At one time, risk management was limited to insurance and the avoidance of lawsuits and accidents. The new risk management also includes using tools developed for the pricing of financial options for the management of financial risks within the firm. Trading in financial markets based on these tools can insulate companies from the risk of changes in interest rates, input prices, or currency fluctuations. When executed properly, the new risk management can be good and even essential to stay competitive. Unfortunately, it can also be bad, wasting resources without risk improvement or increasing risks. The new risk management can even be ugly, generating large losses, as we have seen in widely publicized cases at Barings, Metelgesellschaft, Proctor and Gamble, and other firms. In these and many other firms, employees far down in the heirarchy of control have the authority to take financial positions large enough to generate losses that can bankrupt a firm. Policies for risk management should be put in place at the highest level of a firm, along with monitoring and control systems. The purpose of this article is to provide an introduction to the new risk management and the policy choices firms should be considering.
We start with a discussion of the option pricing tools that make the new risk management possible followed by an example of how the new risk management ought to work. Then we consider implementation issues including some general policy questions as well as some accounting issues.
Starting with the famous work of Black and Scholes, option pricing theory has been very successful in pricing various financial claims. The Black-Scholes model was designed to price standard call and put options, and it has been extended to price all sorts of financial claims. The new risk management uses the same tools.
There were option pricing models prior to the work of Black and Scholes, including some models with formulas similar to the Black-Scholes formula. What made the Black-Scholes model different is that it provides a hedging strategy that is an investment policy with an investment equal to the model's option price and a terminal value equal to the terminal value of the option. Knowing the trading strategy means that the model is not only someone's best guess, but that it is also possible to profit if the model is wrong without speculating. If the model price is lower than the price in the economy, we can sell the option, pocket the excess over the model price, and invest in the hedging strategy to cover the terminal value of the option we have sold. If the model price is higher than the price in the economy, we follow the hedging strategy in reverse, taking a short position instead of a long position and lending instead of borrowing. In the model, the hedge replicates the option value perfectly. In practice, the hedge is not perfect, but it works remarkably well and consequently the Black-Scholes model and its progeny are widely used by practitioners.
In addition to the theoretical tools, the parallel development and maturation of liquid financial markets has made it easier and easier to trade financial risks using options, futures, futures options, swaps, caps, collars, floors, and a variety of other financial instruments that are now traded in liquid financial markets.
One interpretation of using the hedging strategy to replicate the claim is as risk management: when we buy or sell the option, using the hedging strategy allows us to remove the risk and capture the pure economic profit of the transaction. Fundamentally, this is the same as insurance. An insurance policy makes money in bad times (when the insurable event occurs) and loses money in good times (when no insurable event occurs but the premium is paid). The same is true of a hedging strategy; losing money on the hedge in good times and making money in bad times creates a total cash flow which is less volatile. In either, you can pay for the insurance up front or you can pay as you go; for hedging, as for insurance, the arrangement of cash flows accomodates the preference of the insured.
Using dynamic trading strategies to hedge financial options may seem significantly different from hedging price risk in a firm. However, the concept is exactly the same. We are taking the other side of the risky investment in futures or whatever that would be used to replicate the cash flows we are trying to hedge. Normally, these cash flows cannot be hedged exactly, but in that case we come as close as is possible. For example, we may hedge the expected cash flow conditional on the the price of our inputs that can be hedged in futures markets and leave the remainder unhedged (which means that it is born by the stock and bond holders of the firm).
Before turning to the general policy issues in risk management, we will consider a typical example.
Consider the hedging problem of a manufacturer that uses significant amounts of some commodity, let us say copper, as an input. (With little change in the discussion, this input could be zinc, silver, oil, or wheat. Or, with a slightly greater change, the ``production'' could be servicing of core deposits in a bank and the analysis would provide the optimal hedging of interest rates.) We will consider the optimal hedging of copper price movements in the cash flows before turning to a general discussion of policy and oversight.
Consider the following simple example. We will take expected output to be 1,000 units, each of which will sell for $100, where the price is committed to in advance because of long-term contracts, but where the quantity may vary around this expectation because of options in customers' contracts. Each unit will use an amount of copper that would cost $20 purchased forward (in a firm commitment to buy one year from now). If purchased in the spot market, the copper in the unit might cost $25 (with probability 1/4), $20 (with probability 1/2), or $15 (with probability 1/4).
It might seem that an obvious approach would be to forecast demand for copper and then hedge that amount, either by entering a fixed-price contract with the supplier or by buying that amount of copper futures, at a shorter maturity if necessary because one-year futures are not traded or have a very large spread. This may be a natural outcome if hedging were performed by buyers responsible for copper procurement who are evaluated based on the cost of a forecast quantity of copper. However, choosing an optimal hedge of the entire cash flow is more subtle than that.
Table 1 contains an elaboration of the example, based on the reasonable assumption that copper prices tend to be high when the economy is thriving, which is also when the firm's sales will tend to be high. (In the example, it is assumed that sales are uniquely determined by copper prices, but all that is really important is that demand is higher on average when copper prices are high.) Table 1A shows the cash flows in the absence of any special risk management to hedge copper price risk. Table 1B shows the result of hedging by buying forward the expected quantity. Ironically, this naive approach to hedging increases risk exposure, since the firm is already more than hedged by increased sales when the industry is doing well and copper prices rise. The full hedge, the result of which is shown in Table 1C, cannot be implemented by simply buying or selling copper forward one year. However, the full hedge can be implemented using either options or a dynamic trading strategy in forward or futures contracts. Since this type of strategy is typical of hedging problems, it is worth deriving the dynamic hedge and discussing its operation.
Table 1A: Unhedged Cash Flows Here are the cash flows when the firm chooses not to hedge. Copper is an input, and copper prices tend to be high when the economy is doing well, which is also when unit sales are highest.
Proba- Copper Units Output Total Copper Other Profit bility Price Sold Price Sales Expense Expenses (Loss) 1/4 25 1,200 100 120,000 30,000 82,000 8,000 1/2 20 1,000 100 100,000 20,000 78,000 2,000 1/4 15 800 100 80,000 12,000 74,000 (6,000)Table 1B: Naively Hedged Cash Flows Starting with the unhedged cash flows from Table 1A, we consider a naive hedge of copper prices at the expected quantity. This is at best an incomplete hedge of copper costs (since the quantity changes with copper prices). In this case, the naive hedge actually adds risk to the firm, since increased sales mean profits are high when copper prices are high.
Probability Unhedged Hedge Net
1/4 8,000 5,000 13,000
1/2 2,000 0 2,000
1/4 (6,000) (5,000) (11,000)
Table 1C: Fully Hedged Cash Flows
A complete hedge of all the cash flows requires something more than
a simple purchase of futures, since the sensitivity of the unhedged
profit or loss to copper prices is higher when copper prices are low
than when copper prices are high.
Probability Unhedged Hedge Net
1/4 8,000 (6,500) 1,500
1/2 2,000 (500) 1,500
1/4 (6,000) 7,500 1,500
To study the dynamic hedge, we need to consider trading opportunities and information arrival between now and realization of the cash flows a year from now. In the example, we assume that we are hedging copper prices using copper futures contracts. Futures serve the same economic purpose as forward purchase but are somewhat different logistically, since money changes hands immediately when the prospective value of copper rises and falls. Combined with margin requirements designed to cover a large one-day price move, futures eliminate the need for checking the credit of each trading partner. If I buy one futures contract, then at the end of each day I am given (more literally my margin account is credited with) the change in futures price over the day. If I sell one futures contract then I must pay the change. If the futures price increases from $50 to $55, then the owner of 2 futures contracts would collect $10 and someone who has sold 2 futures contracts would have to pay $10. If the futures price instead decreases from $50 to $45, the person short 2 contracts collects $10 and the person long 2 contracts has to pay $10. In general, the futures price need not be exactly equal to the price we would pay for forward purchase, but for most purposes we can think of the two as being the same. In fact, if interest rates are nonrandom (so re-investment rates are known in advance), absence of arbitrage implies that the forward price must equal the futures price, although one futures contract has more impact, since the change in value is up-front, while in a forward contract the change in value occurs at maturity.
In the actual economy, information is arriving minute-by-minute and we can trade on copper prices almost continuously in time. For our simple example, information arrival and trading occur six months from now and again in a year. (This may seem like a useless simplification, but in fact the analysis for the practical model requires more computations but is conceptually no more difficult.) Now, the futures price of copper delivered a year from now is $20. Six months from now, the futures price will by either $22.50 or $17.50, each with probability 1/2. The overall price dynamic is given in Figure 1. The price at a node in the tree is the price paid in a firm commitment to buy copper one year from now. From a given node, an up or down move is equally likely, with probability 1/2, so any given price path has probability 1/4. Consistent with Table 1, the ending node of $20 is twice as likely as the other ending nodes because it can be reached by either an up move followed by a down move (probability 1/4) or a down move followed by an up move (probability 1/4). A final price of $25 comes only from two up moves (probability 1/4), and a final price of $15 comes only from two down moves (probability 1/4).
Now 6 mos 12 mos
hence hence
|- 25
|- 22.50 -|
20 -| |- 20
|- 17.50 -|
|- 15
The terminal cashflow generated by the hedge (including reinvestment) is analyzed in Table 2. For example, the second row shows the effects of the hedge when prices go up and then down (from 20 to 22.50 back to 20). We start with no initial cash. We short 1,333 contracts, and when in 6 months the futures price goes up by 2.50, we owe 2.50 x 1,333 = 3,333, which we borrow. We also adjust our short futures position to 1,200 contracts. When the futures price falls by 2.50, we collect 2.5 x 1,200 = 3,000 in profits from the futures. Given that we owe 3,333 x 1.05 = 3,500 on our loan, our net cash from the hedge is 3,000 - 3,500 for a loss of 500. Added to the unhedged cash flow in that state of 2,000 (from Table 1A), the hedged cash flow is 1,500. The calculations in the other states work the same way.
Futures Cash # Contracts Cash in # Contracts Cash in Pre-hedge Hedged Price Path Now Now 6 mos in 6 mos 1 yr cash flow Cash Flow 20-22.50-25 0 (1,333) (3,333) (1,200) (6,500) 8,000 1,500 20-22.50-20 0 (1,333) (3,333) (1,200) (500) 2,000 1,500 20-17.50-20 0 (1,333) 3,333 (1,600) (500) 2,000 1,500 20-17.50-15 0 (1,333) 3,333 (1,600) 7,500 (6,000) 1,500
We can see now that the dynamic hedge was chosen so that the re-invested proceeds of the hedge plus the original cash flows are made to be constant. The necessary hedge can be computed as follows. The first two rows differ only in the price performance over the last period. Since the difference in pre-hedge cash flow for these two scenarios is 8,000 - 2,000 = 6,000 and the difference in futures prices for the two scenarios is 25 - 20, we require 6,000 / 5 = 1,200 contracts to replicate the cash flows or (1,200) (the opposite position) to hedge the cash flows. Given the calculated hedge at the last date, the caluculation at the next earlier date proceeds in the same way, and so forth back to the start. The details can be filled in by looking at the linear equations implicit in Table 2, or by standard techniques described in option pricing textbooks.
While the model underlying the hedge for the simple example seems too simple, it is in fact similar (except for the number of intermediate trading dates) to the models that have been used successfully in practice. Adding the additional sub-periods is straightforward given modern computing resources.
In the example in the previous sections, we took it for granted that hedging is desireable. However, this is far from obvious, and it is useful to examine potential motives for hedging.
Why should we hedge? The reason for hedging should link back to the overall objective of the firm, which is to create or enhance economic value. There is a general issue of whether the firm should maximize narrowly the value to shareholders, the total value to all financial claimants, or some more general social value to a variety of stakeholders. This distinction will not be so important to us; most importantly, we will assume that taxes (the government's claim) is not part of what we are optimizing, and for concreteness we will speak of maximizing value to shareholders in the firm.
The first and most obvious effect of hedging is that it reduces the volatility of the value received by shareholders. Unfortunately, this does not have any value for most shareholders in a large publicly-traded firm, who hold the shares in a well-diversified portfolio and for whom the additional risk is unimportant. Indeed, a conflict of interest may exist between the majority of shareholders and large shareholders (for example, members of the founding family who hold 30% of the firm and are undiversified): expenditure of resources to reduce risk benefit the large shareholders at the expense of the general public shareholders. Management may have a similar conflict, since risk threatens their jobs and they may have a significant proportion of their wealth tied up in the firm's shares. Since most shareholders in a publicly traded firm would not care about the additional risk due to copper price exposure, this is not a good reason for hedging. (On the other side of the equation, the cost of hedging may be very small; we will consider this further in a later section on cost issues.)
A more subtle argument for managing copper price risk is that it may do ancillary damage within the firm. As an extreme case, adverse copper price movements may push the firm in bankruptcy, which has a number of deadweight costs to the firm, such as the payment to lawyers and accountants and the loss of profitable future projects. More normally, unhedged risk exposure may tend to increase taxes, since taxes tend to look like a convex function, like a call option, of the firm's profitability: while the government receives additional tax payments when the copper price move is favorable, an unfavorable move will not create a compensating tax reduction, given that tax offsets may only be deferred (and may even be lost). A related tax reason for managing copper prices is that the reduction of risk makes it possible to maintain more leverage to reduce corporate tax and avoid ``double taxation.'' (``Double taxation'' is the payment of both corporate and personal taxes on cash flows going to equity, compared with payment of only personal taxes on cash flows going to debt since interest expense is an offset to income in computing corporate taxes. While there are no personal taxes for institutional investors---and therefore no double taxation---the same argument---single taxation versus no taxation---is valid and even more powerful for institutions, since for individuals there is at least a possibility that the corporate tax on equity will be offset by lower taxes at the individual level through deferral of realizing gains or a lower capital gains rate.)
A third argument for managing copper price risk is that many firms have a policy of smoothing earnings, and that hedging can reduce volatility in earnings. Although this is common practice, it is hard to endorse this policy, since it seems to be an expenditure of the owner's resources to minimize the amount of information getting out to the owners. This may make management more comfortable and minimize criticism, but it is not obviously in the interest of shareholders. In some cases, this could be justified in terms of avoiding restrictive debt covenants, but such covenants are nearly binding in only a small proportion of firms that smooth earnings. More common is the opposite extreme case, in which the internal objective of the firm is to make sure earnings do not fall. This may make management comfortable, indeed too comfortable, but it discourages profitable innovation and is often accompanied with small leverage to keep earnings from moving too much, which implies a large voluntary tax contribution not in the interest of shareholders.
A fourth argument for managing copper price risk is to make it easier to give managers incentives to produce profits: by hedging risk, we can make (for example) a division manager's compensation depend closely on value-added that the manager can influence without making the compensation depend on what the manager can't influence (the actual realization of copper prices). This argument for managing copper price risk implies that it may be optimal to manage copper price risk at a division level even if copper prices do not represent a significant contribution to the firm's cash flow.
What risks should we hedge? The question of what risks to hedge must be subordinant to the question of why we should hedge. If there is not a compelling reason why we should be hedging a particular source of risk, then we probably should not be hedging it. One important issue is the question of the sense in which we are to be hedging a certain type of risk. For example, suppose we are hedging a bank's exposure to interest rate risk. Should we be hedging the direct interest mismatch of existing assets and liabilities, or should we be hedging the full economic value, which would include the value of future business. For example, a bank may find that as interest rates rise, core deposits tend to be lost. Current accounting methods make it hard to hedge this sort of risk without penalty (and the risk-based capital requirements from the Basle Accord penalize almost all hedging). There is a related question of whether to hedge cash flows or value. In principle the two are the same (if we were to hedge cash flows far enough out), but in practice hedging cash flows out a year is much different than hedging the firm's entire value. If the purpose of hedging is to eliminate sources of noise that are beyond the manager's control from compensation, it may even be appropriate to hedge particular accounting numbers used in computing compensation rather than cash flow or economic value.
With what instruments should we hedge? For most commonly hedged risks (such as exposure to interest rates, foreign exchange rates, or commodity prices), there are many instruments that can be used for hedging. For example, to hedge U.S. interest rates we can use bonds, repurchase agreements, Treasury bond futures, swaps, caps, or collars. The choice among this set would be determined by pricing and transaction costs, match to hedging needs, and accounting implications.
Support your investment banker. A common response of managers desiring to hedge is to turn the whole problem over to an investment banker who, after all, has the expertise and the traders who can put the hedge in place for you. And, the investment banker is happy to provide ``free'' advice on what to do. As in all markets, the ``free'' advice is priced out in what you pay for the hedge, then some. To avoid paying way too much, it is best to understand how the hedge works and how much it should cost. Ideally, this expertise should be located in-shop; otherwise, is well worth the expense of hiring an expert to monitor the prices being paid to the investment banker. In general competition is also useful to achieve the lowest cost, but will not necessarily produce any incentive to tell you when hedging is unnecessary.
Suppose we put in place the optimal hedge computed above using the model for demand and option pricing theory to determine the correct holding in futures to offset the risk in the cash flows. What will this do to our accounting statements?
In general, accounting looks at the present and the past: accountants are focused on using methods whose results are easily replicable, especially since standard mechanical rules, even if inaccurate, can make available the defense that the firm followed Generally Accepted Accounting Principles (GAAP). Hedge accounting is a relatively new and technical area, and the accounting profession is only starting to address the important issues involved.
First of all, this hedge does not meet the requirements for a hedge according to GAAP. According to FAS 80, a futures contract must be marked to market at the end of the accounting period unless it qualifies as a hedge. To qualify as a hedge, (1) the futures must be designated as a hedge, (2) there must be underlying risk to hedge, (3) while the assessment of risk can be done on a centralized basis (if it is impractical to do otherwise), the risk management is assessed on a decentralized basis looking at specific assets, liabilities, and firm commitments, and (4) there must be a clear economic relationship between the price of an underlying asset, liability, or firm commitment and a high degree of price ``correlation'' is probable. (The reference to correlation bears no relation to the usual statistical definition of correlation: FAS 80 makes it clear that the statistical definition is not intended and may not be relevant in assessing compliance. Unfortunately, FAS 80 does not make clear how correlation should be defined.) Under these rules, our hedge of sales certainly does not qualify, since future sales are off-balance-sheet and are not firm commitments. Even if the sales were on the balance sheet, it is not clear whether they would meet the vague and mysterious requirement that correlation be probable.
Failure to qualify as a hedge often penalizes hedging. A firm that hedges without qualifying will typically have less volatile cash flows in the future, but more volatile reported earnings. This volatility is especially damaging when it causes violation of debt covenants or capital requirements imposed by regulators. Volatility of earnings may also subject management to criticism; given the current frantic environment we may want to pardon a manager who forgoes an economically useful hedge to avoid the appearance of ``risky exposure to derivatives.'' Part of the problem is that there seems to be no simple test that distinguishes risky speculation from good hedging.
One interesting feature of the accounting rules is that what might seem to be economically equivalent hedges have very different accounting treatments. For example, suppose in the example above that demand does not depend on copper prices (putting the same number in all of the ``Units Sold'' column in Table 1A) and that we are simply interested in hedging the input cost at expected demand. Then it might seem equivalent to hedge through a long-term contract with a supplier, by buying copper futures, or by buying shares in a company whose share price tracks copper closely. However, the contract with a supplier has no impact on earnings before the actual sale, buying copper futures is covered by FAS 80 as discussed above, shares in the copper company are accounted at fair value but unrealized gains and losses are unlikely to appear in earnings (FAS 115). In each of these cases, there are various rules somewhat specific (FAS 105 and 107) or incredibly vague (FAS 119) that require a company to report their risk exposure. FAS 119 is especially vague and is basically calling on the companies and the accounting firms to come up with useful reports that can be used as models for later standards. This approach comes from a general recognition that current reporting practice is often misleading, combined with a paucity of good ideas on how to patch things up. It seems that hedging tends to magnify the problems inherent in traditional accounting standards' mix of historical cost and mark-to-market.
It should be mentioned here that some people have proposed universal adoption of mark-to-market (or intrinsic value) accounting, which is ``obviously'' the correct thing to do because that is a good estimate of what the firm is actually worth, and any hedge would be seen for what it is. Unfortunately, it is not at all clear what this means. For example, do we include future sales in our valuation, and if so, how far in the future do we go and how do we forecast and value the future flows? Anyone who has been involved in capital budgeting exercises knows that estimates for the value of future cash flows are so inaccurate that they reflect more the optimism of the forecaster than the prospects for the firm. Even without these conceptual problems, introducing a whole new system of accounting is not a trivial matter. While we are noting that current accounting standards are deficient for measuring risk, we are not suggesting that it is easy to do better.
The differences in accounting treatment of economically equivalent hedges may allow firms to hedge in spite of the deficiencies in the accounting standards. Whether or not a firm that is hedging properly can avoid looking bad, it is clear that a firm that is hedging not at all or even increasing risk can look fine.
Cost Issues
What is the cost of hedging? It is tempting to think that the cost of the hedge is the cost of any securities purchased in the hedge program. In fact, the hedge is often bundled with an investment. If we buy a call option and pay its intrinsic value, that is a fair investment and, absent market imperfections, there is no cost in doing so. In practice, the cost includes transaction costs such as commissions, bid-ask spread, and any internal costs of trading (e.g. hiring a trader and setting up accounting oversight). For publicly traded contracts in liquid markets, the costs are probably small and easy to measure. When hedging using custom contracts provided by investment bankers, the costs are hard to assess (because they are built into pricing) and may be much larger. On a more esoteric point, we may also want to include in the cost of hedging the alternative use of any capital tied up in the investment or in margin or variation accounts. On another subtle point, a hedge may be more costly than it appears if its pricing and tax treatment makes it inappropriate for the firm.
What is the marginal cost that should be used when making decisions about pricing the output? It is probably common to use the hedged price but in fact the marginal cost of the commodity at the time of use is the spot market price (assuming an active market that was probably necessary to implement the hedge in the first place). While we have locked in the price for a fixed amount, that is sunk, and we will collect the profit or bear the loss on that amount however much or little we actually lose. If we need more than that amount, we will buy the excess at the spot price. If we need less than that amount, we will sell the excess at the spot price. In either case, the marginal cost is the spot price. If we act as if the marginal cost is the hedge price, we may be throwing away money. For example, suppose the spot price is higher than the hedge price. If we focus on the locked-in price, we may sell additional units when we could make more money just selling the inputs we have procured.
What is the transfer price that should be used when the commodity is procured by one unit in the firm and used by another? For accounting purposes, it should be decided up front how profits and losses in the hedging program will be shared in the organization. It is probably best to plan to do so in a way that hedges cash flows in each unit, since that will make compensation in each unit more directly indicative to performance within the manager's influence. If this is not decided in advance, there is an inherent unfairness that may result. For example, suppose it is ambiguous or renegotiable what the transfer price is. If the transfer price is the market price when it is low but a hedged price when it is high, the purchasing unit gets a ``free option'' and the procuring unit loses whether or not it is hedged. The free option allows the unit to buy at the hedged price or the market price, whichever is less. The procuring unit always loses money.
Given that standard accounting procedures do not provide a particularly useful picture of the quality of a firm's hedging program, it is especially important for management to adopt and implement an understandable and effective risk-management policy. Such a policy should specify the goal and scope of any hedging activity, and it should also dictate the degree of centralization and the control systems. Furthermore, the policy should provide for oversight and evaluation of the effectiveness of hedging.
A common feature of the biggest disasters is a failure in control systems. Financial firms face a particular temptation to have inadequate controls. After all, firms want to keep successful traders around, and may tend to be sympathetic to their insistence of keeping the bureaucracy from interfering with their work (or even driving them to another firm). A failure to separate the operations and accounting functions from trading was an essential common thread in the recent losses of over a billion dollars each, attributable in each case to a single trader, at Barings, Daiwa Bank, and Sumitiomo. It is important to devote serious talent to the job of monitoring traders, even though the monitoring job is less sexy, somewhat unpleasant, and when things are going well, seemingly unproductive.
Short of disasters, risk management can be counter-productive if it is too localized. For example, the example we discussed earlier showed how a procurement department hedging material costs may actually make overall cash flows more variable if input prices tend to be high when the industry does well. Less damaging but probably wasteful is the prospect of offsetting hedging by different parts of the firm or hedging of economically irrelevant risks. For most firms the benefits of centralization (better control, economies of scale, and cost saving due to internal netting) will dominate the costs (mostly the difficulty of communicating and aggregating needs). Of course, it is a good idea to have a formal policy whether risk management is centralized or dispersed.
A good risk management policy should state the goals of the hedging program. Is it desired to hedge the value or dividends paid to shareholders, and if so, what risks should be hedged and what risks should be born by the shareholders? Should there be hedging on a division or departmental level (to improve planning and incentive compensation) when that hedging does not reduce the overall variability of the firm's value? Should the hedging program be focused on cash flows, earnings, tax avoidance, or something else? There are not yet obviously definitive best answers to these questions, but at least a consistent policy will minimize offsetting efforts.
One important (but probably often neglected) aspect of a risk-management program is the need for ex post evaluation. Especially given that these programs are relatively new, it is entirely possible to design a program that is ineffective or even increases risk (like the naive hedging strategy in our copper price hedging example). Only retrospective analysis of the results can verify that the program is actually reducing risk. The retrospective analysis should also look at any side effects of the hedging, for example variation or margin account payments required to maintain the hedge.
Risk management is an important and difficult area of corporate policy. We have seen interesting news accounts of disastrous failures in risk management. Less spectacular but perhaps more important is the widespread use of futures contracts and swaps to hedge foreign exchange, interest rate, and commodity risks, since without this ability to hedge many profitable business would be just too risky.
The developments over the next few years should be especially interesting, as companies work on implementing vague new accounting standards that require them to describe their risk exposure. It is also an exciting time for the development of internal controls and policies as companies work on developing effective hedges while avoiding catastrophic losses.