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Managing business risks.

ORGANIZATIONS ARE SUBJECT to economy-wide influences as well as to firm-specific risks. Recent developments in managing financial risks apply to nonfinancial as well as to financial firms. This paper will cover: (1) the nature and impacts of business risks; (2) innovative development of instruments and institutions for managing business risks including forwards, futures, swaps, options, and portfolio insurance; (3) their potentials and pitfalls; and (4) implications for business economists.

NATURE AND IMPACTS OF BUSINESS RISKS

The distinction between systematic and unsystematic risks is generally recognized. Systematic risks stem from economy-wide influences, such as unexpected changes in the level of business activity, unexpected inflation, unexpected changes in the levels of interest rates and in the slope of the yield curves. Unsystematic risks vary across industries and firms, reflecting the quality of management, organization efficiency, strategic, operating and financial policies and decisions.

Non financial (industrial) as well as financial companies face both kinds of risks -- economy or industry influences as well as risks related to the activities of the individual firm. Nonfinancial companies have operating risks; they are also influenced by financial risks, both directly because they hold financial assets and financial liabilities but also indirectly from impacts of financial developments on their costs, selling prices, and competitive interactions.

Financial institutions face operating (mangement and credit risks) as well as financial risks such as interest rate risk. Also different industries have different degrees of sensitivities to changes in the level of business activity, interest rate levels, foreign exchange rates, general price level changes, real estate prices, precious metals prices, other commodity prices, etc.

RISK PROFILES AND FINANCIAL ENGINEERING

A long position in an asset gains if its price goes up; a short position in an asset gains if its price goes down. Fixed rate financial assets rise in value with falling interest rates and fall in value with rising interest rates. Positions in financial assets can be hedged by the use of futures and forward markets and by the use of derivative securities such as options, swaps, synthetic securities, and other many new financial instruments created during the past decade [Cox and Rubinstein, 1985; Smith, Smithson, and Wilford, 1990; also references cited therein]. Firms that borrow long-term versus those that borrow short-term have different types of interest rate exposures. These can be hedged by the use of a number of financial instruments. A firm is long in the goods it sells and short in the goods it buys. These exposures can be managed by the use of forward and futures commodity contracts.

A domestic firm has a long position with respect to sales in foreign currencies and short with regard to purchases in foreign currencies; or a firm in a net creditor position with regard to foreign currencies is long in foreign currencies and, when a net debtor in foreign currencies, is in a short position. Foreign exchange risks can be hedged by the use of offsetting transactions in sales and purchase markets, by the use of the forward and futures foreign exchange markets, and by borrowing, lending, and investment activities in domestic versus foreign markets. With this overview as a flamework, specific risk management techniques are next described.

Managing Interest Rate Exposure

Interest rate risk can be analyzed in terms of interest rate movements or their reciprocal in bond price movements. Figure 1 presents a picture for interest rate exposure. The risk profile in the upper panel shows that a long position in fixed rate bonds as a creditor or as owner of bonds has a negatively sloped risk profile with respect to interest rate changes. A short position in fixed rate bonds as an issuer or seller-debtor in bonds has a positive risk profile with respect to interest rate increases.

Offsetting payoff profiles are shown in the lower panel of Figure 1. To offset the negative risk profile for a long position in fixed rate bonds, a number of equivalent actions may be taken. These include: buy a forward contract on interest rates, sell bond futures, take on more debt; or use a swap: pay fixed/ receive floating rates. To avoid the risk of declines in value resulting from falling interest rates with a short position in fixed rate bonds, the opposite actions are taken. These include: sell a forward contract on interest rates, buy bond futures, reduce debt; or swap: pay floating/receive fixed interest rate payments.

The literature demonstrates that forward, futures, and swap contracts are equivalent in their payoff profiles, but have different costs and risks themselves. Different selling, purchasing, borrowing, lending, and/or investment patterns can achieve payoff profiles equivalent to those produced by forward, futures, and swap contracts.

Managing Risky Asset Exposure

Figure 2 analyzes the nature of risky asset price exposures. The risk profile is positively sloped for a long position in risky assets or risky securities. It is negatively sloped with respect to price changes for a short position. The offsetting risk profiles for a long position in risky assets are to sell forwards or futures contracts, increase short positions in assets, short a call plus long a put, or increase the ratio of riskless to risky assets. The offsetting payoff profiles for a short position in risky assets or risky securities is: buy forwards or futures, increase long positions in assets, long a call plus short a put, or increase the ratio of risky assets to riskless assets.

In Figure 2, call and put options are combined to achieve the same payoff profiles as forwards or futures contracts. In Figure 3, the payoff profiles for individual options are further analyzed. Long a call is equivalent to holding a risky security with downside risk limited to the price of the call, as shown in Panel (A). In Panel (B), selling a naked call has a position that magnifies the risk of a short position in the risky security for a rise in prices, but for a fall in prices provides a buffer represented by the price for which the call was sold. In Panel (C), a long position in a put yields gains with a decline in prices and thus offsets the risks of a long position in risky securities. It is also equivalent to being short a stock plus long a call. In Panel (D), writing a put (short a put) has the same risk profile as a long position in risky securities for price declines. This position is equivalent to a long position in securities for a decline in price with a gain equal to long a stock plus shorting a call.

Put-Call Parity

A generalized pattern for the relationship between risky assets, riskless assets, and options is conveyed by the put-call parity relationship (for a compact derivation see Cox and Rubinstein, pp. 41-42).

So + Po - Co = Bo (1)

Put-call parity shows how synthetic securities can be created. A riskless security (Bo) can be achieved by long positions in a stock and put combined with a short position in a call. Equation (1) can be rearranged to illuminate other groups of relationships. Equation (la) shows that a long position in a risky stock plus a short position in a riskless bond (selling a bond) is equivalent to being long a call and short a put.

So - Bo = Co - Po (la)

The relationship is depicted in Panel (A) of Figure 4. It represents the same risk or payoff profile as a long position in a risky asset or buying a forward or futures contract or swap. Multiply both sides of Equation (la) by - 1, to obtain Equation (lb), which states that a long position in a riskless bond plus a short position in a risky stock is equivalent to being short a call plus long a put as depicted in Panel (B) of Figure 4.

Bo - So = Po - Co (lb)

This is the payoff profile of a short position in a risky asset or stock or selling a forward, futures, or swap contract. Other forms of risk management may also be employed.

Static and Dynamic Hedging

A hedge is created by investing in (or selling) securities that are related to a particular risk exposure. If the value of a portfolio declines with higher interest rates (fixed rate bonds), a hedge would call for holding another portfolio whose price increases with the rise in interest rates (short fixed rate bond futures). A fixed or static hedge ratio works only when the inverse relationship between the hedge asset and the risk being hedged remains stable. In practice, this usually requires that the relationship (basis) between spot and future prices does not change.

If the prices or returns of the risk-exposed assets change relative to the hedge asset, the hedge ratio must be adjusted. An example of dynamic hedging is portfolio insurance. In portfolio insurance, a risky asset is combined with a riskless asset or with put options whose ratios are adjusted continuously to move toward a desired target portfolio value. [For simple numerical illustrations see Alexander and Sharpe, 1989, pp. 583-586].

Duration Analysis

Duration analysis also represents a form of dynamic hedging. Duration was developed to measure bond price sensitivity (elasticity) -- the percentage change in the value of a bond (or portfolio) related to the percentage change in market yield levels. The calculation of duration is the weighted average (in years) of the times at which the present values of payments generated by a bond are received. As an elasticity measure, duration has a negative sign because bond prices move inversely to interest rate levels. However, the absolute value of the elasticity measure is precisely the duration of the bond in years (for numerical illustrations see Weston and Copeland, 1992).

When the durations of assets and of liabilities are equal, the duration of equity is zero -- the value of a firm or portfolio is unchanged by changes in market yields. If the duration of equity is high, the value of a firm or portfolio will be highly sensitive to interest rate changes. Duration measures have been applied to the analysis of bank balance sheets and weighted by estimates of riskiness in a 1991 Federal Reserve Bulletin paper [Houpt and Embersit]. Continuous adjustment of assset and liability durations can be used to immunize the value of the equity from interest rate level changes. Contingent immunization represents an active portfolio management strategy that uses expectations about future changes in yields to manage the sensitivity of the value of the firm (or portfolio) to changes in interest rate levels.

POTENTIALS AND PITFALLS

These recent developments in financial engineering have been widely employed [Smith and Smithson, 1990]. What do we learn from their applications and actual use? These hedging instruments are a form of insurance. If successful, at a cost they reduce the volatility or variance of fluctuations in accounting measures of profitability or in returns to shareholders. But the use of financial hedging instruments cannot substitute for effective strategic and operating management. Financial engineering can contribute to the performance of a company, but it cannot substitute for the efficiency of its fundamental business operations and management.

Exchange rate movements can severely affect a firm's revenues and profits. It is useful to use hedging instruments to neutralize their impact. But financial hedging alone cannot make U.S. industries such as automobiles competitive with its foreign rivals. Even in financial industries the use of financial risks cannot substitute for good management and sound analysis of credit risks. Interest rate movements can produce substantial losses for financial institutions. The secondary effects can be even more serious. Losses from adverse interest rate movements have caused financial institutions to take on greater credit risks in the attempt to offset adverse developments in interest rate relationships. But as a Federal Reserve study concludes, "the more than 1,200 bank failures in the past decade demonstrate that the principal risk to commercial banks is credit risk" (which means quality of management as weld [Houpt and Embersit, 1991, p. 628].

Limitations

The fascination with developing complex sophisticated hedge and arbitrage models can actually be costly to financial institutions. The models typically make implicit forecasts about movements in the yield curve (its level and its slope), in volatilities of prices and returns and in the risk premiums the market requires for differences in risk levels. These problems are complicated by the implicit options in both assets and liabilities held by financial institutions. Assets such as fixed rate mortgages contain implicit options to prepay. The rate of prepayment is difficult to predict because it is sensitive to movements in interest rate levels. Examples can be cited of financial hedges that aggravated credit risk problems of S&Ls and commercial banks. [See a number of case studies in Charles McCoy, "Many Big S&L Losses Turn Out to be Due to a Financial Gamble: 'Risk-Controlled Arbitrage' was Sold by Wall Street and Backed by Regulators," Wall Street Journal, August 9, 1991, pp. Al, 8.]

Natural Hedges

Alternative management strategies and policies can substitute for the use of derivative securities in managing risks. One is adjusting patterns of revenue and payments streams. For example, some firms were hedging both purchases from abroad and sales abroad by using forward contracts in the foreign exchange markets. These costs were avoided when it was recognized that offsetting patterns of purchases and sales abroad among different currencies could substitute for the use of financial hedging operations [J. Fuerbringer, "Learning to Dance with a Bouncy Dollar," New York Times, September 8, 1981, Section 3, pp. 1, 6].

Natural hedges can also be constructed by altering country patterns of sales and sourcing. Other characteristics of revenue and cost flows can be adjusted - fixed versus variable costs, for example. Or investment and financing policies can change assets versus liability patterns. A debtor (creditor) firm gains (loses) from unanticipated inflation. A debtor (creditor) with regard to foreign currency obligations benefits (loses) if the foreign currency falls in value.

A U.S. firm with foreign sales may build some manufacturing facilities abroad to protect against a rising value of the dollar. Its U.S. facilities are helped by a declining value of the dollar; its offshore facilities are helped by a rising value of the dollar. This is another "natural hedge" in that one risk profile is offset by an opposite payoff profile. Such on-balance sheet risk management is inappropriately criticized when only one part of the hedge is evaluated. A declining dollar may negatively impact foreign production facilities, but that is only part of the analysis.

The use of (off-balance sheet) financial instruments can be combined with the use of naturalhedges or on-balance sheet transactions, some of which involve high costs and inflexibility. But financial hedges may not cover all requirements of a firm. For example, forward or futures currency contracts are available for only relatively few countries and their maturities do not cover long-term investments.

IMPLICATIONS FOR BUSINESS ECONOMISTS

A leading treatise on managing financial risk states, "Because forecasting cannot be relied upon to eliminate risk, the remaining alternative is to manage the risks" [Smith, Smithson, and Wilford, 1990, p. 44]. A literal translation of this statement is that because business economists cannot forecast, instruments such as forwards, futures, swaps, and options must be called upon to manage risk. But the work of the business economist is not simply to forecast. Business economists seek to assist organizations in dealing with instabilities and uncertainty by analyzing and understanding the implications of government policies, consumer and business behavior. Business economists seek to help organizations manage risks, assisting firms to position themselves to anticipate and realign policies in changing economic, political, and cultural environments.

The roles of business economists and financial risk managers are complementary. Illustrative is the development of the Arbitrage Pricing Model [APT] in financial analysis [Ross, 1976; Roll and Ross, 1980]. The APT holds that the returns on risky assets are not fully explained by a single factor such as returns on the market or movements in GDP. APT points to the role of other variables such as inflation rates, unemployment rates, twists in the yield curve, shifts in yields on less risky versus more risky assets. Other candidates would include shifts in the price of commodities such as oil, precious metals, etc.

Business economists and investment advisors have long studied the impact of APT-type macroeconomic variables on the economic position of business firms and on investment return patterns. APT represents a formal model that seeks to measure these sensitivities and to price them. Its testing methodologies are still evolving and its coefficients require updating. Thus while APT formalizes some aspects of business economic analysis, the experience and capabilities of both financial economists and business economists could fruitfully interact.

A number of strategies, policies, and instruments can contribute to enhancing the social product of an organization. A wide variety of activities are involved: investment in innovation, investment in plant and equipment, the location of investments, sourcing policies, relationships with suppliers among others, including the use of instruments such as forwards, futures, swaps, and options. One approach is not always better than another - each has comparative advantages. Some combinations are more effective for some circumstances with a different set for others.

CONCLUSIONS

Financial engineering has produced some exotic new instruments to help control certain types of risk. The innovations in combining financial instruments for changing payoffs in relation to risks provide some new and useful tools and insights. These developments in financial engineering merit study and use by business economists. These new methodologies do not necessarily substitute for alternative types of approaches. They enlarge the contents of the tool box for dealing with opportunities and threats under uncertainty.

The mix of the kinds of efforts employed by business economists may thereby be altered and the nature of the efforts employed extended. Rather than substituting for the analysis of economic forces and policies, the new risk management tools extend the range and scope of the activities of business economists. These new financial techniques also provide an area for increased interactions between business economics and financial analysis.

REFERENCES

Alexander, Gordon J., and William F. Sharpe, Fundamentals of Investments, Englewood Cliffs, New Jersey: Prentice Hall, Inc., 1989.

Cox, John C., and Mark Rubinstein, Options Markets, Englewood Cliffs, N.J.: Prentice-Hall Inc., 1985.

Houpt, J.V., and J.A. Embersit. "A Method for Evaluating Interest Rate Risk in U.S. Commercial Banks," Federal Reserve Bulletin, 77 (August 1991), pp. 625-637.

Roll, R., and S. Ross, "An Empirical Investigation of the Arbitrage Pricing Theory," Journal of Finance, (December 1980), pp. 1073-1103.

Ross, S., "The Arbitrage Theory of Capital Asset Pricing," Journal of Economic Theory, (December 1976), pp. 341-361.

Smith, Clifford W., Jr., and Charles W. Smithson, The Handbook of Financial Engineering, Grand Rapids, Philadelphia: Harper Business, 1990.

_________; and D. Sykes Wilford, Managing Financial Risk, New York: Harper & Row Publishers, 1990.

Weston, J. Fred, and Thomas E. Copeland, Managerial Finance, Fort Worth, Texas: The Dryden Press, 1992.

* J. Fred Weston is Professor Emeritus of Managerial Economics and Finance at the Anderson Graduate School of Management, University of California, Los Angeles, CA. He also is an Associate Editor of this journal. This paper was originally presented at the Annual Meeting of the NA.BE on September 2.5, 1991. It has benefited from the comments of my colleagues Clement Krouse, Eduardo. Sehwartz and Richard Roll.

1 See references at end of text.

In recent decades, the economic and financial environments have experienced much turbulence and instability. The increased volatility in financial prices stimulated innovations resulting in many new financial instruments and techniques. Based on the premise that forecasting is unable to eliminate risks, financial economists have proposed the use of new financial instruments and methodologies for managing risks.' This paper summarizes the nature of the new techniques, their potentials and pitfalls, and their implications for business economics.
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Author:Weston, J. Fred
Publication:Business Economics
Date:Apr 1, 1992
Words:3293
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