A FRAMEWORK FOR RISK MANAGEMENT
Managers should be aware of risks beyond their control. Fluctuations in economics and financial variables like exchange rates, interest rates, commodity prices have had destabilizing effects on corporate strategies and performance. Dealing with those unexpected risks, many companies are using derivatives like forward, future, options, and swaps. The growth of derivatives is due to innovations by financial theorists who, during the 1970s, developed new methods-such as the Black Scholes option-pricing formula-to value these complex instruments. But unfortunately, those financial engineers do not give managers any guidance on how to deploy those innovations most effectively because without a clear set of risk management goals, using derivatives can be dangerous. Companies will loose lost substantial of money because of taking positions in derivatives that did not fit well with their corporate strategies. So ultimately, a company’s risk management strategy needs to be integrated with its overall corporate strategy.
The risk-management paradigm rests on three basic premises:
- The key to creating corporate value is making good investments.
- The key to making good investments is generating enough cash internally to fund those investments.
- Cash flow-so crucial and can be disrupted by movement of external factors.
A risk management program should be ensuring the company has the cash available to make value- enhancing investment. So managers will be better equipped which risks should be hedged and which risks should be left un-hedged.
Modigliani and Miller who introduced “Modern Finance” said that value was created on the left-hand side of balance sheet when companies made good investments-say plant, equipment, R & D, or market share-that ultimately increased operating cash flows. But companies faced real trade-offs in finance their investments. If a company needed to build a plant, it can use fund from retained earning, or...