A Framework for Risk Management

Future markets are nothing new, and before the stock market, they existed in many places in the form of crop trade, back in the middle ages.

Farmers would hedge their risks by selling their crops to consumers at preset prices on a predetermined future date. This provided assurance to a risk-averse farmer that his crop price would not fluctuate in the future.

Corporations managing risk themselves face a fundamental question: why do they need to do it? Individuals and investment groups can manage the risk on their own. Making good investments seems like a better option.

Hedging bets are mostly fictional transactions that don’t affect the value of any operating asset of the company, making it a loss-making proposition if the transaction costs and other overheads are added up.

Risk management through hedging allows companies to borrow from themselves, transferring funds to where they are needed the most.

• The main objective of risk management is that the company should have cash available for making value-enhancing investments.
• Companies prefer to fund their investments with internal, retained earnings, and not through any outside equity. External financing is seen as a costly affair.
• Multiple studies on companies managing risk using hedging strategies reveal that it is almost a zero-sum game and does not insulate them from all kinds of risks.

Top leaders and managers can benefit from these broad guidelines on risk-management issues:

1. Companies in the same sector need not necessarily have the same hedging strategies.
2. Companies can benefit from risk management strategies even if they don’t have any major investments in assets or real estate.
3. No-debt companies having lots of cash can also take advantage of various hedging strategies.
4. Multinational companies (MNCs) need to recognize that foreign exchange risks affect both the company cash flow and investment opportunities.
5. Companies should pay attention to what strategies other companies, especially their competitors are devising.
6. Senior managers should not delegate risk management completely to financial specialists, as it can be misaligned with the company's broader vision.