A FRAMEWORK FOR RISK MANAGEMENT

In recent years, managers have become aware of how their companies can be buffeted by risks beyond their control. Fluctuations in economic and financial variables such as exchange rates, interest rates, and commodity prices have often had destabilizing effects on corporate strategies and performance. To insulate themselves from such risks, many companies are turning to the derivatives markets, taking advantage of instruments like forwards, futures, options, and swaps. Although heavily involved in risk management, most companies do not have clear goals underlying their hedging programs. Without such goals, using derivatives can be dangerous. Kenneth Froot, David Scharfstein, and Jeremy Stein present a framework to guide top-level managers in developing a coherent risk-management strategy. That strategy cannot be delegated to the corporate treasurer - let alone to a hotshot financial engineer. Ultimately, a company's risk-management strategy needs to be integrated with its overall corporate strategy. The authors' risk-management paradigm rests on three premises: (1) the key to creating corporate value is making good investments; (2) the key to making good investments is generating enough cash internally to fund them; (3) cash flow can often be disrupted by movements in external factors, potentially compromising a company's ability to invest. Therefore, a risk-management program should have one overarching goal: to ensure that a company has the cash available to make value-enhancing investments.