Global risks Featured

7:00pm EDT November 24, 2006

Our nation’s most successful firms are ones whose financial managers understand how to raise and allocate capital as well as arbitrage and hedge risks in the global market.

Arvind Mahajan, Lamar Savings Professor of Finance at Texas A&M University, has spent decades observing how multinationals manage risk. His take: good risk management is based on a keen understanding of, and adherence to, corporate objectives. “This is a subtle point that’s often overlooked,” says Mahajan. “Risk management has to be in consonance with the identity of the firm.”

Smart Business spoke with Mahajan about how risk needs to be addressed. His proposal: view risk in a holistic way and always consider the impact of a risk management decision on the overall value of a firm.

What are some key ways that derivative instruments can aid the financial manager in achieving financial objectives?

Derivatives can help, but only if senior executives clearly plan their overarching corporate objectives to include risk management. We see an example of this in the foreign exchange arena. If an integrated currency risk management program is important to an organization, and the firm has done a fair amount of introspection to determine who they are and which risks they want to bear and which they do not, then costs associated with exchange rate hedging can be reduced. In such a case, individual units within an organization will not instigate hedging transactions without considering the existing exposure of other units. Such an approach reduces transaction costs while benefiting the company as a whole. Too often, managers hedge risk only in their functional area of responsibility without analyzing exposure across the enterprise.

Is there a convergence of prices or are there special circumstances when risk is priced differently for the same product?

Even in the U.S., where markets are more efficient, price differences can occur and these could be caused by market sentiment or participant psychology. This is corrected with time. However, in international markets, there are also imperfections that place limits on arbitrage such as transaction/information costs, or capital and foreign exchange controls and differential taxes, which are the result of government policies. While the consequences of some of these imperfections cannot be circumvented, creative organizations can find ways to successfully negotiate around them.

For example, foreigners may be restricted or find it very expensive to invest in some countries’ capital markets. To get around such constraints, clever financial intermediaries created American Depository Receipts (ADRs) and country mutual funds, which allow the U.S. investor to participate in certain foreign markets they may not otherwise be able to. Restrictions can impede foreign and domestic prices to converge in the real sector of the economy as well, providing a unique opportunity for multinational firms to profitably exploit them. Existence of such firms and astute traders, increasing awareness of international portfolio diversification benefits coupled with development of financial engineering products are expediting price convergence. A trend toward reduction in barriers and the ability to communicate and transmit information swiftly are resulting in a more integrated global market.

As American firms seek partnerships with foreign firms for the competitive advantages they offer, how can businesses better manage foreign exchange risk?

Foreign exchange risk emerges irrespective of whether you have foreign partnerships. The risk arises the moment you have potential cash inflows or outflows in a currency other than your own. When you are able to match the timing and magnitude of these flows in the same currency, you wash out the risk.

With increasing globalization, firms have to contend with foreign exchange risk. The easy solution is to match currency denominations of your inflows and outflows or insist that payment received or made be in your home currency but this is not always possible.

In that case, you can create currency hedges, and there are many ways to do this. The simplest one is a money market hedge where you hedge exposure by selling dollars and buying, say, pounds in the spot market and investing the proceeds in a bank to pay off a later pound liability. Another method is to hedge using forwards or futures: signing a contract today to transact at a set price (in this currency) at a predetermined time in the future. Alternately, you could use currency put and call options, and it’s in this area of derivatives where the greatest innovations have occurred.

ARVIND MAHAJAN is the Lamar Savings Professor of Finance at the Mays Business School at Texas A&M University. Reach him at (979) 845-4876 or mahajan@tamu.edu.