676 Part Eight Risk Management
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Risk management requires some degree of centralization. These days many companies
appoint a chief risk officer to develop a risk strategy for the company as a whole. The risk
manager needs to come up with answers to the following questions:- What are the major risks that the company is facing and what are the possible conse-
quences? Some risks are scarcely worth a thought, but there are others that might cause
a serious setback or even bankrupt the company. - Is the company being paid for taking these risks? Managers are not paid to avoid all
risks, but if they can reduce their exposure to risks for which there are no corresponding
rewards, they can afford to place larger bets when the odds are stacked in their favor. - How should risks be controlled? Should the company reduce risk by building extra
flexibility into its operations? Should it change its operating or financial leverage? Or
should it insure or hedge against particular hazards?
The Evidence on Risk Management
Which firms use financial contracts to manage risk? Almost all do to some extent. For example,
they may have contracts that fix prices of raw materials or output, at least for the near future. Most
take out insurance policies against fire, accidents, and theft. In addition, as we shall see, managers
employ a variety of specialized tools for hedging risk. These are known collectively as derivatives.
A survey of the world’s 500 largest companies found that most of them use derivatives to manage
their risk.^6 Eighty-three percent of the companies employ derivatives to control interest rate risk.
Eighty-eight percent use them to manage currency risk, and 49% to manage commodity price risk.
Risk policies differ. For example, some natural resource companies work hard to hedge
their exposure to price fluctuations; others shrug their shoulders and let prices wander as they
may. Explaining why some hedge and others don’t is not easy. Peter Tufano’s study of the gold-
mining industry suggests that managers’ personal risk aversion may have something to do
with it. Hedging of gold prices appears to be more common when top management has large
personal shareholdings in the company. It is less common when top management holds lots
of stock options. (Remember that the value of an option falls when the risk of the underlying
security is reduced.) David Haushalter’s study of oil and gas producers found the firms that
hedged the most had high debt ratios, no debt ratings, and low dividend payouts. It seems that
for these firms hedging programs were designed to improve the firms’ access to debt finance
and to reduce the likelihood of financial distress.^7(^6) International Swap Dealers Association (ISDA), “2009 Derivatives Usage Survey,” http://www.isda.org.
(^7) See P. Tufano, “The Determinants of Stock Price Exposure: Financial Engineering and the Gold Mining Industry,” Journal of Finance 53
(June 1998), pp. 1014–1052; and G. D. Haushalter, “Financing Policy, Basis Risk and Corporate Hedging,” Journal of Finance 55
(February 2000), pp. 107–152.
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Derivatives usage
26-2 Insurance
Most businesses buy insurance against a variety of hazards—the risk that their plants will be
damaged by fire; that their ships, planes, or vehicles will be involved in accidents; that the
firm will be held liable for environmental damage; and so on.
When a firm takes out insurance, it is simply transferring the risk to the insurance com-
pany. Insurance companies have some advantages in bearing risk. First, they may have consid-
erable experience in insuring similar risks, so they are well placed to estimate the probability
of loss and price the risk accurately. Second, they may be skilled at providing advice on
measures that the firm can take to reduce the risk, and they may offer lower premiums to
firms that take this advice. Third, an insurance company can pool risks by holding a large,
diversified portfolio of policies. The claims on any individual policy can be highly uncertain,
yet the claims on a portfolio of policies may be very stable. Of course, insurance companies