Fifteen years ago, you couldn’t fill a small room with energy CEOs interested in discussing how credit risk affects their companies’ bottom lines. But a recent series of contract defaults,...
Are They Betting The Company?
Eleven questions to ask senior managers about their risk-management objectives.
It is almost impossible to design an effective hedge program without first determining the exact objectives a company wants to achieve. Although this sounds obvious, it rarely is. Management usually can agree that the firm should hedge to reduce risk, but “risk” is too vague a term to justify hedging on its own.
Risk is best defined as the uncertainty around the firm’s ability to meet its stated objectives. Board members, senior management, traders, and the risk manager do not always share the same views of the company’s objectives, and therefore may define risk differently. For example, the CFO may be most concerned with achieving earnings-per-share (EPS) forecasts given to equity analysts; the risk manager with avoiding surprises in the mark-to-market; senior management with accumulating cash for strategic acquisitions; and the board with achieving other broad strategic goals.
Since objectives rarely are discussed, the parties involved usually are unaware that their opinion of the company’s objectives often differs from that of everyone else. Different objectives are exposed to different risks, so hedging and risk management strategies will vary.
As an example, suppose a firm’s objective is to ensure sufficient operating cash flow to fund an acquisition. A hedging strategy that could potentially deplete the firm’s cash reserves through collateral requirements would then not be as attractive as one that delivers cash upfront and is supported by contingent capital.
Aligning company objectives can be a time-consuming but useful experience. The first step is to interview all relevant personnel. Company interviews should include members of the board, senior management, the risk manager, and the head of trading, but the interviews need not stop within the company. Equity and debt analysts can provide insight into how investors and lenders perceive the company’s objectives and risks. Poorly performing and poorly communicated hedging strategies often have resulted in significant declines in equity value and investor confidence, so it pays to invest some time understanding analyst concerns and educating them on the company’s objectives and reasons for hedging.
Standardized questions can help identify the most important issues and allow the various answers to be compared.
To avoid conflicts of interest, the interviews should be conducted by an independent source, such as the risk manager or an external third party. Whoever it is, someone who is formally tasked with its successful completion in a timely manner must lead the project.
Once the interviews are completed, the results may be collected and summarized into a consistent and complete set of financial objectives and risk-management principles from which an effective risk policy and hedging strategy can be derived. Of course, it’s not that simple; usually the final set of objectives and principles is the result of countless meetings and spirited discussion. A tight deadline from a ratings agency or the board usually serves to speed things up and