This article explores a paradox in the current practice of risk management. Academic research argues strongly that risk management creates value. Most of the academic research focuses on risk management that decreases variability of firm value or cash flows. Despite this academic literature, however, the practice of risk management is rather limited and it does not seem to correspond to the recommendations of academics. Does this mean that academic theories of risk management are not useful? Is there too little risk management? Is it the right kind of risk management?
In the first part of this article, I review some evidence we have about risk management practice. Part of this evidence has to do with the derivative losses of the past few years. What do these losses tell us about practice? Would these losses have occurred if firms had followed modern corporate finance theory? The rest of the evidence consists of survey data. All of the evidence shows that firms let their views about the rewards for bearing hedgeable risks affect their hedge ratios in a significant way. This raises the question of whether such a practice is consistent with modern risk management theory.
I present the main elements of this theory. Whereas much of the literature interprets this theory as suggesting that firms should hedge risks to reduce the variance of cash flow, I show that the theory properly interpreted is consistent with some of current practice and can be used to improve current practice. The theory implies that some firms should hedge all risks, that other firms should not worry about risk at all, and finally, that some firms should worry only about some kinds of risks. Some firms have a comparative advantage in taking some types of risks; others do not.
I argue that existing risk measures such as VAR or the variance of cash flows cannot be motivated from existing theory. I present a risk measure which has a foundation in modern finance theory and is easy to compute. Finally, I conclude with a discussion of the management of risk management. If risk management is not focused on variance reduction, then much more attention should be devoted to the control, management and evaluation of risk taking and we should develop a better understanding of the agency costs of risk taking.
The paper proceeds as follows. Section 2 discusses empirical evidence. Section 3 reviews existing academic theories of risk management. Section 4 evaluates the empirical evidence in light of the academic theories. Section 5 makes the argument that firms have comparative advantages in taking some risks. Section 6 discusses why risk-taking differs across firms. Section 7 provides risk measures that are consistent with current practice and academic theories. Section 8 examines how risk management should be organized when it involves exploiting views.
Section 9 concludes. Section 2. Risk management in practice. In one of their papers on Metallgesellschaft, Culp and Miller have a startling footnote: “We need hardly remind readers that most value-maximizing firms do not hedge. ” (Culp and Miller (1995), p. 122. ) Is this really true? How would we know? They refer to survey evidence. The Wharton-Chase study sent questionnaires to 1,999 firms. Of these firms, 530 responded. Only 34. 5% of the firms answer “yes” when asked if they buy or sell futures, forwards, options, or swaps.
Interestingly, large firms use derivatives a lot more: 65% of the large firms use derivatives, whereas only 13% of the small firms use derivatives. Of the firms that use derivatives, the only uses of derivatives on which more than half the firms using derivatives agree are to hedge contractual commitments and to hedge anticipated transactions taking place within twelve months. About 2/3 of the firms responded that they never use derivatives to reduce funding costs by arbitraging the markets or by taking a view, never use derivatives to hedge the balance sheet, foreign dividends and economic or competitive exposure.
The study was updated in 1995 and its results published in 1996 as the Wharton-CIBC Wood Gundy study. Although the 1995 questionnaire was sent to more firms, it received substantially fewer answers than the 1994 questionnaire. Nevertheless, the results of the 1995 confirm the results of the 1994 study. One striking result of the 1995 study is that over a third of all derivative users say that sometimes they actively take positions based on their market views of interest rate and exchange rates. Dolde (1993) also conducted an extensive survey.
He sent his questionnaire to Fortune 500 companies. 244 companies responded. 85% said that they were using derivatives to manage financial risks. Almost all companies who responded (90%) said that their view would affect the extent to which they hedge. For the companies surveyed, the focus of risk management was mostly on transaction exposures. Another recent study by Price Waterhouse surveys in the first half of 1995 386 leading companies based in 16 countries outside the U. S. 1 7% of the companies treat their treasury function as a profit center.
In these cases, the firms try to make a profit by actively managing the financial risks of the business and hence do not simply hedge passively. This view of having the treasury operations used to make profits is one that holds frequently within U. S. firms also. Typically, however, the extent to which treasury operations try to make profits is by varying the hedge ratio depending on their expectations. For instance, in some periods, they do not want to be long in a currency because they expect it to depreciate.
The bottom line from these surveys and other surveys is that firms do not systematically hedge, that the extent to which they hedge depends on the view they take, and that use of derivatives is greater for large firms than small firms. Many of the well-reported derivative problems of recent years are fully consistent with this survey evidence and make it possible to understand practice better. We briefly review two cases where firms lost large amounts of money as a result of risk management programs.
Metallgesellschaft. The case of Metallgesellshaft has generated strong controversies. Nevertheless, there is general agreement about the facts of the case. MGRM, the oil marketing subsidiary of Metalgesellshaft in the U. S. , had contracted to sell 154 million barrells of oil through fixed-price contracts over a period of ten years by the end of 1993. These fixed-price contracts created a large exposure to oil price changes. MGRM therefore decided to hedge. However, it did not do so in a straightforward way.
It decided to take positions in short-term contracts, both futures and swaps. One can estimate the minimum-variance hedge position for MGRM in short-term contracts. One such estimate, by Mello and Parsons (1995), is that the minimum-variance hedge position would have 1 See Financial Times , Tuesday October 17, 1995, p. 26. required the forward purchase of 86 million barrels of oil. According to them, this position would have minimized the variance of the present value of MGRM’s hedged position in oil over the near future and would have needed to be changed over time.
Yet, MGRM bought 154 million barrels in short maturity contracts. Hence, in no sense did MGRM use a hedge that minimized the variance of its hedged position in oil. MGRM took the position it did because it thought it could benefit from the typical backwardation of oil futures. Backwardation is the situation where spot prices are higher than futures prices. Over the near future, the long position of 154 million barrels is equivalent to a pure hedge position of 86 million barrels of oil and a speculative position of 58 million barrels of oil.
Over the long haul, however, the speculative position taken by MGRM involves a bet on the basis since MGRM has to deliver 156 million barrels of oil to its customers. 2 As the oil prices fell, MGRM lost on its futures positions and gained on its cash positions – i. e. , the oil it had promised to deliver was worth less. However, the backwardation of oil futures disappeared for a period of time, so that MGRM’s views on the basis proved wrong and generated losses for that period of time.