The use of insurance and derivatives is well-established as a way of protecting against adverse events - fires, natural disasters, currency movements and so on - that can play havoc with business plans and returns.
Individual hedging decisions have their own problems: costs can be too high for the risk they cover, risks may be overlooked, or hazards may be over-estimated. But looking at individual risks in isolation can also be inefficient and unnecessarily costly.
Companies may find that an exchange rate movement that will hurt one part of its business will benefit another. By looking at all the currency transactions and exposures across a business and netting them off against each other, the overall exposure may well be much less or even negligible. Money that would have been spent on individual hedging transactions can be saved.
If such an approach sounds commonsensical, consider that many businesses have silo structures where divisions operate as independent profit centres, which inevitably encourages a localised approach to risk management.
An integrated approach can also bring other perspective benefits. On the face of it a business might appear to face any number of risks - currency, interest rate, natural disaster - that taken together appear to be potentially overwhelming. But the chance of everything going wrong at the same time - the perfect storm - may well be small, in which case it may be cheaper to save on the hedging costs and simply accept the occasional hit.
Clearly, this overview approach points to the need for a chief risk officer who will have financial as well as people skills because of the need to interact with different operating units.
Many companies also now regard risk management as integral to their wider financial management. Risk is a potential cost to capital, so risk management is just a part of capital management. Importantly, too, risk reduction can enhance enterprise value.
What strategies can this produce? A company worried about the risk of going bankrupt might seek to structure itself with less debt and more equity. A business concerned about maintaining a ready source of cash to finance growth might use an interest rate derivative to smooth cash flows. Or a retailer might use weather derivatives to hedge against the risk that severe weather keeps people from shopping.
Source: Special section: CFOs at work: viewing business strategies through a finance lens
Leveraging Risk Management, Knowledge@Wharton, 9 February 2006
Review by Steve Lodge