A Framework for Risk Management

In recent years, managers have become increasingly

aware of how their organizations can be buffeted

by risks beyond their control. In many cases,

fluctuations in economic and financial variables

such as exchange rates, interest rates, and commodity

prices have had destahilizing effects on corporate

strategies and performance. Consider the following

examples:

D In the first half of 1986, world oil prices plummeted

hy 50%; overall, energy prices fell hy 24%. While

this was a boon to the economy as a whole, it was

disastrous for oil producers as well as for companies

like Dresser Industries, which supplies machinery

and

just that. The General Accounting Office reports

that hetween 1989 and 1992 the use of derivativesamong

them forwards, futures, options, and swapsgrew

hy 145%. Much of that growth came from

corporations: one recent study shows a more than

fourfold increase hetween 1987 and 1991 in their

use of some types of derivatives.'

In large part, the growth of derivatives is due to

innovations hy financial theorists who, during the

1970s, developed new methods-such as the Black-

Scholes option-pricing formula-to value these complex

instruments. Such improvements in the technology

of financial engineering have helped spawn

a new arsenal of risk-management weapons.

Unfortunately, the insights of the financial engineers

do not give managers any

guidance on how to deploy

the new

A Framework for

Risk Management

by Kenneth A. Froot, David S. Scharfstein, and Jeremy C. Stein

equipment

to energy

producers. As domestic

oil production collapsed, so did demand for

Dresser's equipment. The company's operating

profits dropped from $292 million in 1985 to $139

million in 1986; its stock price fell from $24 to $14;

and its capital spending decreased from $122 million

to $71 million.

D During the first half of the 1980s, the U.S. dollar

appreciated by 50% in real terms, only to fall hack

to its starting point by 1988. The stronger dollar

forced many U.S. exporters to cut prices drastically

to remain competitive in glohal markets, reducing

short-term profits and long-term competitiveness.

Caterpillar, the world's largest manufacturer of

earthmoving equipment, saw its real-dollar sales

decline hy 45% between 1981 and 1985 before increasing

hy 35% as the dollar weakened. Meanwhile,

the company's capital expenditures fell from

$713 million to $229 million before jumping to

$793 million in 1988. But hy that time. Caterpillar

had lost ground to foreign competitors such as

Japan's Komatsu.

In principle, both Dresser and Caterpillar could

have insulated themselves from energy-price and

exchange-rate risks hy using the derivatives markets.

Today more and more companies are doing

weapons most

effectively. Although

many companies

are heavily involved

in risk management, it's

safe to say that there is no single, well-accepted

set of principles that underlies their hedging programs.

Financial managers will give different answers

to even the most hasic questions: What is

the goal of risk management? Should Dresser and

Caterpillar have used derivatives to insulate their

stock prices from shocks to energy prices and exchange

rates? Or should they have focused instead

on stabilizing their near-term operating income,

reported earnings, and return on equity, or on removing

some of the volatility from their capital

spending?

Without a clear set of risk-management goals, using

derivatives can be dangerous. That has been

Kenneth A. Froot is a professor at the Harvard Business

School in Boston. Massachusetts. David S. Scharfstein is

the Dai-lchi Kangyo Bank Professor and Jeremy C. Stein

the J.C. Penney Professor, at the Massachusetts Institute

of Technology's Sloan School of Management in Cambridge.

Massachusetts.

HARVARD BUSINESS