Fluctuation in Economic and Financial Variables

Topics: Finance, Corporate finance, Peak oil Pages: 20 (7350 words) Published: January 21, 2013
In recent years, managers have become increasingly aware of how their organizations can be buffeted by risks beyond their control. In many cases, fluctuations in economic and financial variables such as exchange rates, interest rates, and commodity prices have had destahilizing effects on corporate strategies and performance. Consider the following examples: D In the first half of 1986, world oil prices plummeted hy 50%; overall, energy prices fell hy 24%. While this was a boon to the economy as a whole, it was disastrous for oil producers as well as for companies like Dresser Industries, which supplies machinery and

just that. The General Accounting Office reports that hetween 1989 and 1992 the use of derivativesamong them forwards, futures, options, and swapsgrew hy 145%. Much of that growth came from corporations: one recent study shows a more than fourfold increase hetween 1987 and 1991 in their use of some types of derivatives.' In large part, the growth of derivatives is due to innovations hy financial theorists who, during the 1970s, developed new methods-such as the BlackScholes option-pricing formula-to value these complex instruments. Such improvements in the technology of financial engineering have helped spawn a new arsenal of risk-management weapons. Unfortunately, the insights of the financial engineers do not give managers any guidance on how to deploy the new

A Framework for
Risk Management
by Kenneth A. Froot, David S. Scharfstein, and Jeremy C. Stein equipment to energy producers. As domestic oil production collapsed, so did demand for Dresser's equipment. The company's operating profits dropped from $292 million in 1985 to $139 million in 1986; its stock price fell from $24 to $14; and its capital spending decreased from $122 million to $71 million. D During the first half of the 1980s, the U.S. dollar appreciated by 50% in real terms, only to fall hack to its starting point by 1988. The stronger dollar forced many U.S. exporters to cut prices drastically to remain competitive in glohal markets, reducing short-term profits and long-term competitiveness. Caterpillar, the world's largest manufacturer of earthmoving equipment, saw its real-dollar sales decline hy 45% between 1981 and 1985 before increasing hy 35% as the dollar weakened. Meanwhile, the company's capital expenditures fell from $713 million to $229 million before jumping to $793 million in 1988. But hy that time. Caterpillar had lost ground to foreign competitors such as Japan's Komatsu. In principle, both Dresser and Caterpillar could have insulated themselves from energy-price and exchange-rate risks hy using the derivatives markets. Today more and more companies are doing HARVARD BUSINESS REVIEW Novtmbcr-Dcccmbfr 1994

weapons most effectively. Although many companies are heavily involved in risk management, it's safe to say that there is no single, well-accepted set of principles that underlies their hedging programs. Financial managers will give different answers to even the most hasic questions: What is the goal of risk management? Should Dresser and Caterpillar have used derivatives to insulate their stock prices from shocks to energy prices and exchange rates? Or should they have focused instead on stabilizing their near-term operating income, reported earnings, and return on equity, or on removing some of the volatility from their capital spending? Without a clear set of risk-management goals, using derivatives can be dangerous. That has been Kenneth A. Froot is a professor at the Harvard Business School in Boston. Massachusetts. David S. Scharfstein is the Dai-lchi Kangyo Bank Professor and Jeremy C. Stein the J.C. Penney Professor, at the Massachusetts Institute of Technology's Sloan School of Management in Cambridge. Massachusetts. 91

RISK MANAGEMENT made abundantly clear hy the numerous cases of derivatives trades that have backfired in the last couple of years. Procter & Gamble's losses in customized interest-rate...
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • financial Essay
  • Economics Essay
  • Essay on Financial and Economic Analysis
  • ECONOMICS Research Paper
  • Economics Essay
  • An Economic Analysis of Financial Structure Essay
  • Financial Economics: Problem Set Essay
  • economics Essay

Become a StudyMode Member

Sign Up - It's Free