Economics And Finance Risks Question

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Economics 373
24 March 2021
SHORT WRITING ASSIGNMENT 5
One of the hottest topics in all of finance is risk management. But what does that mean,
exactly, in the context of corporate finance? Froot, Sharfstein and Stein spell out what they think
is the role and purpose of risk management for the corporation in their classic article, “A
Framework for Risk Management.” In this article, they spell out what they see as the general
role of risk management as well as conditions that govern whether a firm should hedge a
particular risk.
One example of a risk that is often hedged is the fuel costs of airlines. Read the articles
about airlines’ hedging of their jet fuel costs and reflect on this practice of hedging (or not
hedging) in the context of the Froot et al article.
Write a paper that describes when companies should hedge a particular risk, according to
Froot, Sharfstein and Stein. In particular, see whether you can figure out what the statistical rule
(of thumb) is that is lurking in their analysis. Aim the paper at arguing whether Southwest did
(does) the right thing by hedging its jet fuel risk exposure, according to their framework.
Alternatively, you could consider what Delta did and argue whether their actions were
appropriate according to the Froot et al framework.
If you like, you can use your paper as a platform to argue against the role of risk
management as spelled out in “A Framework for Risk Management.”
Note: there are some really stupid quotes in a couple of the WSJ articles regarding expost hedging. Quite simply speaking, you can’t hedge an exposure after the fact.
The Economy: Iraq to Halt Oil Exports in Support
of Palestinians — Quick Jump in Fuel Prices
May Leave Some Airlines Short-Changed on
Hedges
By Scott McCartney and Melanie Trottman . Wall Street Journal , Eastern edition; New York, N.Y. [New
York, N.Y]09 Apr 2002: A.2.
ProQuest document link
ABSTRACT (ABSTRACT)
Jet fuel prices have climbed to 69 cents a gallon from less than 60 cents a gallon in January and are heading
higher. But only 22% of the fuel needs of UAL Corp.’s United Airlines, for instance, is hedged at a cap of 71 cents a
gallon, according to Deutsche Bank Securities Inc. America West Airlines, which staved off a bankruptcy filing last
fall only with government loan backing, doesn’t have any hedges in place. Delta Air Lines is in better shape, with
half its jet fuel needs for the rest of the year locked in at 61 cents a gallon, which is the equivalent of about $20 a
barrel for crude oil, according to Deutsche Bank Securities.
For airlines, fuel accounts for roughly 11% of operating expenses. The current prices are still lower than airlines
had to pay only a few years ago, but the sharp rise has left some airlines off guard. Higher fuel costs can squeeze
earnings sharply since airlines have had difficulty raising ticket prices and face little chance of passing higher
costs on to consumers. In addition, carriers already have a fuel surcharge in place from last year, so that option
can’t be added.
FULL TEXT
The quick jump in oil and fuel prices has caught some airlines a bit flat-footed.
Typically, airlines try to take the financial bumps out of oil-price swings by using commodity markets to hedge
against higher jet fuel prices, the second biggest expense behind labor.
Jet fuel prices have climbed to 69 cents a gallon from less than 60 cents a gallon in January and are heading
higher. But only 22% of the fuel needs of UAL Corp.’s United Airlines, for instance, is hedged at a cap of 71 cents a
gallon, according to Deutsche Bank Securities Inc. America West Airlines, which staved off a bankruptcy filing last
fall only with government loan backing, doesn’t have any hedges in place. Delta Air Lines is in better shape, with
half its jet fuel needs for the rest of the year locked in at 61 cents a gallon, which is the equivalent of about $20 a
barrel for crude oil, according to Deutsche Bank Securities.
After Iraq cut off its shipments of crude oil yesterday, oil prices spiked above $27 a barrel, which could translate
into jet fuel prices of between 75 cents and 80 cents a gallon or more.
For airlines, fuel accounts for roughly 11% of operating expenses. The current prices are still lower than airlines
had to pay only a few years ago, but the sharp rise has left some airlines off guard. Higher fuel costs can squeeze
earnings sharply since airlines have had difficulty raising ticket prices and face little chance of passing higher
costs on to consumers. In addition, carriers already have a fuel surcharge in place from last year, so that option
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can’t be added.
“It’s costing Southwest and it’s costing the industry a lot of money,” said Gary Kelly, chief financial officer at
Southwest Airlines. “And it’s at a time when we were hoping to see some offset against other cost increases like
security and insurance costs.”
Southwest has 50% of its fuel hedged at around $24 to $25 a barrel for the first half of the year, 60% in the third
quarter and 80% in the fourth quarter. Southwest figured the risk of rising energy prices wouldn’t materialize until
late this year, Mr. Kelly said.
For the just-completed first quarter, the airline industry is expected to post a $2 billion loss, on top of losses last
year of $7.2 billion. Those huge losses came during a time of relatively low fuel prices. In January, for example,
airlines paid an average 61.7 cents a gallon for jet fuel, down 28.7% from a year earlier, according to the Air
Transport Association.
Those relatively low prices, and what appeared to be stability in oil markets, may have led airlines to relax hedging
programs, especially when they were madly cutting costs after Sept. 11. Airlines typically use contracts in futures
markets to lock in set prices or at least cap the price on future fuel needs. If prices spike, the contracts can pay off
handsomely. But the contracts can be expensive, and if the prices are low and the outlook seems stable, airlines
often roll the dice.
“It costs money to hedge, and with oil analysts saying prices would stay between $20 and $24 a barrel, airlines
went on to other cost items,” said Deutsche Bank airline analyst Susan Donofrio.
The carriers in the toughest financial position, including United and America West, are the ones with the least
protection currently. US Airways Group Inc., another airline with financial challenges, has only 26% of its fuel needs
hedged in the second quarter, the carrier said.
Many carriers are expected to see some profit this year, and analysts say what matters most is whether the
economy continues to rebound, bringing more business-travel traffic and higher fares. What’s more, a federal tax
rebate coming back to airlines should help blunt the impact of higher fuel prices.
Delta, with 50% of its fuel locked in at what now seem like low prices, is in the best shape for fuel this year,
according to Ms. Donofrio. AMR Corp.’s American and Continental Airlines both have 40% of their respective fuel
needs locked in for the rest of the year, with American hedged at $24 a barrel and Continental one dollar a barrel
higher.
(See related article: “OPEC Faces a Quandary: Provide Surplus Supply Or Stand by Arab Nation” — WSJ April 9,
2002)
DETAILS
Subject:
Airlines; Petroleum; Hedging; Costs; Commodity prices
Business indexing term:
Subject: Hedging Costs Commodity prices
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‘Predatory and Opportunistic’: Southwest Seizes
the Moment — No-frills airline is expanding into
new cities as rivals struggle
Sider, Alison . Wall Street Journal , Eastern edition; New York, N.Y. [New York, N.Y]17 Nov 2020: A.1.
ProQuest document link
FULL TEXT
The pandemic is forcing many airlines to defend their turf. Southwest is using it to invade.
Even as air travel languished in this fall, Southwest Airlines Co. executives fanned out to cities from Palm Springs,
Calif., to Sarasota, Fla., to scope out potential new markets. The airline is adding four more cities to its network this
year and announced plans for six more in 2021. And it’s looking for more. It hasn’t added airports this quickly since
integrating with AirTran Holdings, which it bought in 2011.
“It sounds risky to go open a bunch of new cities, but the alternative is worse,” says Andrew Watterson,
Southwest’s chief commercial officer. “You could wait till Covid is over. But that’s far too long.”
Through its history, Southwest has leapt at opportunities to encroach on rivals’ territory when they were struggling.
If successful this time, it would be a prime example how some U.S. companies, taking advantage of the carnage
around them, can come out of crises stronger.
Southwest’s bet this time is particularly striking, as the Covid-19 pandemic is leaving no airline unscathed. United
Airlines Holdings Inc., American Airlines Group Inc. and Delta Air Lines Inc. have together lost $23.5 billion this year
through September. Southwest has lost $2.2 billion in the period, on track to break a 47-year profitability streak,
and has told unions that furloughs — the first in its history — are inevitable early next year without pay cuts or
government stimulus.
Airlines are offering 42% less flights this month than last November. Southwest flights are down about 36%.
Southwest’s third-quarter revenue of $1.8 billion was down 68% from a year earlier and the carrier burned through
$12 million in cash a day — a figure it says it trimmed to $10 million a day in October.
Southwest accounted for about 20% of domestic air traffic in the quarter, behind only American, according to
Transportation Department figures. While it has borrowed billions this year as it contends with the pandemic, it still
has more cash than debt.
Many airlines are rewriting their route maps. But while most are experimenting with new routes among cities they
already fly to, Southwest is adding airports.
Southwest had less debt coming into the crisis than some rivals, has lower costs and is more focused on domestic
destinations where travel is expected to rebound before travel abroad. That has allowed it to move into openings at
airports such as Chicago’s O’Hare airport that previously had no space for new entrants and to re-evaluate cities
such as Colorado Springs, Colo., that once didn’t seem worth the investment. It started flying from Miami and Palm
Springs on Sunday and announced plans last month to begin flying from Houston’s George Bush Intercontinental
Airport.
“Southwest is going to look at what the holes are in the majors’ networks,” says Matt Lee, vice president of
operational planning at aviation-consulting firm Landrum &Brown, “and fill them in the interim.”
Capt. Jon Weaks, head of the union representing Southwest’s pilots, which is fighting pay cuts, described the
expansion strategy as “predatory and opportunistic — which we like.”
Whether that opportunism is enough will depend partly on the pandemic’s effect on travel. Southwest will face
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pressure from discounters including Spirit Airlines Inc. and Allegiant Travel Co., which often charge lower fares and
are finding opportunities to enter emptier airports. Several major carriers are cutting into one of Southwest’s big
selling points by doing away with most domestic change fees.
And Southwest in the past stumbled with expansion, in 2011 when it moved into Newark Liberty airport, a United
hub. It struggled to compete in transcontinental flights and never gained more than about 5% share of passengers
there, pulling out last year. “If they couldn’t make Newark work,” says Mark Kopczak, an aviation consultant who
previously led Spirit’s network-strategy team, “how are they going to pull the same thing off at O’Hare?”
Southwest’s Mr. Watterson says the airline’s business model — selling tickets directly to customers rather than
through online travel agencies — works best where it has a big customer base. “That’s the case in Chicago,
Houston and South Florida,” he says, but not in Newark.
Mr. Watterson and Adam Decaire, two executives responsible for Southwest’s commercial and network strategy,
say they had expansion in mind in early August during their quarterly day in the hot seat with CEO Gary Kelly.
Known internally as “stump the chump,” the daylong meeting is a chance for executives to quiz their network
gurus, and no question is off limits.
Mr. Watterson and other Southwest executives had watched what looked like a summer rebound slow in late June,
then stall in July as Covid-19 infections rose. Southwest and carriers such as American that had bet on summer
travel pulled down thousands of flights scheduled for August and September.
But, Mr. Watterson says, he began realizing that cutting flying and costs could do only so much to get back to
breaking even and that waiting for demand to return would take too long: “We needed to force a pace.”
Physically distanced amid big screens and piles of binders in the boardroom, Mr. Watterson and Mr. Decaire ran
through two decades of Southwest’s network history. After 9/11, it was one of few airlines to remain profitable:
While it didn’t add new cities right away, it picked up market share when rivals pulled back and expanded into longhaul routes that had been dominated by bigger airlines.
In 2009, when some others had retrenched with the financial crisis, it had gone into Boston’s Logan and New
York’s LaGuardia — airports its legendary CEO Herb Kelleher had earlier spurned as too crowded and expensive. It
added service to Minneapolis and Milwaukee that year, too. Those moves paid off: 20% of its 2010 revenue growth
came from new cities.
“We can do that same thing again. But we have to do it on a bigger scale, because the hole we’re in is bigger,” Mr.
Watterson recalls saying during the meeting.
The play, Mr. Watterson and Mr. Decaire say, is to spread Southwest’s planes into new places rather than
continuing to offer so many multiple daily flights in cities where it knows customers aren’t flying as much.
Southwest keeps a list of airports where its Boeing 737s can reach from its existing cities. From among those, its
planners had been combing for places with untapped demand that it could quickly hook into its network.
“Even if that market is still depressed,” Mr. Watterson says, “it’s still brand new revenue.”
The idea clicked for Mr. Kelly, Southwest’s CEO, Mr. Watterson and Mr. Decaire say. “I’m happy to play offense,” Mr.
Kelly later said on the quarterly earnings call about two months later.
For decades, Southwest was among the fastest-growing U.S. airlines, known for splashy entrances into new cities
and starting fare wars. It had a more measured growth pace in recent years. Last year, its growth was constrained
by the grounding of the 737 MAX following two fatal crashes.
Southwest lost some of its low-cost advantage, having evolved from a disruptive upstart. With competition from
ultradiscounters and basic-economy fares that airlines like United, American and Delta launched, Southwest
doesn’t always have the lowest prices, though it doesn’t charge for bags and other extras.
It shrank capacity by 1.6% in 2019, its first contraction in a decade. Earlier this year, Mr. Decaire says, he fretted he
didn’t have enough airplanes to keep up with booming demand in cities Southwest already flew to.
The pandemic offered a new chance. Most cities it has picked are ones it had hoped to fly to eventually, and it now
has planes to spare and airports with space, Mr. Decaire says: “We probably put in a decade’s worth of new city
growth into Southwest.”
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Other airlines, too, are redrawing their maps somewhat during the pandemic, including United, which said this
month it will return to New York’s John F. Kennedy airport after departing five years ago. It is launching nonstop
flights from places like Cleveland to cities in Florida. United has also added flights to several small cities, some
under a subsidy program from the Transportation Department.
Spirit gained slots at Orange County’s John Wayne Airport, a long-held goal for the ultralow-cost carrier. JetBlue
Airways Corp. has been expanding at Newark and has launched 60 new routes — nearly all from its existing cities -as it tries to reorient its network outside its strongholds in the Northeast, which were hard hit by the virus. “We
didn’t have great pandemic geography,” says Scott Laurence, JetBlue’s head of revenue and planning.
American, which added back flights more quickly this summer than some rivals, is trying things like short-haul
flights within Florida. “The cost of experimentation right now is really low,” says Brian Znotins, American’s vice
president of schedule and network planning. American had to pull back on its big summer flying push but added
back flights this fall as demand started to return again.
Overall, other airlines have largely retreated into their main hubs. American and Delta have suspended flying in
dozens of smaller markets.
Some of Southwest’s new destinations fit the profile of places airlines are looking at for pockets of growth, such as
sun and ski destinations. Others are cities Southwest believes can feed passengers into its network through
connecting traffic — a shift for a carrier that historically focused on nonstop service.
In its early days, Southwest favored cheaper and less crowded secondary airports — like Chicago’s Midway Airport – tapping demand other airlines ignored, says Pete McGlade, an architect of Southwest’s network strategy and now
a consultant. Over the years, Southwest made inroads at other carriers’ hubs: becoming one of the largest in
places such as Phoenix and Denver, and dominating cities like St. Louis that were once strongholds for others.
Expanding from secondary airports to larger ones is a longstanding Southwest strategy — a pattern it has followed
in New York, Boston and, through its AirTran acquisition, Washington, D.C. It is now picking places that can help
bring in revenue fastest, Mr. Watterson says: “We need to get back to break-even, we need to stop burning cash.”
One lesson Southwest learned from previous ventures into rival territory: Go big. With enough flights to any given
city, Mr. Watterson says, “The other airlines can’t really touch you.” Southwest will start 20 flights a day from
O’Hare in February.
Southwest says it closely followed discussions a few years ago about O’Hare’s expansion, including a new lease
agreement that gives Chicago greater ability to award gates to new entrants. But it never saw a way in, Mr.
Watterson says: “It wasn’t until Covid times when we saw a dramatic reduction in O’Hare activity that we could go
in and get access to gates.”
With fewer flights arriving from abroad, “common use” gates at O’Hare’s international terminal had extra capacity.
Southwest pounced. “If we don’t move now,” Mr. Kelly, the CEO, said during the October earnings call, “we risk
never getting in there.”
Houston’s William P. Hobby Airport, which Southwest dominates, is a trek for people in northern Houston and
surrounding suburbs. Before the pandemic, Southwest had spoken to airport officials about expanding at Hobby,
says Mario Diaz, executive director of Houston’s airports. About 2 1/2 months ago, the airline instead asked to add
service at the city’s bigger airport, George Bush Intercontinental, after a more than 15-year absence. Southwest
last month said it would begin flights from that airport in the first half of 2021.
Before the pandemic, the airline had considered airports serving Steamboat Springs and Telluride — Colorado ski
towns — and picked Steamboat. In a year when skiing looks to be one of few activities people may travel for, Mr.
Watterson says, the airline’s planners thought, why not both? Southwest announced service to the additional
airport on Oct. 8.
Even as the pandemic now worsens, says Mr. Watterson, Southwest still needs to tap new markets and believes
the strategy will hold up. Mr. Decaire says Southwest is seeking markets it can stay in after the pandemic. “We
don’t want to do anything now just for a few months,” he says. “We’re definitely out scouting more cities.”
Credit: By Alison Sider
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Southwest Airlines’ Big Fuel-Hedging Call Is
Paying Off — Carrier Was Able to Protect Itself
Against Soaring Energy Prices in Second Half
By Melanie Trottman . Wall Street Journal , Eastern edition; New York, N.Y. [New York, N.Y]16 Jan 2001:
B.4.
ProQuest document link
ABSTRACT (ABSTRACT)
Early in the year, Gary Kelly, the carrier’s chief financial officer, made the call to hedge 100% of Southwest’s jet-fuel
needs for the third and fourth quarters. Although there is no futures market for jet fuel, Southwest bought
contracts that locked in prearranged prices of crude and heating oil, whose price moves most closely in line with
that of jet fuel. To protect itself in case the cost of jet fuel fell below Southwest’s locked-in price, the carrier also
bought call options that would allow it to buy crude at lower fixed prices.
As a result, Southwest was able to cover its needs for the second half of last year at a level equivalent to $23 a
barrel for crude oil. As oil prices soared above $30 a barrel, Southwest saved $43.1 million in the third quarter,
reporting a 45% year-over-year increase in net income in a period that hammered some of its competitors. For the
fourth quarter, Southwest is expected to report today that it earned about $140 million, or about 28 cents a share,
helped by hedging-related fuel savings of between $60 million and $65 million.
That Southwest even made such an aggressive call underscores a strategic shift in the way airlines are choosing
to protect themselves against soaring jet-fuel prices, their second-largest expense after labor. Hedging positions
are growing larger, and airlines are devoting greater resources to hedging activities. Carriers also are increasingly
using hedging as a tool to manage earnings in an ultracompetitive environment. By isolating the assumed cost of
jet fuel well in advance, airlines can build budgets around that cost and better determine what their earnings will
be.
FULL TEXT
Southwest Airlines, the no-frills, low-fare carrier, is often ridiculed for its cattle-call seating and lack of meals. But
there is one unlikely business for the airline in which it clearly is state of the art: commodities hedging.
High jet-fuel bills have wreaked havoc on the airline industry, forcing bankruptcy filings of some start-up carriers,
lowering earnings at major airlines and widening losses at others. Most airlines hedge their fuel costs, but few as
extensively last year as Southwest, and the practice has paid off big.
Early in the year, Gary Kelly, the carrier’s chief financial officer, made the call to hedge 100% of Southwest’s jet-fuel
needs for the third and fourth quarters. Although there is no futures market for jet fuel, Southwest bought
contracts that locked in prearranged prices of crude and heating oil, whose price moves most closely in line with
that of jet fuel. To protect itself in case the cost of jet fuel fell below Southwest’s locked-in price, the carrier also
bought call options that would allow it to buy crude at lower fixed prices.
As a result, Southwest was able to cover its needs for the second half of last year at a level equivalent to $23 a
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barrel for crude oil. As oil prices soared above $30 a barrel, Southwest saved $43.1 million in the third quarter,
reporting a 45% year-over-year increase in net income in a period that hammered some of its competitors. For the
fourth quarter, Southwest is expected to report today that it earned about $140 million, or about 28 cents a share,
helped by hedging-related fuel savings of between $60 million and $65 million.
“We came to grips at the beginning of the year that we were faced with a prolonged shortage of crude,” said Mr.
Kelly. “We thought that any price in the low 20s [per barrel of oil] was a good one.”
That Southwest even made such an aggressive call underscores a strategic shift in the way airlines are choosing
to protect themselves against soaring jet-fuel prices, their second-largest expense after labor. Hedging positions
are growing larger, and airlines are devoting greater resources to hedging activities. Carriers also are increasingly
using hedging as a tool to manage earnings in an ultracompetitive environment. By isolating the assumed cost of
jet fuel well in advance, airlines can build budgets around that cost and better determine what their earnings will
be.
AMR Corp.’s American Airlines has hedged its jet fuel costs for a number of years, but recently has grown more
aggressive in this practice. “We really get aggressive when we start seeing these upticks” in fuel prices, said
spokesman John Hotard.
The risk for airlines, however, is that aggressive hedging, which amounts to educated gambling on volatile energy
prices, can result in expensive mistakes if carriers guess wrong.
In the past, Southwest rarely ever hedged more than 20% to 30% of its fuel needs, and left the task to a single
employee on a part-time basis. Last year, the carrier assigned hedging to an internal finance staff of three,
including Mr. Kelly, and outside industry experts.
“I think airlines have more refined strategies today than they did years ago,” said Mr. Kelly. “This current
environment begs for some different approach than what we were using in the past.”
The increased risk of volatile fuel costs has hit some carriers hard this year. Start-ups like Las Vegas-based
National Airlines and Dallas-based Legend Airlines filed for bankruptcy protection last month, both citing
escalating fuel prices as one reason for the drain on their funds.
Major carriers have suffered, too. UAL Corp.’s United Airlines, US Airways and Trans World Airlines are expected to
post losses for the fourth quarter, though fuel is only one of many issues, including labor, troubling those carriers.
Even though traffic has been strong and fares have been high, both American and Delta Air Lines are expected to
report a decline in earnings — largely because of fuel. America West Airlines and Alaska Airlines, a unit of Alaska Air
Group Inc., will be hit hard too, with both expected to swing to quarterly losses from earnings a year earlier.
Northwest Airlines’ earnings are expected to be flat with a year earlier.
Southwest is one of only two of the top 10 in the U.S. expected to report increased year-over-year earnings for the
fourth quarter, according to a survey conducted by First Call/Thomson Financial. Continental Airlines, also 100%
hedged in the fourth quarter, is the other, although its expected 38% profit increase isn’t quite as substantial as the
56% expected for Southwest.
Even though it hedged all of its fuel needs, Southwest’s fuel tab will still rise significantly. The carrier’s thirdquarter fuel bill was up 27%, at least one-third of which can be attributed to increased flying. The airline expects
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In recent years, managers have become increasingly aware of how their organizations can be buffeted hy risks beyond their controi. In many cases,
fluctuations in eeonomie and financial variables
such as exchange rates, interest rates, and commodity prices have had destabilizing effects on corporate strategies and performance. Consider the following examples:
D In the first half of 1986, world oil prices plummeted by 50%; overall, energy prices fell by 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 between 1989 and 1992 the use of derivativesamong them forwards, futures, options, and swapsgrew by 145%. Much of that growth came from
corporations: one recent study shows a more than
fourfold increase between 1987 and 1991 in their
use of some types of derivatives.’
In large part, the growth of derivatives is due to
innovations by financial theorists who, during the
1970s, developed new methods-such as the BlackScholes option-pricing formula-to value these complex instruments. Sueh 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 doweapons most
mestic oil production collapsed, so did demand for
effectively. AlDresser’s equipment. The company’s operating
though many comprofits dropped from $292 million in 1985 to $139
panies are heavily inmillion in 1986; its stock price fell from $24 to $14;
volved in risk management, it’s
and its capital spending decreased from $122 milsafe to say that there is no single, well-accepted
lion to $71 million.
set of principles that underlies their hedging proD During the first half of the 1980s, the U.S. dollar
grams. Financial managers will give different anappreciated by 50% in real terms, only to fall back
swers to even the most basic questions: What is
to its starting point by 1988. The stronger dollar
the goal of risk management? Should Dresser and
forced many U.S. exporters to cut prices drastically
Caterpillar have used derivatives to insulate their
to remain competitive in global markets, reducing
stock prices from shocks to energy prices and exshort-term profits and long-term competitiveness.
change rates? Or should they have focused instead
Caterpillar, the world’s largest manufacturer of
on stabilizing their near-term operating income,
earthmoving equipment, saw its real-dollar sales
reported earnings, and return on equity, or on redecline by 45% between 1981 and 1985 before inmoving some of the volatility from their capital
creasing by 35% as the dollar weakened. Meanspending?
while, the company’s capital expenditures fell from
$713 million to $229 million before jumping to
Without a clear set of risk-management goals, us$793 million in 1988. But by that time, Caterpillar
ing derivatives can be dangerous. That has been
had lost ground to foreign competitors such as
Japan’s Komatsu.
Kenneth A. Froot is a professor at the Harvard Business
School in Boston. Massachusetts. David S. Scharfstein is
In principle, both Dresser and Caterpillar could
the Dai’lchi Kangyo Bank Professor and Jeremy C. Stein
have insulated themselves from energy-price and
the J.C. Penney Professor, at the Massachusetts Institute
exchange-rate risks by using the derivatives marof Technology’s Sloan School of Management in Camkets. Today more and more companies are doing
bridge, Massachusetts.
HARVARD BUSINESS REVIEW November-December 1994
91
RISK MANAGEMENT
made abundantly clear by the numerous cases of
derivatives trades that have backfired in the last
couple of years. Procter & Gamble’s losses in customized interest-rate derivatives and Metallgesellschaft’s losses in oil futures are two of the most
prominent examples. The important point is not
that these companies lost money in derivatives, because even the best risk-management programs
will incur losses on some trades. What’s important
is that both companies lost substantial
sums of money – in the case of Metallgesellschaft, more than $1 billion – because they took positions in derivatives that did
not fit well with their corporate strategies.
Our goal in this article
is to present a framework
to guide top-level managers in developing a coherent risk-management
strategy-in particular, to
make sensible use of the
risk-management firepower available to them
through financial derivatives.’ Contrary to what senior
managers may assume, a company’s risk-management strategy
cannot be delegated to the corporate
treasurer-let alone to a hotshot financial engineer. Ultimately, a company’s risk-management
strategy needs to be integrated with its overall eorporate strategy.
Our risk-management paradigm r