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Wednesday, April 24, 2013

Risk Management: Isn’t it Also a Risk?

Risk management is just as common to our everyday existence as the very concept of our ‘self-preservation’. It is very much a part of human psyche, yet so eluding. When one enquires with passengers in an airplane that is wildly rocking flying through turbulence zone, to ascertain if all of them have an equal degree of anxiety, some may sound highly anxious while some others coolly snooze off. Event is same but the effect is different from person to person. Is it because each person is ascribing his own value to risk? Obviously………


The universe is a web of complex variables.  Their interrelationship is hard to decipher. Business is a subset of this complex web. Nothing is certain here. But many outcomes of such relationships are plausibly probable. Mankind has a natural tendency to welcome those relationships that have high probability of high gain while shunning those of high probability of high loss. And businesses are no exception to this propensity. Most of the businesses strive to keep away from high probability of high loss events as they are known to affect their profitability. It is in their attempt to perfect this art that businesses have evolved the concept of “risk management”.

Risk Management: What is it
Risk is defined as “the degree to which an outcome varies from expectation”. Risk is known to seep into just everything. Its all pervasiveness is quite challenging to every business. To manage this unwanted uncertainty in the outcome of business processes, managements are required to understand, anticipate and plan for managing the risk. Risk management process essentially involves:
•   Identification and evaluation of exposures to risk.
•   Designing cost efficient and effective alternative tools and techniques to effectively avoid, retain, transfer and/or control the identified risks.
•   Selection of desirable alternatives within the budgetary constraints.
•   Implementation and administration of the chosen alternative(s), and
•   Dynamic monitoring and review systems to better the risk management process.
Risk management decision-making is thus “a factor of uncertainty, volatility and utility”. The first two factors—uncertainty and volatility—can be mathematically deduced and hence it would be the same whoever estimates it, while the real problem emerges with the measurement of ‘utility’ value of the chosen risk management tool or the very risk management process, since it is highly subjective. The sense of utility, which is one’s perception or feeling of the need or value of a given risk management practice/tool, is the point of differentiation between risk management practices and policies. Ultimately, it is the perception or the appetite or the value that individuals attach to a given risk and its management that gets transformed as the risk and risk management tool of the corporates. Similarly, the consequences of the cumulative perception of risk and risk management techniques adopted by the employees such as board of directors, CEOs, managers, etc., get transferred to the corporates. And here lies the risk of risk management practices adopted by a business. Before we take a look at the embedded risks in risk management, let us examine what the financial pundits have to say about risk management per se.

Risk Management: Is it Necessary
Merton Miller & Christopher Culp, economists from University of Chicago, observed, “most value-maximizing firms do not hedge”1. Even according to the Modigliani and Miller Paradigm, risk management is irrelevant to the firm and they demonstrate that firms make money only if they make good investments of those that increase their operating cashflows. According to them, it does not matter whether those investments are financed by debt, equity or by retained profit. The methods of financing, they said, will only determine how a firm’s value is divided among its investors but not the value itself. If this assertion is right, it has critical implications for hedging: If methods of financing and the financial risks thereof do not matter, there is no point in managing risk. In other words, hedging cannot increase the firm’s value; on the other hand, it only adds to its cost, for derivatives do not come free. Does incurring additional cost with no matching returns amount to exposing the firm to risk? 

As against this, George Allayannis and James P Weston2, examined the use of foreign currency derivatives in a sample of 720 large nonfinancial firms between 1990 and 1995 using Tobin’s Q as an approximation for firm market value and found significant evidence that the use of FCDs is positively associated with firm market value. They also averred that firms that begin a hedging policy experience an increase in value above those firms that choose to remain unhedged and that firms that quit hedging experience a decrease in value relative to those firms that choose to remain hedged.

But Rene Stelz3 argues that there are only a couple of good reasons why a firm should hedge: One, to cut tax bills, and two, being unable to get cash when it needs it, or facing a serious risk of running short. He, therefore, opines that a firm with low debt need not hedge, as the risk of it getting into financial trouble is remote. 

Myron Scholes4, an economist at Stanford University, however, does not agree with this thesis.He is of the opinion that firms with low debt could reduce their risk by hedging, and so be able to borrow more and rely less on equity. And equity is more risky to service than debt.All this discussion leads to the conclusion that hedging of risks by non-financial companies is not that obvious. What is now happening mostly under the name of hedging is ‘transaction hedging’ and this has raised an allegation against finance managers: All hedging is nothing but financial managers’ hunches or a reflection of their fascination for fancy derivatives.

Risk Management: Strategic Hedging
Amidst these conflicting arguments there emerges a strong theoretical case for ‘strategic hedging’ from the perspective of the company’s overall cash flows. Strategic hedging goes beyond finance and derivatives. It expects businesses to understand all the main risks to which their future cash flows are exposed. It also takes cognizance of the trade-off between financial hedging and “natural” and operational alternatives. Strategic hedging essentially rests on running the firm’s budget forecast through multiple simulations to reflect different currencies, different interest rates and growth scenarios. Such strategic risk analysis facilitates well informed decisions on whether and how much to hedge. To hedge or not to hedge is thus not a simple question. To decide on hedging strategy managers need to have right answers to three fundamental questions:
•   How well the manager understands the firm’s risk exposures?
•   If identified, would hedging these risks make shareholder better off?
•   If so, is it practical to hedge these risks adequately?
There is of course no ‘set of rules’ that can provide right answers to these questions and guarantee that there would be no wild fluctuations in a company’s financial fortunes.

Hedging: Embedded Risks
Hedging is a method whereby one can reduce the financial exposure faced in an underlying asset due to volatility in prices by taking an opposite position in the derivatives market in order to offset the losses in the cash market by a corresponding gain in the derivatives market. Constructing a hedge essentially involves:
•   Identification of the exposure one is facing.
•   Measure that exposure, and
•   Construct another position with the opposite exposure.
Construction of an exact opposite position to the existing risk exposure results in a perfect hedge. Such opposing positions, when they come together, automatically offset each other. But there is always a problem: how to strike a balance between uncertainty and the risk of opportunity loss?
The problem of setting an effective hedge ratio has two dimensions:
•   Uncertainty: If a firm does not hedge the transaction, it cannot know with certainty at what rate of exchange it can exchange its dollar export proceeds for rupees—it could be at a better rate or a worse rate.
•   Opportunity: If firms enter into a hedge transaction such as a forward contract they would, of course, be certain of the rate at which they would be exchanging the export proceeds. But now they have taken an infinite risk of ‘opportunity loss’.

During 1984, Lufthansa, a German airlines company, signed a contract to buy aircrafts from an American company—Boeing in a deal valued at $3 bn. At that time, dollar was strong and market held an opinion that it was sure to get even stronger. In that context, the CFO of Lufthansa hedged company’s exposure to dollar by buying a forward contract for $1.5 bn. The central idea behind this hedging is: If the dollar strengthens, it would lose on its aircraft contracts but gain on the forward contract. There is another interesting dimension to this hedge: Lufthansa’s cash flow was also in effect dollar denominated and thus had a fair level of ‘natural hedge’. In this episode, dollar weakened by around 30% during 1985, and thus the forward contract inflicted heavy losses on the company. The moral is: Deciding to hedge is one thing, and getting it right is quite another.

There is yet another dimension to hedging: Hedging has a cost. If the expected risk does not materialize, hedging will prove an ineffective way of doing business. All these complexities associated with hedging through derivatives pose a great challenge to arrive at a right hedge ratio. It is these uncertainties associated with the outcome of risk management practices that make risk management itself a risk.

Risk Management: How it could be a Risk
To quote Anthony Storr—“doubt and uncertainty are distressing conditions from which men and women passionately desire release……. As a species we are intolerant of chaos and have a strong predilection for finding and inventing order.” And this ‘predilection’, however, varies from man to man, whether he is a chairman, managing director, CEO or a floor level manager. These differences ultimately reflect in their identification of the very ‘risk’ itself, its evaluation, deciding whether to hedge against the risk or not and if so by what means. These differences make different kinds of reflection on different strategies chosen by them. Again, perceptions and its reflections on the decisions keep changing from situation to situation and also from time to time. It is this uncertainty and variations in individual approaches to manage business risk that are potential enough to make risk management itself a risk. Let us now examine this phenomenon as reflected in various risk management techniques:

Risk Profile of Executives
The potential of people to cause risk depends on the risk, skill, and ethical-profile of the people who manage the risks for it is these skills attitudes, and orientation towards risk that define the style of discharging the given role. To be more precise, it is the ‘risk propensity’ of the people that matters most under risk management. Risk propensity is the “tendency of a decision-maker either to take or avoid risks” and it is treated as a summary concept of the risk taking behavior of an executive across time and situation. Research indicates that risk taking in any domain is influenced by a combination of factors such as age, sex, desire to seek sensation, values, openness etc., of the people entrusted with the responsibility of managing the business. Risk behavior is mostly patterned—some are likely to be constantly risk takers, some others are constantly risk averse, while a third group may have a domain specific pattern of risk behavior. Low neuroticism and agreeableness provide the insulation against concern about negative consequences and low consciousness lowers the cognitive barriers. Most people take risk in order to reap some psychological or material benefit but not for its risk own sake. People with high consciousness will pursue these benefits through disciplined striving rather than risk taking. On the other hand, people with low consciousness are often noticed attempting to “get rich quickly”—like Nick Leeson of Barings Bank by taking chances rather than through controlled effort. Some people in their obsession for career progression ambitiously work for business targets with even a myopic focus and in the process expose the businesses unwittingly to greater risk. 

Human Folly, Fantasy and Roguery
The personality profile of an individual in terms of over confidence, optimism, hindsight, pattern seeking, overcompensation, myopia, inertia, complacency, zealotry impacts the role of these executives in making ‘risk management’ a risk. It is the folly, human error and ignorance and tendency of people loosing their grip on whatever they are handling under a crisis situation that turn their risk management related decisions into risk. The science of evolutionary psychology tells us that crooked thinking is deeply embedded in our design and how we fall prey to this phenomenon while trying to be rational. Fantasy-led delusions such as ‘inflated confidence’, ‘escalated commitment’, ‘illusions of control’ are also known to drive people to control the uncontrollable or “predict what in reality is mostly random” and thus make their risk management actions highly risk prone.

Greed, fear, and ego are the other three motives that have a tremendous influence on the handling of risk management techniques by people. It is greed that motivates people to work for long hours, take jobs that are otherwise not interesting, and sacrifice long-term interests for short-term gains. Greed simply drives people crazy to maximize their status/ranking in the organization. In this mad rush they lose sight of the risks that they are taking and whose consequences they are transmitting to the organization. Similarly, fear is another motive that makes them “loss averse” and thus sucks them into disastrous act such as concealing losses, doubling of bets to recover the losses, etc. Ego is another motive that makes executives ignore warning signs and get carried away by the flood of their egos adventurously, all at the cost of the business interests.

Model Errors
A model is often said to be, of course rightly, as good as the assumptions that have gone into it. Once assumptions are defined, the model gives the same estimate of the risk exposure. But each analyst will define his own ‘assumption’ for estimating risk exposure in the same model and thus get his own value. Similarly, given the chance each analyst will love to draw his own model, which means each model is again exposed to its own errors committed by each model designer. It is this ‘uncertainty’ that is associated with various financial models developed and used by the businesses in managing their risks that is likely to create a ‘fresh risk’. 

Similarly, assumption and input errors, analytical errors, user errors, interpretation errors are more prone to derail the total risk management process, causing more harm to business than good. Secondly, it is to be borne in mind here that all these assumptions and interpretations are quantified by the human beings who differ from each other in ascribing a value in numerical terms to any given ‘utility’. This ‘uncertainty’, that is associated with every exercise pertaining to risk identification, estimation, selection of risk management techniques, their implementation, monitoring and effecting midcourse correction which are carried out by human beings can itself pose a risk to the business. If the chief risk management officer or others engaged in risk management of a business cannot transform business data into meaningful streams of information that can facilitate a deeper understanding of the business and its vulnerabilities, no successful risk management can be accomplished. On the other hand no wonder, if it generates a fresh risk for which a business may not be even prepared to handle it all of a sudden.

No wonder, the foregoing discussion leaves one in wilderness. The very thought of risk management practices generating a fresh risk is quite perplexing. But the truth cannot be wished away. Here it is worth recalling what Shankaracharya used as an example—Rajju- Sarpa Bhranthi—to explain the concept of Maya. To quote him: There lies a rope on the road. Assume you are walking in the dusk. Immediately on seeing the rope you took it for a snake, you got frozen with fear, or you look for a stick to beat the snake with it or, you cry for help. In the meanwhile, assume, someone came with a lantern. In the light, you realize that it is not snake but a rope, or the man who brought the lantern tells you that is not snake but a rope. This sudden realization that is not a snake but only a rope makes you feel ashamed of your earlier fear. And you breathe respite. Now the question is: How the “real rope” became a “snake” and suddenly how the snake became the real rope. Shankaracharya says that it is our Ajnana—lack of knowledge­—that made us perceive the rope as a snake. But no sooner the light came—the Jnana dawned on us, we saw the real rope. So what is critical here is—the Jnana. And it is the same what is required to manage ‘risk’ and ‘risk management techniques’ too.

Risk and risk management are, after all, always future-oriented. The consequences of risk management are realized only in the future. And anything associated with future is uncertain and that is the risk what a business may stand exposed to while practicing risk management. It is apt to recall here what the Nobel laureate Richard Feynman once said: “It is in the admission of ignorance and the admission of uncertainty that there is hope for the continuous motion of human beings in some direction that does not get confined, permanently blocked, as it has so many times before in various periods in the history of man”. The only certainty is uncertainty and the only weapon to beat it is the ‘confidence’ and the Jnana of risk or Maya, risk management and their interconnectivity, which alone can steer us through the maze of risk unscathed.                                                                                                                                                                                                                                                                                                   -grk


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