A Framework for Risk Management

Froot, Scharfstein, and Stein

The purpose of risk management for an organisation is to ensure availability of funds for financing investments.  Risk management does not create new wealth; investment does. Wealth-creating investment is only possible if there are funds available to finance it. Risk management must be used to ensure the organisation has enough funds to finance its wealth-creating investments should events arise that threaten the availability of funds.

The best funds to use for funding investments are funds created internally.  Funds obtained through debt make the company less attractive for further debt, which may result in a dangerous spiral where it cannot obtain debts when it needs them.  Funds raised from equity raise the problem of investors knowing that organisations sell equity when they know it is overpriced.  So despite Modigliani and Miller, who posited that how the funds are obtained is generally irrelevant, internally generated cash is best for funding further investments.

Hedging is one way to insulate the organisation from fluctuations of funds availability.

To determine what to hedge, think about events you wish to hedge against, and understand the impact of that event to your cashflow requirements for funding wealth-creating investments.  For example, if your company manufactures in Europe (Euro) and sells in the USA. Suppose the Euro appreciates thus making sales in the USA slower. Then cashflow is lessened because a) there is less product demand in the USA and b) the value of dollar sales has decreased comapred to Euro, therefore, there is little incentive to further increase production capacity in Europe, therefore there is lessened need for cashflow during the time.  Thus there is little need to hedge.

However, if opposite occurs, and the Euro depreciates, then sales to the US can be expected to increase (cheaper products), however,

Risk management “lets companies borrow from themselves” by shifting funds to when they are more needed.

The goal is to align the internal supply of funds with the demand for funds. The goal is not to insure against the events (such as exchange rate fluctuations) but to ensure the company has the cash it needs during such times.

The company shouldn’t need to worry much about its own stock prices.  That is a problem for individual investors. They can mitigate that risk through diversification.

Choices of which financial instrument to use must not be left to financial engineers. Managers must align the instrument to the corporate goal – which is to ensure availability of cash appropriate to the environment it is hedging against.

Two key issues in derivative features is mark-to-market vs over the counter. In the former, you need to top up daily to compensate for short term losses. In the latter you only need to pay at maturity date.  The other feature is linearity vs non-linearity. Futures and forward contracts may have no floor. There is symmetry in your gain or loss. Options allows setting a floor to loss, while keeping the option to benefit from the event.

The Risk-Return Effects of Strategic Responsiveness: A Simulation Analysis

Torben Juul Andersen and Richard A. Bettis

Summary:

Companies in turbulent dynamic markets experience volatility in their performance. The turbulence described here is not only a case of going back and forth, or cyclical changes, but a case of structural changes.   Companies need to undergo learning about the new changes, devise new strategies to adapt to the changed market and implement those strategies.  This is called strategic responsiveness.

The paper creates a simulation model to determine the risk and return effects of being strategically responsive.

Organisations learn in at least three ways. One, they gain new knowledge (perhaps a better mental model) and notice that current peformance can be improved.

First order learning involves improving current processes. Second order learning creates new knowledge which changes practices.  Continuous improvement may lead to very efficient processes that are no longer required.

Competitive advantage arises from knowledge creation which increases range of strategy options.  Market learning which is about acquiring insights about market conditions prepares the way to taking steps to capitalise on the market condition.

The simulation model finds that strategic responsiveness does play a part in improving performance in a dynamic environment.  It does not require perfect learning since perfect learning costs more and the extra cost offsets the improvement in cashflow.  Strategic responsiveness is a way to achieve higher performance at lower risk.

When to trust your gut

Alden Hayashi, Harvard Business Review

Summary:

Many decision situations do not lend themselves to quantitative analysis.  For one thing, the situation may be so complex that quantitative analysis simply cannot be applied. Examples include areas in public relations, which person to hire, research, marketing, and strategy.

In other cases there just is not enough data to perform quantitative analysis.

Even if data could eventually become available, there are times when decisions have to be made quickly, or else the opportunity is gone. There is no time to gather and analyse data in a systematic and rational manner. Situations like this can be expected to become more common in today’s increasingly turbulent and globalized economy, where things can change at the drop of a hat.

Executives in the strategic positions of organisations often face these types of situations.  They have to rely on gut instinct to make their decisions.  Although in some cases they are provided the results of quantitative analysis, the numbers are often biased to show why something is a good thing.  For example, mergers and acquisitions often show why the merger would succeed (from a quantitative point of view).  The executives have to rely on their instinct to tell them why it might not work.

The question for a decision maker then is how to tune in to your inner instincts and how to tune your inner instincts.

Executives and researchers discover that you need to have your subconscious knowledge emerge and connect with your conscious knowledge.  This can be done through meditative activities such as driving, day-dreaming, showering, and so on – it all depends on what works for you.

Our emotions assist in the decision making process by filtering out patterns that do not apply and by emphasising patterns that apply. In a sense, our emotions sort out and shortlist the considerations that our rational part of the brain can work with. When making decisions, be aware of your emotions and take them into consideration.

Gut instinct is simply based on rules and patterns we have within our subconscious. Some patterns may be built-in (true instincts).  Some are acquired through experience.

The quality of our gut instinct depends on the number of patterns our subconscious stores, the variety of patterns, and how it is able to interconnect those patterns.  The number of patterns come from our experiences, the variety comes the variety of experiences.

Instincts do not guarantee correct decisions. We need to continually self-assess our decisions and ‘train’ our instincts.  We can do this be reviewing our past decisions, reviewing why they were wrong, or why they were right.

Finally, it is important not to fall in love with your original decisions, but to keep flexible and adjust it as new information becomes available.