe is paid, people expect the company
to continue to pay bribes in the future. Turning down bribe requests is often a better
strategy. Refusal to pay bribes has to be supported by a strong corporate culture and a
corporate code of conduct. The top management must assure managers that the
company will support them when they refuse to pay a bribe. In India, the Tatas have
built up a formidable reputation for not entertaining bribe requests. Similarly, Texaco
has steadfastly refused to pay bribes. Its vehicles pass through various border crossings
in Africa, without any bribes being sought.
PITFALLS TO BE AVOIDED
Very often, companies take an ad hoc approach to political risk management. They
spend much time and effort dealing with easily identifiable risks, or get distracted by
headline news and do not pay adequate attention to less visible but potentially more
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damaging risks. They lack result-orientation and spend far too much time on issues
where improvements are hard to achieve or where they have little control. Kidnapping,
for example, is a much-exaggerated risk and distorts the country risk out of proportion.
In statistical terms, the probability of a road accident is higher than that of a kidnapping!
But kidnappings are rare and make headline news. So, they make a greater impact.
Weak institutions (like failing legal systems), biased regulatory systems, the
governments inability to provide basic infrastructure or maintain law and order often
create more problems. Prevention is generally better than cure in political risk
management. Reactive strategies result in a lot of time being spent on damage control.
This is usually expensive and demanding, as it involves the use of expensive lawyers
and senior diplomats. Moreover, it is often difficult to undo the damage to ones
reputation once a risk erupts. Companies often do not spend adequate time in
identifying the different stakeholders involved and managing the interaction with them.
The different stakeholders include home-country and host-country governments, local
governments in the host country, and regulators, local communities, labor, NGOs and
shareholders. The rise of the Internet has facilitated speedy dissemination of information
and can bring together disparate activist groups from across the world.
Another pitfall that organizations must avoid is misalignment of management incentives
with the goals of the company as a whole. Country managers may downplay the risk
levels to protect their own turfs. This can be discouraged through suitable performance
appraisal systems. Approaches to political risk management need not be very elaborate.
Indeed, attempts to quantify the risk beyond a point should be avoided. More than
number crunching and model building, building good relations with local governments
and communities through proactive moves is more important. Many managements lay
disproportionate emphasis on country specific factors and wrongly assume that the
profitability of a foreign operation is primarily determined by the socio-political
environment of the host country, i.e., there is a direct correlation between a countrys
destiny and the fate of all foreign investments operating there. In the past two decades,
the scenario has changed, with governments increasingly operating through constraints
and controls on specific companies. Today, sociopolitical vulnerability of a corporation
depends on its ability to depoliticise itself while remaining socially active and
responsive. Sophisticated vulnerability management can help a company avoid being
singled out for punitive action by the host country. Companies should keep their feet
firmly planted on the ground and focus on those issues which can be managed and
which are within their control. Poor socio-political vulnerability management of many
companies is due to their attempts to manage issues that are unmanageable. Examples of
unmanageable issues include stability of the local government, stability of the local
currency and conditions in the local labor markets. In general, country-specific issues
tend to be non-manageable while company-specific issues are manageable.
Political risk analysis is a multi-dimensional task that should consider various political,
economic and socio-cultural factors. In many cases, forecasts have to be necessarily
judgmental. However, intuition should be backed by rigorous analytical techniques
wherever possible. Companies should not cling to old myths about political risk
poorer the country more the risk, or more the disparities in income distribution, more
the risk. The attack on the World Trade Center in New York is clear evidence that even
developed nations are not immune to political risk. Moreover, the tendency to take
business decisions on the basis of first impressions or insignificant events must be
curbed. Executives should not be unduly influenced by periodic swells of optimism and
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pessimism and swing from one extreme to the other when sporadic events such as a
student riot or a political kidnapping takes place. Understanding how economies and
regimes will develop is a difficult, if not impossible, task. Maintaining constant
vigilance, developing scenarios and digesting events as and when they occur, can all
enhance a companys ability to deal with political risk.
21.13 ENTERPRISE RISK MANAGEMENT FRAMEWORK

A key objective of Enterprise Risk Management (ERM) is to ingrain risk management
into the organization culture by making it a core value of the organization and building
it into day-to-day practices. The systems and processes of the organization should
enable managers to know what risks are being taken, quantify them and assess whether
they are within prescribed limits. They should also facilitate corrective action, where
necessary. The various scams and disasters in recent times (including Barings, Orange
County and UBS) have made it clear that general managers cannot let treasurers and
other managers operate merrily without being questioned when they are taking huge
financial decisions. A system of checks and balances is necessary to keep risks within
specified limits. Along with systems and processes, it is also important to shape the
culture of the organization and check dysfunctional tendencies. The right culture
encourages entrepreneurial risk taking but discourages gambling.
ROLE OF THE SENIOR MANAGEMENT
The board and the senior managers need to send strong signals that they consider risk
management a priority. The board should play an active role in identifying the risks that
may have a significant impact on the fulfillment of corporate objectives. It should
review information on these significant risks from time to time. The board should come
to a consensus regarding what risks are acceptable, the probability of their occurrence
and the type of mechanisms and processes needed to reduce their impact. The board
should realize that whatever be the sophistication of the control systems and processes,
risks due to poor judgment, human error and unforeseen circumstances can never be
completely eliminated. It should be emphasized that the role of the board is not to
advocate complete elimination of risk. In a competitive market place, not taking risks
could turn out to be a risk in itself. In fact, if effective risk management processes are in
place, the board may decide that more risks have to be taken to exploit the opportunities
available for the business to succeed in the long run.
The board and the senior management team should play an active role in the following
areas:
Understanding the Risk Profile: The board members should clearly understand the
risks to which the company is exposed. The board should further decide which risks are
acceptable and which must be eliminated through the use of hedging techniques.
Setting Policy: The board should prepare policy guidelines, including the corrective
action to be taken when things go wrong. For example, there should be guidelines on
when and how to unwind an unprofitable position, if rates move unfavorably. The exit
strategy should be based on the amount of money the company is willing to put to risk.
Establishing Controls: Steps should be taken to ensure effective implementation of
policies. An independent risk management unit is desirable. Ideally, risk managers
should not report to traders. It is a good practice to make risk managers report to people
one level higher than those who execute and approve derivative transactions.
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Setting-up Systems: The most expensive but integral part of a comprehensive risk
management function is consolidation and integration of data from a number of
different systems across the companys operations.
Checking Compliance: The risk manager should send reports regularly to the senior
management and the board. These reports should check compliance with policies and
procedures and make independent evaluations of the various derivatives positions. The
reports should also indicate whether the positions are synchronous with the companys
accounting department and with the disclosures in the companys financial reports.
Periodic Review: The board must make it clear to traders and treasury managers that
any violation of policies, guidelines or controls will be punished. When limits are
violated, the board should not hesitate to take immediate action and send clear signals
that indiscipline will not be tolerated.
Aligning Control Systems with Corporate Strategy
Many of the risks that organizations assume are man-made. Fluctuations in the
environment do create uncertainty. But, how to deal with this uncertainty is in the
hands of the organization. Some companies take disproportionate risks in their endeavor
to maximize returns. Enron, which has recently gone bankrupt, is a good example.
Others take fewer risks and are happy with moderate returns. So, it is necessary to
quantify as many parameters as possible and lay down guidelines for employees on the
amount and type of risk they can assume and how they must manage these risks. An
effective management control system provides the necessary checks and balances. A
well-designed organizational structure, effective reporting systems backed by the
requisite IT infrastructure and well thought out compensation and incentive plans are
integral components of a good control system. A .management control system ensures
that there is internal consistency between the companys long-term objectives and dayto-day operations. The starting point in designing the management control system is a
good understanding of the companys strategies. The issues involved are whether the
strategy is internally consistent and consistent with the environment, whether the
strategy is appropriate in view of the available resources involving an acceptable degree
of risk, whether there is an appropriate time horizon for the strategy, and finally whether
the strategy is workable in the given situation. A strategy should be consistent both with
the environment and with the organizational goals and objectives. Strategy formulation
should keep in view the resources available and the risk-taking capabilities of the
management. Appropriate criteria should be developed to assess whether the strategy
will work given the organizational capabilities. Since implementation of strategy
involves commitment of resources, the management should determine the time frame
over which a given strategic choice will have its impact. This is necessary to
understand whether the company has adequate staying power till the strategy is
satisfactorily implemented.
Planning and control play an important role while implementing any strategy. The
management first decides what the organization plans to achieve in a given time period.
This is the planning aspect. Next comes the measurement of what is happening.
Managers have to decide whether the difference between the desired state and actual
state is significant or not. Accordingly, they need to take corrective action, where
necessary. This is the control aspect. Control systems in an organization typically
involve the functions of Planning, Coordination, Information sharing and reporting,
Deciding the action to be taken based on targets and performance, Influencing people,
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changing their behaviour and aligning their goals with those of the organization. Control
systems should align individual and corporate objectives and discourage excessive risk
taking. For example, the annual bonus of a treasurer should not be based solely on the
profits he or she generates. It should take into account the riskiness of the activities
undertaken and the contribution the treasurer has made to non-trading activities.
The collapse of Barings was due to a divergence between individual and corporate
objectives. While on the subject of strategy formulation and implementation, let us note
that an organization has three broad layers, corporate management, divisional
management and operating management. The corporate management is responsible for
the performance of the organization as a whole. The divisional management is
responsible for the performance of geographic regions or product divisions.
The operating management takes care of day-to-day activities and is responsible for the
accomplishment of specific operational tasks. The type of risks each layer has to
manage is different though there may be overlaps.
A management control system will be ineffective without relevant information.
To monitor and control risk, information should be easily accessible. Management
Information Systems (MIS) help in collecting, processing and presenting information to
the management to help take better decisions. A good MIS forms the backbone of any
risk management system. The presentation of the information will depend on the
managerial level at which it will be used and how the information is generated.
Strategic planning relies heavily on external information. Management control largely
uses data generated within the organization. Operational control uses data generated in
the context of specific tasks or activities. Data generated during the process of strategic
planning may not be very accurate, because of the uncertainties involved. Data
generated in the case of management control and operational control is more accurate
and reliable because they relate to events taking place currently or which have taken
place in the immediate past. A good MIS provides both financial and non-financial
information in a user-friendly form, highlighting the critical factors. In general, MIS
generates two types of reports control and information. Control reports focus on the
comparison of actual performance with standard performance. Information reports give
information about the state of affairs at periodic intervals. An effective MIS should be
timely, accurate and relevant. It should provide the right information, in the right place,
at the right time and at a reasonable cost.
Continuous monitoring is necessary to ensure the integrity of risk management controls
and systems. Auditing and testing should be undertaken periodically to check the
robustness of the systems, procedures and controls. Audits are used to set standards and
assess the effectiveness and efficiency of the system in meeting these standards. They
help managers to identify the scope for improvement and act as a reality check by
assessing how organizational processes are working. Sometimes, audits may identify
outdated strategies. A comprehensive audit reviews all the processes associated with
measuring, reporting and managing risk. It verifies the independence and effectiveness
of the risk management function and checks the adequacy of the documentation. Audits
should be held regularly to take into account changes in the circumstances and to
monitor progress. The frequency of audits would depend on how integral it is to the
companys strategy, the time and expenditure involved, etc. Audits can be performed in
various ways surveys, questionnaires, focus groups. Audits however cannot mobilize
people into action. Indeed, in some of the classic failures like Barings and Bhopal,
audit recommendations were not implemented.
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Integrating Risk Management with Structure, Culture and Processes

The focus on risk management needs to be reflected in the organizations structure,
culture and processes. The organizational lines of responsibility and authority need to be
established and communicated clearly. A single point source of responsibility that acts
as a check on risky strategies is desirable. Thus, a Chief Risk Officers (CRO) post
should be created. The CRO should be empowered to impose checks and balances
wherever appropriate. A clear set of corporate objectives and strategies that indicate the
acceptable attitudes to risk taking and the establishment of guidelines within which the
various trading and operating units should function is also a must. Organizational
processes and procedures must be designed according to corporate priorities and goals
rather than regulatory requirements. While they must provide the necessary checks and
balances, they must also empower the staff and facilitate quick but informed decisionmaking instead of entangling them in red tape and bureaucracy. A companys culture is
nothing but the shared beliefs, values and perceptions held by its employees. In a strong
culture, these values and beliefs are shared widely by employees and evoke strong
commitment. Culture facilitates control by developing a sense of group loyalty and by
reducing dissonance. Indeed, self-control through the acceptance of common values
can be a very effective control system. However, strong cultures can also create
problems while managing change. In general, strategy and culture must be consistent.
For businesses to prosper, entrepreneurial risk taking is necessary. Yet, too much risk
taking can lead to a gambling mentality. The right culture ensures that employees do
not put the future of the company at stake in their drive to achieve results. So, when
organizations design reward systems for achievers, they also need to have checks and
balances to monitor the way in which results are being achieved. In cultures, where the
boss knows best and the top management doesnt take bad news or constructive
criticism in the right spirit, things can go seriously wrong all of a sudden. If there is a
tendency to keep looking at employees who report bad news, as troublemakers and poor
team players, problems will remain hidden under the carpet. Over a period of time, such
an attitude will have a significant negative impact. Reputed Fortune 500 companies like
General Motors, Kmart and IBM have all run into problems at some point of time or the
other because of the shoot-the-messenger syndrome. When employees perceive their
career progression as a zero-sum game unintended consequences often result. Poor
information sharing and lack of coordination are quite common in such situations. Not
only that, in their determination to get ahead of their peers, employees may try to improve
their short-term performance by indulging in acts which may harm the company in the
long-run. In some cases, wrong signals sent by the top management result in dysfunctional
decision-making. In the Union Carbide factory in Bhopal, for example, local managers in
their efforts to cut costs in a loss making operation, decided to violate even the most
elementary safety measures.
a.
In which areas, the board and the senior management play an active role?
.
.
.
b.
Explain the importance of Planning and control in implementing any strategy.

.
.
.
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KNOWLEDGE SHARING AND RISK MANAGEMENT

Much of the literature on risk management has focused on strengthening the control
systems and modifying incentive programs. The assumption is that checks and balances
combined with the right incentives will limit risk to manageable proportions. Yet, it is
very often the way the knowledge of an organization is shared between traders and the
senior management that determines a firms capacity to deal with risk. By its very
definition, risk means vulnerability. Especially in the case of financial risk, much of the
vulnerability is due to external fluctuations in commodity prices, interest rates, foreign
exchange rates and so on. A threshold level of knowledge is critical in anticipating and
interpreting these events. Many of the biggest financial disasters in recent times have
been partly, if not completely, due to ineffective knowledge management practices. To
tap knowledge effectively and leverage it for the benefit of the organization, capabilities
have to be built in generating, accessing, transferring, representing and embedding (in
processes, systems and controls) knowledge. In sum, what is needed is an
organizational culture that values, shares and uses knowledge.
Rapid rates of technological obsolescence, globalization, deregulation and increasing
volatility in the financial markets have increased the vulnerability of companies and put
a premium on knowledge. It is not that knowledge does not exist within the
organization. It exists, but within the brains of a few people such as traders and
treasurers. The challenge is to capture this knowledge and make it available to other
employees to facilitate the process of organizational learning. Consider a large MNC.
For its financial risk management practices to be effective, the senior management and
the treasury would need to have shared beliefs about expectations of the future, risk
disposition, riskiness of the hedging strategy employed and the acceptable pay-back
period. In the case of Metallgesellschaft, the German oil refining and trading company,
the headquarters and the US subsidiary were not aware of the different accounting
standards in the two countries. Looking back, a mechanism to share knowledge
between headquarters and the subsidiary, might well have averted the crisis.
Traders gain insights as they operate in the markets and interact with other market
participants. Such knowledge influences their individual decision-making processes.
The challenge for organizations is to capture this knowledge and share it with other
managers in the system, so that they have a reasonably good understanding of what is
going on at the trading desk. An excess of control systems can also produce an illusion
of control, hiding the very real risks that lie in those areas where much that is not
quantifiable or constant must be factored into a decision, in which onus is on good
contextual knowledge to reduce the inevitable ambiguity. A plethora of controls will
not help a trading operation if traders do not share contextual knowledge about their
insights with their managers or if traders operate with assumptions that differ from the
equity holders of the firm. Many of the quantitative models which treasurers and
derivative traders use, incorporate various forms of knowledge. What must be kept in
mind here is that knowledge is not static. It should be frequently upgraded by
questioning the assumptions behind the model as conditions in the environment change.
It is the frontline employees, the traders who first come to know what is happening
outside. So systematic efforts must be made to collect their insights and disseminate it
so that the senior management has a grip on what is happening. The senior management
should also spend some of its time in face-to-face interaction with the traders. This
helps in transfer of implicit knowledge that is difficult to document and transmit in the
form of reports. While a scientific, rational approach to risk management is desirable, it
141
is equally important to understand the behavioral issues involved. Ultimately, it is the

actions of individual managers, which make or break a company. A deep understanding
of the decision-making processes is necessary to put in place the required systems and
processes. Indeed, systems and processes by monitoring risk systematically can actually
facilitate more risk taking. A supportive organizational culture can motivate employees to
take calculated risks but without throwing caution to the winds. Shaping a culture is a
long-drawn-out process but time and effort must be invested to align culture with the
companys long-term strategy. A dysfunctional culture can bring a company to ruin.
THE NEED FOR AN INTEGRATED APPROACH
Finally, we examine the importance of taking an integrated approach to risk
management. Integrated risk management is all about the identification and assessment
of the risks of the company as a whole and formulation and implementation of a
company wide strategy to manage them. In the past, a systematic and integrated
approach to risk management was more an exception than the rule. Fortunately, the
scenario is changing. The cumulative experience of the past decades in managing risks,
development of financial management and probability theories and the availability of a
wide-range of financial instruments have made ERM a reality. ERM combines the best
of three different but complementary approaches. The first is to modify the companys
operations suitably. The second is to reduce debt in the capital structure. The third is to
use insurance or financial instruments like derivatives.
Take the case of environmental risk in a chemical plant. Modifying the companys
operations could mean installation of sophisticated pollution control equipment or using
a totally new environment friendly process. The company could also reduce debt and
keep plenty of reserves to deal with any contingencies arising out of environmental
mishaps. Exxon got away with the Valdez spill because it had enough financial
resources to cope with an adverse situation. A third alternative is to buy an insurance
policy that would protect it in case an accident occurs and big compensation payments
have to be made to victims. Taking an insurance cover is simple, but it implies a
minimalist, defensive approach. On the other hand, tailoring the operations creates
possibilities for process innovations and more sustainable competitive advantages by
getting ahead of other players in the industry. Consider an oil company that needs a
steady supply of petroleum crude to feed its refineries. Oil prices can fluctuate, owing
to various social, economic and political factors. The company can set up a large
number of oil fields all over the world to insulate itself from volatility. This would limit
the damage that can be caused by OPEC, terrorist strikes or instability in Islamic
countries. If there is a long recession, the best bet for the company would be to keep
minimum debt and maintain huge cash reserves on the balance sheet. The company may
also resort to buying oil futures contracts that guarantee the supply of oil at
predetermined prices. A company like Walt Disney that operates theme parks is
exposed to weather risks. If weather is not sunny, people will not turn up. So, Disney
took the decision to set up a theme park in Florida. Today, Disney can buy weather
derivatives or an insurance policy to hedge the risks arising from inclement weather.
The software giant, Microsoft manages its risk by maintaining low overheads and zero
debt. But Microsoft also has organizational mechanisms to deal with risk. The capacity
of a software company can be defined as the number of software engineers on its pay
rolls. Excess capacity can create serious problems during a downturn. So, Microsoft
believes in maintaining a lean staff. It depends on temporary workers to deal with
surges in workload from time to time. This not only reduces the risk associated with
economic slowdowns but also results in greater job security to its smaller group of
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talented, permanent workers. An airline can manage its exposure to fluctuating oil
prices by taking operational measures to cut fuel consumption. It can also purchase
more fuel-efficient engines. It can also buy financial instruments such as futures to
hedge this risk.
Various factors determine the choice of the approach organizational, financial and
modification of the capital structure. Often a combination of these approaches makes
sense. The choice between a financial and organizational solution depends on the
specific risk. Strategic risks for example, invariably need organizational solutions.
These are the risks that Drucker describes as unavoidable risks. Such risks are built into
the very nature of the business. But, in many other situations, financial solutions such as
derivatives or insurance may be more efficient than organizational solutions. One way
to resolve this dilemma is to estimate the amount of capital to be set aside to deal with a
risk. This can be compared with the costs involved in transferring the risk such as
insurance premium or option premium. Financial solutions are often useful when
enough data is available to analyze, model and evaluate the event. Operational
approaches to risk management are difficult and complicated in some situations. They
may be too complicated, too expensive or may conflict with the companys strategic
goals. By using financial instruments, companies may be able to focus on specific risks
and hedge them at a lower cost. Unfortunately, financial instruments are not available
for some types of risk, especially those that are difficult to transfer. Also, they are only
suited for risks, which can be clearly, identified and quantified. The ultimate strategy for
the rainy day is to keep overheads and debt low and hold lots of cash to tide over
uncertainties about which managers have little idea today. Indeed, equity is an all
purpose risk cushion. The larger the amount of risk that cannot be accurately measured
or quantified, the larger the equity component should be. Of course, lower risk through
use of more equity also implies lower returns, as equity is a more expensive source of
funds. This trade-off should always be kept in mind.
The challenge for companies lies in taking an integrated view of the three different
approaches. Indeed, one approach if implemented can have an impact on the other two.
For example, the debt employed by a company depends on its capital expenditures,
which in turn may depend on the companys diversification plans. Similarly, crossbusiness risks should not be overlooked. In 1988, Salomon Brothers unsuccessful
attempt to takeover R J R Nabisco changed its risk profile adversely. This had a
negative impact on Salomons derivatives business. Company wide integration of risk
management activities also enables the purchase of more cost effective insurance and
derivative contracts. In 1997, Honeywell purchased an insurance contract that covered
various types of risks property, casualty, foreign exchange, etc. Honeywell cut its
insurance costs by 15% in the process. Aggregate risk protection not only costs less
than individual risk coverage but also is usually better suited to the companys risk
management needs. Integrating risk management activities implies a single way of
speaking about risk across the organization. This means arriving at a standard definition
of risk for the entire firm. In the years to come, finance professionals will have to learn
to work with business units as partners and capture both the hard financials and the
strategic intent of any project.
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HOW DIFFERENT RISKS INTERACT WITH EACH OTHER

An attempt to control one type of risk often has an impact on other types of risk. Let us
understand the dynamic interaction of different risks, through examples.
Consider environmental risk management. One way to mitigate environmental risk is
self-regulation. Companies come together, set standards and commit themselves to the
implementation of these standards. This is meant to pre-empt government legislation
and avoid the problems associated with government interference in business operations.
But self-regulation involves agreement and co-operation among rivals and may attract
anti-trust concerns. So, care should be taken to ensure that self-regulation is perceived
to be promoting consumer welfare and serving the public interest. Most importantly, the
companies involved should effectively communicate the benefits associated with their
self-regulation initiatives to the public and the government. Anti-trust and technology
risks are closely related. In technology driven industries, the adoption of standards is a
very important activity. Indeed, standards are meant to reduce risk for both suppliers
and users by organizing and disseminating information and facilitating the compatibility
of products and services in the market. Development of standards, involves firms
coming together and cooperating. To avoid anti-trust attention, companies would do
well to keep records of the deliberation process. They should make the standard as
broad-based as possible by involving many players. They must also make the standards
more performance-based than design-based. By linking standards to performance,
companies can send clear signals that the customers interests are at the heart of the new
initiative and any product or process innovation in this direction will be encouraged.
There is a strong linkage between vertical integration and technology management.
Vertical integration may reduce risk by developing internal capabilities and retaining
proprietary information. However, in the process, access to a specialized suppliers
technology may be lost. On the other hand, a decision to outsource may result in a high
degree of vulnerability because of excessive dependence on the supplier for an
important technology. Thus, vertical integration and technology risks are interrelated.
Technology and legal risks often go together. Technology companies often need strong
competencies in legal matters, especially patents. Microsofts technological capabilities
are well known. Yet, it was a legal innovation, which marked the turning point for
Microsoft. When IBM asked Microsoft to develop the operating system for its PC,
Microsoft retained ownership of the Disk Operating System (DOS) and insisted on
licensing rather than outright sale. When it comes to patents, technology and legal
issues are closely linked. Even if a company were good at innovating and developing
new technologies, without a well thought-out patent strategy, it would find it extremely
difficult to commercialize its inventions. So, a fundamental understanding of the legal
issues associated with intellectual property rights, is a must for companies, whose
competitive advantage depends on technological innovations. Branding and ethical risks
are closely connected. A brand which misleads customers, or which plays on the
emotions of gullible customers is perceived to be unethical. Brand managers have to
take special care to ensure that their actions, such as advertising campaigns are
perceived to be socially responsible and in the interests of customers. Similarly,
outsourcing and ethical issues have a strong overlap, especially in the case of premium
brands. Nike is a good example.
In many Mergers and Acquisitions (M&A), legal and human resources risks are
involved. Anti-trust authorities may put the deal under a microscope and impose
various conditions that may seriously undermine the projected synergies. In extreme
144
cases, they may even block the deal. This is exactly what happened in the case of GE
and Honeywell. Similarly, many mergers fail because of a poor strategy for retaining
key employees. Especially, in the case of high tech mergers, retaining key employees is
a strategic challenge. Hence, such mergers should be planned and implemented with a
very strong people orientation. There is a very strong overlap between technology and
M&A risks. In technology driven businesses, many large companies do not do all the
research in-house. They use their large market capitalization to acquire smaller, more
innovative companies. In the late 1990s, Lucent acquired several independent firms for
their bright ideas. Indeed, some industry experts, including Marc Andreassen, the
founder of Netscape, have argued that innovations in the contemporary business
environment, happen only in small start-up firms, which are then systematically
acquired by dominant companies (Netscape itself was acquired by AOL). While this
makes sense, it also implies that technology companies need to have strong capabilities
in managing acquisitions. A wrong acquisition will send money down the drain.
A good example is AT&Ts acquisition of NCR. Similarly, a right acquisition, if not
well managed may fail to generate the returns expected. Managing the integration
process, is one of Ciscos core competencies today and indeed one of the main reasons
for its technological strengths. For technology companies, managing reputation risk
through sound disclosures is also critical. Many of these companies are characterized by
high market capitalization based on expectations rather than tangible financial
performance. So, they need to communicate clearly with their shareholders and the
financial community in which direction technology is moving and what they are doing
about it. Otherwise, stock prices may plummet. This would be a real setback because
the acquisitions made by such companies are facilitated by their high market
capitalization. Companies like AOL and Cisco have mastered the art of keeping
financial analysts happy by sharing information regularly, in a transparent manner.
Environmental and political risks are also closely related. Inadequate attention to
environmental issues often invites government intervention. This can lead to closure or
even confiscation of assets in extreme cases. On the other hand, a systematic, proactive
approach can keep the government away. This argument is especially valid in the case
of industries, such as mining, which governments consider strategic. There is no better
example than Tata Steel in this regard. The company mines iron ore in parts of Orissa
and Bihar. Its management of environmental and safety issues has been exemplary and
even at the height of Indian socialism, no government dared interfere, leave alone
nationalize these operations in a country where mining has been traditionally considered
a strategic industry. Political and ethical risks are also closely connected. Issues like
bribery have strong ethical implications. To manage political risks, it is often tempting
to use such unethical means. This is not desirable, as mentioned earlier. Similarly, a
company may think it makes good business sense to keep the host country dependent on
it for technology. But if this is perceived to be socially irresponsible, the government
can put several stumbling blocks.
A failure to understand the interaction of risks can lead to serious problems. Bankers
Trust, in the mid 1990s, decided to reward its sales staff using a formula that took into
account both the profits generated and the market risk taken. This resulted in damaged
client relationships, a major legal dispute with Procter & Gamble and negative
publicity. Similarly, many banks gave dollar denominated loans on floating rate terms
to countries like Mexico and Brazil to eliminate both exchange rate and interest rate
risk. When US interest rates skyrocketed and the dollar appreciated in the early 1980s,
145
there were major defaults. In short, market risk had been transformed into credit risk. It
is precisely because attempts to control one type of risk may result in other type of risk,
that the need for Enterprise Risk Management has become compelling.
IMPLEMENTING ERM
The transition from piecemeal management of risks to ERM involves considerable
investment of time and money. Some of the important obstacles to the implementation
of ERM include lack of alignment between risk management and planning processes,
lack of role clarity, distortions in information flows and inadequate understanding of the
benefits of ERM. To put in place a successful ERM system, companies have to integrate
it with the planning process, build support for the concept across the organization and
appoint the right champions. ERM should be tightly integrated with capital allocation,
corporate strategic planning and business unit strategic planning. Where possible, it
should also be integrated with functions like product design, human resources and other
less strategic but nevertheless important managerial processes. To build support for
ERM, companies must demonstrate that it creates value, minimizes bureaucracy by
keeping the processes simple and strikes a balance between local and central control. A
suitable organizational structure is vital for implementing ERM. Making the existing
head of risk management or the CFO, Champion of the ERM initiative is not always
appropriate. Many companies are looking at a new post, the Chief Risk Officer (CRO)
who can discharge functions such as informing the board about the major risks, framing
ERM implementation strategies, overseeing risk reporting and monitoring and
educating people about risk management. Alternately, a committee consisting of top
managers can be used to spearhead the ERM initiative. The CRO need not necessarily
be a new hire. In many cases, a senior manager can be given this additional charge.
Designating a specific individual as CRO removes ambiguity about where the ultimate
responsibility for stopping risky transactions those are against the interests of
shareholders lies. He or she should hold single point responsibility while managing a
crisis. The CRO should be fully aware of the risk tolerances and the risk management
objectives of the board and the nature of risk exposures faced by the firm. The CRO
should obviously be separated from functions where risk taking is involved. Preferably,
the CRO should be reporting to the board and not to the CFO. Irrespective of who is
appointed as the CRO, one thing is for sure. The CRO must balance a short-term trading
mindset with a long-term strategic orientation. In other words, he must be conversant with
the languages of both trading and strategy. Though, on the one hand, the ultimate
responsibility for risk management lies with the CEO, the CEO should not find himself
reduced to an operating manager. The CEO also cannot afford to get involved in all the
operational issues. So he has to necessarily depend on the skills of the CRO to balance the
long term and short-term perspectives while managing risk. An independent risk
management function facilitates the development and ongoing improvement of models,
systems, and processes used to quantify risks. It ensures that risk management policies and
procedures are consistently applied across all the units in the corporation. It also plays a
policing role to check that policies are being implemented effectively. And it helps in
taking an aggregate view of the different exposures held by the organization.
Senior management involvement is a must while implementing ERM. Since an
integrated approach to risk management requires a thorough understanding of the
companys operations as well as its financial policies, risk management is clearly the
responsibility of senior managers. It cannot be delegated to derivatives experts nor can
management of each individual risk be delegated to separate business units. Although
146
management will no doubt seek counsel from managers of business units or projects, it
must ultimately decide which risks are essential to the profitability of the company,
taking into account cross-risk and cross-business effects and develop a strategy for
managing those risks. It is a good idea to conduct a senior management workshop that
can develop a plan for implementing ERM. The workshop can deal with important
issues such as business strategies of the firm, current state of risk management in the
organization, the objectives of the proposed ERM system, and difficulties in
implementing ERM given the organizational culture and the best practices in ERM.
The workshop can go a long way in arriving at uniform risk management terminology
across the organization and in developing a vision for the ERM initiative. All risks can
be traced to decisions taken by an individual or by a group of individuals. Typically,
the person who manages the risk is different from the owner. So, in the normal course,
the risk owner is totally excluded from the risk management process. This is hardly a
desirable situation. So, business unit managers who are typically the risk owners need to
be involved in the risk management process. The extent of involvement depends on how
the risk is being managed, whether it is being transferred to another party or retained inhouse and dealt with operationally.
ERM is still an evolving subject. The difficulties in implementing ERM should not be
underestimated. To be effective, ERM should be strategic rather than tactical in its
orientation. A tactical orientation means that the objectives are limited, typically
involving hedging of explicit future commitments. A strategic approach looks at how
the company as a whole and its competitive position within the industry will be affected
by the risk management processes selected. An integrated approach requires an overall
understanding of the companys operations as well as its financial policies.
Consequently, it views ERM as the responsibility of senior managers and does not
allow it to be delegated to the treasury desk or individual businesses. Risk management
needs to be integrated with corporate strategy. The challenge for CEOs is to understand
the various risks their organizations face and get involved in the management of these
risks instead of abdicating the responsibility to operating managers.
21.14 SUMMARY
Enterprise Risk Management (ERM) can be considered to be a logical extension of
corporate risk management. It speaks about some of the advanced areas of risk
management, such as technology risk, anti-trust risk, environment risk, political risk,
etc. Basically the unit deals with the holistic framework of risk management that an
organization needs to consider in turbulent times.
21.15 GLOSSARY
Systematic Risk is the possibility of the fluctuation of the market price of a financial
asset in comparison to that of the movement of the market of that type of assets in general.
Swap is the agreement through which a series of exchanges of periodic payments (both
Sovereign Risk is the chance that a government may bar an issuer of equity or debt
instrument to repatriate dividend or interest to any foreign country.
Price Risk is a financial risk sustained by a company due to the fluctuations of the
prices of the physical or financial assets, products or liabilities.
Environmental Risk is the possibility of harm to people and the environment owing to
human activities.
147
Aswath Damodaran. Investment Valuation, 2002 by John Wiley & Sons, Inc.
Donald De Pamphillis. Mergers, Acquisitions and other Restructuring Activities,

2001 by Academic Press
Frank C. Evans, David M. Bishop. Valuation for M&A Building Value in

Private Companies, 2001 by John Wiley and Sons, Inc.

a.
Political risk arises from the possibility that political decisions or events may
adversely affect a companys profitability. It covers actions of governments that
interfere with business transactions resulting in loss of profit potential.
In extreme cases, political risk results in confiscation of property. The more
common scenario is one in which government imposes constraints on the conduct
of business. Enron has encountered various problems since its entry into India.
b.
To commercialize an idea successfully, a number of different stages must be

completed, each more difficult than its predecessor. Not only must each of these
stages be completed successfully, but also adequate resources be mobilized to
facilitate transition from one stage to the next.
Imagining: Developing the initial insight about the market opportunity

for a particular technical development.
Incubating: Nurturing the technology sufficiently to gauge whether it can

be commercialized.
Demonstrating: Building prototypes and getting feedback from potential

investors and customers.
Promoting: Persuading the market to adopt the innovation.
Sustaining: Ensuring that the product or process has a long life in the
market.
a.
Interest rate risk arises when the income of a company is sensitive to interest rate
fluctuations. Consider a company that is going to need funds, after a few months.
If interest rates go up in the intervening period, the firm will be at a
disadvantage. Similarly, if the company is going to have surplus funds a couple
of months from now and interest rates fall, the firm will incur a loss.
b.
Steps in Financial Risk Management

Four steps are involved in financial risk management:
148
Identification of risks.
Quantification of risks.
Framing of policies to transform the risk into a form, with which the
company is comfortable.
Implementation and control.
a.
b.
The board and the senior management team should play an active role in the
following areas:
Understanding the Risk Profile
Setting Policy
Establishing Controls
Setting-up Systems
Checking Compliance
Periodic Review.
Planning and control play an important role while implementing any strategy.
The management first decides what the organization plans to achieve in a given
time period. This is the planning aspect. Next comes the measurement of what is
happening. Managers have to decide whether the difference between the desired
state and actual state is significant or not. Accordingly, they need to take
corrective action, where necessary. This is the control aspect.

A. Multiple Choice
1.
2.
The aim of risk management is to _______________.

a.
Maintain unsystematic risk at the desired level
b.
Maintain systematic risk at the desired level
c.
Cost to be kept minimum
d.
Both (a) and (c) above
e.
Both (b) and (c) above.
Risk includes ________________.

a.
3.
4.
Upside potentials
b.
Downside movement
c.
Certain losses
d.
Both (a) and (b) above
e.
All of the above.
Which of the following is a primary risk?

a.
Regulatory risk.
b.
Interest rate risk.
c.
Counterparty risk.
d.
Inflationary risk.
e.
None of the above.
The manner in which a firm handles political risk ultimately depends on its ____.
a.
technology.
b.
management skills.
c.
logistics.
d.
nature of the industry.
e.
All the above

149
5.
Asset-liability management can be used to manage

a.
Exchange risk
b.
Interest rate risk
c.
Default risk
d.
Liquidity risk
e.
Only (a), (b) and (d) of the above.
B. Descriptive
1.
Define risk Management. What are the features of enterprise-wide risk

management?
2.
What is the importance of Environmental Risk Management?
3.
What are the factors to be considered by MNCs to evaluate political risk?
practice only.
150
NOTES
151
NOTES
152

Block
Unit
Nos.
Unit Title
INTRODUCTION TO STRATEGIC FINANCIAL
MANAGEMENT
1.
Strategic Financial Management: An Overview
2.
Firms Environment, Governance and Strategy
3.
Valuing Real Assets in the Presence of Risk
4.
Real Options
II
STRATEGIC CAPITAL STRUCTURE

5.
Capital Structure
6.
Dividend Policy
7.
Allocating Capital and Corporate Strategy
8.
Financial Distress and Restructuring
III
STRATEGIC ENVIRONMENT ANALYSIS

9.
Industry Analysis, Financial Policies and Strategies
10.
Information Asymmetry and the Markets for Corporate

Securities
11.
Managerial Incentives
12.
Decision Support Models
IV
CORPORATE ACCOUNTING AND BUSINESS

STRATEGY
13.
Financial Statement Analysis
14.
Inflation Accounting
15.
Working Capital Management
16.
Strategic Cost Management

17.
18.
Risk Management and Corporate Strategy
19.
Organization Architecture, Risk Management, and

Security Design
20.
21.

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Strategic Financial Management

Dr. Lata Chakravorty

Prof. P. Bala Bhaskaran

Dr. Dhananjay Keskar

Course Preparation Team

Prof. Hilda Amalraj

Prof. Bratati Ray

Dr. Vijaya Lakshmi S

Dr. Vunyale Narender

Ms. Sunitha Suresh

Prof. Arup Chowdhury

The ICFAI University Press, All rights reserved.

The ICFAI University Press, Hyderabad

STRATEGIC RISK MANAGEMENT

UNIT 17 CORPORATE RISK

Approaches to Risk Management

The Process of Risk Management

Techniques of Risk Management

Guidelines for Risk Management

Understand the meaning of risk;

Know the sources of risk;

Identify the approaches to risk management;

Explain the techniques of risk management; and

Learn the guidelines for risk management.

Strategic Financial Management

17.3 MEANING OF RISK

Corporate Risk Management

17.4 SOURCES OF RISK

Strategic Financial Management

Corporate Risk Management

Strategic Financial Management

What is meant by Liquidity risk?

How do you define risk management?

17.5 APPROACHES TO RISK MANAGEMENT

Corporate Risk Management

Strategic Financial Management

17.6 THE PROCESS OF RISK MANAGEMENT

Corporate Risk Management

Figure 1: Normal Distribution of Security

Strategic Financial Management

Corporate Risk Management

17.7 TECHNIQUES OF RISK MANAGEMENT

Strategic Financial Management

Corporate Risk Management

How does combination be termed as an approach to risk management?

What is meant by Value at Risk?

17.8 GUIDELINES FOR RISK MANAGEMENT

Strategic Financial Management

Corporate Risk Management

17.11 SUGGESTED READINGS/REFERENCE MATERIAL

Donald De Pamphillis. Mergers, Acquisitions and other Restructuring Activities.

17.12 SUGGESTED ANSWERS

Risk Management: is the logical development and execution of a plan to deal

Combination refers to the technique of combining more than one business

Strategic Financial Management

Value at Risk is an estimate of the level of loss on a portfolio which is expected

17.13 TERMINAL QUESTIONS

Which of the following statements defines risk?

Possibility of actual outcome being different from the expected outcome.

There are a number of specific, probable outcomes, but it is not certain as

There are a number of probable outcomes, the outcomes being unknown

Only (a) of the above.

Both (a) and (b) of the above.