There is a wide range of strategies available to managers seeking to reduce the level of risk encountered in the operation of their enterprise. Some of these strategies make use of derivative securities and well-developed hedging strategies. Before turning to hedging strategies, we review other approaches open to managers seeking to control risk.
Acquisition of Additional Information
In many cases, the risk facing a manager arises because of a lack of information. For example, when making the decision to develop and market a new product, there is considerable risk regarding the market’s acceptance of the new product. To reduce this risk, many firms “test-market” the product in a limited area or present the product to panels of consumers for their evaluation. These tactics provide important information to the company as it seeks to assess the probability of success of the new product.
Information can also be purchased from individuals or firms that possess the knowledge the decision maker seeks. For example, a wildcat oil-drilling firm will employ the services of petroleum geologist as it attempts to determine where to drill exploratory wells. Similarly, companies that plan to sell new debt securities often pay to have their bonds “rated” by one of the bond-rating services, such as Moody’s or Standard & Poor’s. The ratings applied to the bonds reduce the risk of determining the yield that will have to be offered to investors when the bonds are sold.
Because collecting additional information is costly, wealth-maximizing firms will pay for the additional information as long as the marginal value of that information is expected to exceed the marginal cost of acquiring it. For example, securing a bond rating from Moody’s or Standard & Poor’s is a relatively low-cost process. The benefits of reduced risk uncertainty in the minds of bond investors often save a company many millions of dollars in their borrowing costs.
Barings Bank PLC and Nick Leesona
Barings Bank PLC was an old-line British Merchant Bank founded in 1763. It catered to royalty. It financed the Louisiana Purchase in 1803 as well as the Napoleonic Wars. Barings survived wars and depressions in the following years and had to be rescued from looming bankruptcy by the Bank of England in 1890. It declared bankruptcy in February 1995.
Nick Leeson originally came to Barings as a clerk. He came from a humble family background but rose quickly in the largely blue -blood bank. His big opportunity came when he was sent to the firm’s Indonesian office to straighten out some troubling back-office problems that arose because of the rapid growth of the Indonesian stock exchange and the inability to keep up with deliveries of stock certificates. Leeson did such a great job of cleaning up these problems that he was quickly promoted. In 1992, he was assigned to Barings’ new Singapore branch and soon was named the head of derivatives trading there. Leeson’s trading activities focused on futures contracts for the Japanese Nikkei 225 stock index, 10-year Japanese government bonds, and euro-yen deposits. Because these derivatives traded simultaneously on the Osaka Securities Exchange and the Singapore International Monetary Exchange, Leeson found opportunities to take advantage of arbitrage opportunities between the two markets.
But Leeson was not content with small arbitrage profits. He soon began to take speculative positions in these futures contracts. In a cleverly designed scheme of accounting fraud, he was able to conceal the magnitude of his trading position in these securities. In 1994, Leeson bet that Japanese stocks and interest rates would rise, when, in fact, they fell dramatically. Rather than sell the contracts to neutralize his speculative position, he continued to buy. Each decline was treated as a buying opportunity.To make up for increasing losses, he began to double his “bets” on the future movement of these securities. But prices did not move as he predicted. In order to meet the margin calls on his growing positions, he falsified internal records and recorded fictitious trades. He also sold straddles on the Nikkei index as a way to generate the funds needed for his margin calls. By February 1995, Leeson had accumulated losses of $1.2 billion.
The lessons of the Barings case are important. First, there needs to be a clear separation between the backoffice operations and the front-office traders.This was not the case at Barings Singapore—thus giving Leeson the opening needed for his illegal trading scheme. Second, the case illustrates the importance of close supervisory control over risk management professionals. The home office thought that Leeson was merely engaging in arbitrage transactions, when, in fact, he had become an aggressive speculator. Close supervisory control of every company’s risk management function is essential to be certain that the transactions really do have the goal of reducing risk for the enterprise. Speculation in the derivatives markets is not a proper activity for risk managers. Finally, of course, the best defense against unethical practices by risk managers is to hire individuals with the highest ethical standards and to tolerate no breaches of these high standards.
We saw in that there is considerable value in diversifying a portfolio of assets, because the risk of that portfolio will normally be less than the weighted average risk of the assets in the portfolio. This principle is widely applied by individual investors as they make their stock and bond investment decisions. Diversification can also have value for individual firms. Many firms work to diversify their customer and supplier base so that they will not be severely impacted by negative developments at a single customer or supplier. Firms arrange for multiple supply sources of key resources. Similarly, they seek to expand the customer base to diversify away some customer risk. Without a diversified customer and/or supplier base, it is conceivable that the long-term viability of a company could be threatened by the failure of a single customer or supplier.
Although this type of within-company diversification is prudent, some firms have carried the concept of prudent diversification to counterproductive ends. During the 1960s and 1970s, many firms such as ITT, Gulf and Western, LTV, and Litton Industries attempted to reduce the risk of their operations by diversifying into a wide range of often-unrelated industries. The rationale that was made for these far-flung acquisitions was to reduce the inherent operating risk of the enterprise. For example, U.S. Steel acquired Marathon Oil because of the cyclical risk of the steel industry. Ford Motor acquired a network of savings and loan institutions, and Reynolds Tobacco diversified into food products, shipping, and oil and gas acquisitions.
It soon became apparent that acquisitions such as these made little sense. If investors wanted to diversify their portfolios, they could do so much more cheaply than companies, who often paid acquisition premiums of 25 to 75 percent. Second, these acquisitive firms had little expertise in running such far-flung enterprises. What do the executives at Reynolds Tobacco know about running Sea Land, a container shipping company? As it grew increasingly apparent that this type of diversification outside of management’s areas of expertise was not value enhancing, many of these firms subsequently sold off their unrelated businesses, often at a significant loss, and returned to their core business.
Hence, we can conclude that diversification of the customer and supplier base within its core business can often be a value-enhancing strategy, but diversification into unrelated businesses often results in the destruction of value.
When a firm makes a premium payment to an insurance company, the firm is exchanging the premium payment for protection against specified losses, up to the limits identified in the policy. Insurance is commonly available for losses due to fires, natural disasters, accidents occurring in the workplace, the death of key employees, fraud, product liability, thefts, certain unforeseen business interruptions, and potential liabilities of officers and directors that may arise in the course of exercising their fiduciary responsibilities to the firm. Some financial instruments such as corporate bonds are backed by insurance that guarantees the payment of principal and interest.
When deciding which risks should be insured externally, and which should be selfinsured, managers are confronted with a trade-off between a certain, small, periodic cost (the insurance premium) and the uncertainty of bearing the full cost of a large loss from time to time. The willingness of managers to assume some insurable risk, the cost of the insurance, the severity of the consequences of experiencing an uninsured risk (could it lead to financial distress?), and the competitiveness of the pricing for any insurance product all determine whether insurance is purchased. For these reasons, it is common to find that large companies generally buy insurance against events that can lead to losses large enough to cause financial distress. At the same time, these companies typically self-insure against smaller, more routine losses. They reason that these small losses are not of the size to have a material impact on the performance and viability of the firm. Hence, there is no reason to pay the administrative costs associated with the pricing of insurance products.
Gaining Control over the Operating Environment
Some business risks can be reduced by actions designed to gain control over the operating environment. For example, to ensure adequate outlets for its products, a firm may establish a network of exclusive dealerships, such as is common in the automotive marketplace. If access to raw materials is uncertain, a firm may integrate backwards to the source of supplies. The use of patents and copyrights can protect a firm against immediate competition. Patents are the backbone of several major industries such as the branded, prescription pharmaceutical industry. These patents secure the intellectual property rights of the developer (inventor) and provide a strong incentive for continued innovation and the associated economic gains to society from continued technological and innovative progress.
Legal action is often used to enforce rights under patents and copyrights. For example, in 1993 Intel, a maker of computer microprocessor chips, filed an intellectual property infringement suit against one of its major competitors, Advanced Micro Devices (AMD), charging the AMD’s “clone” chip violated valuable Intel copyright rights. The lawsuit was widely viewed as an effort by Intel to create fear and uncertainty in the minds of AMD’s customers and hence dissuade them from using the AMD chips in their personal computers.Legal action of this type is often required to secure intellectual property rights under patent and copyright laws.
Limited Use of Firm-Specific Assets
If a firm builds a plant that can only be used to produce its specific product, that firm has effectively limited its options should the product prove to be unsuccessful. The more general the purpose of the assets employed by a firm, the more flexibility that firm has to redeploy these assets to other uses. A trade-off exists between the use of firm- or product-specific assets, which are likely to be more efficient, and the use of more general-purpose assets, which give the firm increased future flexibility.When planning new investments, this trade-off must be carefully evaluated.
The case for using more general-purpose assets is well-illustrated in recent trends in the manufacture of automobiles. In the past, car companies built plants that had the capacity to produce only one type of vehicle. It usually took up to two years to convert a plant from making cars to making small SUVs. In recent years, many automakers, particularly Honda and Toyota, have aggressively pursued flexible manufacturing techniques.
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Financial Management Tutorial
The Role And Objective Of Financial Management
The Domestic And International Financial Marketplace
Evaluation Of Financial Performance
Financial Planning And Forecasting
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Risk And Return On At&t Common Stock
Fixed-income Securities: Characteristics And Valuation
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Capital Budgeting And Cash Flow Analysis
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The Cost Of Capital
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Capital Structure Management In Practice
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The Management Of Cash And Marketable Securities
Management Of Accounts Receivable And Inventories
Lease And Intermediate-term Financing
Financing With Derivatives
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