Risk, the Limits of Financial Risk Management, and Corporate Resilience

In managing their risk, firms can mitigate some risks they are exposed to using financial instruments instead of changing their operations. The most used financial instruments to mitigate risk are derivatives. Mitigating risks operationally can be extremely expensive. Mitigating risks using financial instruments can be extremely cheap. As a result, using financial instruments, such as derivatives, can at times be the best approach to risk mitigation. Using derivatives in risk management can be very cheap because the markets for commonly used financial products are often very competitive, so that transaction costs are low. In a recent article available at (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4932973), I address the use of financial instruments, especially derivatives, to mitigate risks for non-financial companies. I argue that the use of derivatives to mitigate risks for non-financial firms is limited and explain why it is so. The fact that the use of derivatives is limited does not mean that firms should give up managing risks that cannot be mitigated through derivatives, but instead they should focus on building resilience to maximize their value.

Financial risk management for non-financial corporations has been studied extensively. There is a large literature that examines how firms manage risks using derivatives. This literature finds that firms typically use derivatives to manage risk and not to speculate. The literature has identified a number of reasons why firms would want to manage risk even when their equity is owned by well-diversified investors who can diversify the firm’s idiosyncratic risks. Among the reasons identified in the literature, the two that have received the most support empirically are managerial incentives and financial distress. In general, management is affected by firm risks differently from shareholders. For instance, managers cannot diversify risks like shareholders can. As another example, shareholders’ wealth increases linearly in the price of shares (i.e., a doubling in the stock price doubles the value of a shareholder’s stake), but managers’ wealth may increase non-linearly in the price of shares (i.e., a doubling in the stock price may more than double or less than double the value of a manager’s stake). For instance, managers may have been granted options. The value of options increases with the volatility of the underlying common stock, so that managers holding options may be more willing for the firm to take risks than shareholders. The empirical literature shows that the exact nature of how managers’ wealth is affected by changes in their firm’s stock price affects the extent to which the firm hedges. As a result, a firm’s choice of managerial compensation plans directly affects how the firm will hedge and hence the risk of a firm.

There is much research in financial economics showing that financial distress has deadweight costs. In this context, the existence of deadweight costs means that a loss reducing the firm’s financial strength causes a decrease in the firm’s value greater than the loss itself. This excess loss could arise because, for instance, the firm may no longer be able to pursue the strategy it adopted when it was financially healthy. As a result, the possibility that a firm could become financially distressed reduces the value of the firm before financial distress ever materializes as firm value is discounted to reflect the possibility of that excess loss. Hence, even if the materialization of the risk of financial distress might be immaterial because of diversification, the present value of the expected impact of the risk on the firm cannot be reduced by diversification. That impact goes straight to the brokerage account of shareholders. As a result, shareholders will want the firm to hedge against the risk of financial distress if financial distress causes important deadweight costs. The literature shows that empirically the potential costs of financial distress affect hedging. However, this evidence is stronger for firms that are not already close to distress. By the time a firm is close to distress, using derivatives can be quite difficult because derivatives counterparties require collateral that is going to be expensive for the firm to put up, if it has any available collateral.

Though firms use derivatives to hedge, the literature finds that financial risk management is mostly, but not exclusively, used for the management of well-defined near-term risks. As a result, financial risk management is quite limited as a tool to manage firm-wide risk. There are several reasons for this. The first reason is that short-term risks are much easier to assess and quantify. A firm often knows the precise date of a payment to be received in foreign currency. This makes it easy to sell the receipt forward. A firm typically knows little about what its foreign currency exposures will be five or ten years from now. If a foreign currency depreciates too much, it may exit a market. Innovation and competition may increase a firm’s exports or decrease them. Firms find it much harder to plan as the time horizon lengthens, but without knowing what the firm intends to do, it is extremely challenging, if possible at all, to quantify the risks to which it is exposed. The second reason is that financial hedges that reduce the long-run exposure of a firm can create short-run volatility in a firm’s accounting performance and liquidity. In addition to these two reasons I discuss explicitly, managerial incentives can also make hedging long-term risks unattractive for management. For instance, the associated earnings volatility is problematic if management’s compensation depends explicitly or implicitly on earnings, as it often does.

Optimal risk management for risks that are hard to quantify or even identify must focus on policies that build corporate resilience. Corporate resilience is the ability of a firm to absorb adverse shocks in such a way that it can keep pursuing its strategy. If an adverse outcome occurs, policies exist to minimize the adverse effect of that outcome that do not involve using financial instruments. Some of these policies are financial policies. They involve the choice of cash holdings and the choice of leverage. A highly levered firm can easily become financially distressed if there is an adverse outcome. With financial distress, the firm may have to sell valuable assets and cancel valuable projects, in part because it will face difficulties raising funding. A firm with low leverage is unlikely to become distressed and may find the necessary funding. Similarly, a firm can hold liquid assets as a buffer. Other policies involve the firm’s operations. For instance, a firm can address the risk of supply chain disruptions by holding more inventories or developing relationships with multiple suppliers. Generally, this means that the firm wants to develop both financial and operational flexibility to manage risks. This area of risk management is critically important, but it is underdeveloped in practice in part because of insufficient research that provides helpful guidance.