424 Planning and Forecasting
risks by diversifying their holdings within their portfolios, and so they do not
want business managers to devote resources to managing risks within the firm.
Loss prevention and control involves embarking on a risky project, yet
taking steps to reduce the likelihood and severity of any losses potentially re-
sulting from uncontrollable factors. In the f lying example, loss prevention and
control would be the response of the airline passenger who chooses to f ly, but
also selects the safest airline, listens to the pref light safety instructions, sits
near the emergency exit, and perhaps brings his or her own parachute. The
passenger in this example has no control over how many airplanes crash in a
given year, but he or she takes steps to make sure not to be on one of them, and
if so, to be a survivor.
Risk transfer involves shifting the negative consequences of a risky factor
to another person, firm, or party. For example, buying f light insurance shifts
some of the negative financial consequences of a crash to an insurance company
and away from the passenger ’s family. Should the airplane crash, the insurance
company suffers a financial loss, and the passenger ’s family is financially com-
pensated. Forcing foreign customers to pay for finished goods in your home cur-
rency rather than in their local currency is another example of risk transfer,
whereby you transfer the risk of currency f luctuations to your customers. If the
value of the foreign currency drops, the customers must still pay you an agreed
upon number of dollars, for example, even though it costs them more to do so in
terms of their home currency.
No one risk management approach is ideal for all situations. Sometimes
risk avoidance is optimal; sometimes risk retention is the desired strategy.
Recent developments in the financial marketplace, however, have made r isk
transfer much more feasible than in the past. More and more often now, espe-
cially when financial risks are involved, it is the most desirable alternative.
In recent years there has been revolutionary change in the financial mar-
ketplace. The very same marketplace that traditionally facilitated the transfer
of funds from investors to firms, has brought forth numerous derivative instru-
ments that facilitate the transfer of risk. Just as the financial marketplace has
been innovative in engineering various types of investment contracts, such as
stocks, bonds, preferred stock, and convertible bonds, the financial market-
place now engineers risk transfer instruments, such as forwards, futures, op-
tions, swaps, and a multitude of variants of these derivatives.
Reading stories about derivatives in the popular press might lead one to
believe that derivative instruments are dangerous and destabilizing—evil crea-
tures that emerged from the dark recesses of the financial marketplace. The
cover of the April 11, 1994, Time magazine introduced derivatives with the
caption “High-tech supernerds are playing dangerous games with your money.”
The use of derivatives has been implicated in most of the financial calamities
of the past decade: Barings Bank, Procter & Gamble, Metallgesellschaft, Askin
Capital Management, Orange County, Union Bank of Switzerland, and Long-
Term Capital Management, to name a few. In each of the cases, vast sums of
money quickly vanished, and derivatives seemed to be to blame.