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Part 8 Risk Management

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ost of the time we take risk as God-given. A project

has its beta, and that’s that. Its cash flow is exposed to

changes in demand, raw material costs, technology, and a

seemingly endless list of other uncertainties. There’s nothing

the manager can do about it.

That’s not wholly true. The manager can avoid some

risks. We have already come across one way to do so:

firms use real options to provide flexibility. For example,

a petrochemical plant that is designed to use either oil or

natural gas as a feedstock reduces the risk of an unfavor-

able shift in the price of raw materials. As another example,

think of a company that employs standard machine tools

rather than custom machinery and thereby lowers the cost

of bailing out if its products do not sell. In other words, the

standard machinery provides the firm with a valuable aban-

donment option.

We covered real options in Chapter 22. This chapter

explains how companies also use financial contracts to pro-

tect against various hazards. We discuss the pros and cons

of corporate insurance policies that protect against specific

risks, such as fire, floods, or environmental damage. We then

describe forward and futures contracts, which can be used

to lock in the future price of commodities such as oil, copper,

or soybeans. Financial forward and futures contracts allow

the firm to lock in the prices of financial assets such as inter-

est rates or foreign exchange rates. We also describe swaps,

which are packages of forward contracts.

Most of this chapter describes how financial contracts

may be used to reduce business risks. But why bother? Why

should shareholders care whether the company’s future profits

are linked to future changes in interest rates, exchange rates,

or commodity prices? We start the chapter with that question.

Managing Risk

26

CHAPTER

Financial transactions undertaken solely to reduce risk do not add value in perfect and effi-

cient markets. Why not? There are two basic reasons.

∙ Reason 1: Hedging is a zero-sum game. A corporation that insures or hedges a risk does

not eliminate it. It simply passes the risk to someone else. For example, suppose that

a heating-oil distributor contracts with a refiner to buy all of next winter’s heating-oil

deliveries at a fixed price. This contract is a zero-sum game, because the refiner loses

what the distributor gains, and vice versa.^1 If next winter’s price of heating oil turns out

to be unusually high, the distributor wins from having locked in a below-market price,

but the refiner is forced to sell below the market. Conversely, if the price of heating oil

is unusually low, the refiner wins, because the distributor is forced to buy at the high

(^1) In game theory, “zero-sum” means that the payoffs to all players add up to zero, so that one player can win only at the others’ expense.
26-1 Why Manage Risk?
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