A Framework for Risk Management - Deepstash

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Risk Management In Organizations

Many companies use the insights of financial managers and external consultants to manage their risk. A one-size-fits-all solution is not yet in existence when it comes to risk management.

These companies usually use derivatives like forwards, options, swaps and futures to offset their risk, but without a clear set of risk-management goals, the use of derivatives can increase the risk substantially.

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A Coherent Risk Management Strategy

Top-level managers and financial engineers must work in tandem to develop and execute a strong risk-management strategy. The three basic premises for this corporate strategy are:

  1. Creating corporate value by making good investments.
  2. Generating cash internally to fund the investments.
  3. Having a strong cash flow.

The single goal for this strategy is to have enough cash available to make value-boosting investments.

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Hedging In The Middle Ages

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.

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Modern Finance: Corporate Risk Management

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.

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The Need For Hedging

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.

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Guidelines For Managers

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.

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