Corporate

Risk
Management
@ EDHEC

Prof. Schroth Corporate Risk Management

Contents MSc in Corporate Finance & Banking
FX Exposure
Economic exposure
EDHEC Business School
Direct and indirect
exposures
Measuring economic
exposure
Enrique Schroth
IRM
Diversification
Natural hedges
Professor of Finance
Strategic hedging
IRM EDHEC Business School
Risk
management
in practice
Lecture 5
12-14 October 2022

1 / 44
 Contents

Corporate
Risk
Management
@ EDHEC
1 Contents
Prof. Schroth
2 FX Exposure
Contents Economic exposure
FX Exposure Direct and indirect exposures
Economic exposure
Direct and indirect
Measuring economic exposure
exposures
Measuring economic
exposure 3 IRM
IRM
Diversification
Diversification
Natural hedges
Strategic hedging
Natural hedges
IRM Strategic hedging
Risk
management
IRM
in practice
4 Risk management in practice

2 / 44
 Economic exposure

Corporate
Risk
Management
@ EDHEC

Prof. Schroth
• Reading: Stulz, Chapter 7.
Contents

FX Exposure • One-off, short-maturity, predictable deals can be easily

Economic exposure
Direct and indirect
hedged with derivatives.
exposures
Measuring economic
exposure
• Non-linear, long-term expoures to a combination of risk
IRM factors wih different degrees requires a different approach
Diversification
Natural hedges • How can we address economic exposure?
Strategic hedging
IRM ⇒ from a deal-based to a strategic, integrated approach
Risk
management
in practice

3 / 44
 What is economic exposure?

Corporate
Risk
Management
@ EDHEC

Prof. Schroth • A firm that sells internationally:

Contents
• has contracted sales and expenses: fixed transaction
FX Exposure exposures;
Economic exposure • has probable and possible future sales and expenses:
Direct and indirect
exposures expected transaction exposures.
Measuring economic
exposure

IRM • FX rate changes will alter

Diversification
Natural hedges • the e (or $, or £) value of sales and expenses, but also ...
Strategic hedging
IRM

Risk
management
in practice

4 / 44
 What is economic exposure?

Corporate
Risk
Management
@ EDHEC

Prof. Schroth • A firm that sells internationally:

Contents
• has contracted sales and expenses: fixed transaction
FX Exposure exposures;
Economic exposure • has probable and possible future sales and expenses:
Direct and indirect
exposures expected transaction exposures.
Measuring economic
exposure

IRM • FX rate changes will alter

Diversification
Natural hedges • the e (or $, or £) value of sales and expenses, but also ...
Strategic hedging
IRM
• the quantity of foreign currency (directly and indirectly).
Risk
management
⇒ this is economic exposure
in practice

4 / 44
 Example: Italian wine exporter

Corporate
Risk • The IWE sells wine to Europe and the US
Management
@ EDHEC
• Suppose the Euro weakens with respect to the US$ (e.g.,
Prof. Schroth
because the US FED raises US$ interest rates)
Contents • Direct effects
FX Exposure
Economic exposure
• Sells more wine in US (its product is cheaper now)
Direct and indirect • Sells more wine in Europe (US wines become more
exposures
Measuring economic
exposure
expensive)
• Profits from US are worth more in Euros now but ...
IRM
Diversification
Natural hedges
Strategic hedging
IRM

Risk
management
in practice

5 / 44
 Example: Italian wine exporter

Corporate
Risk • The IWE sells wine to Europe and the US
Management
@ EDHEC
• Suppose the Euro weakens with respect to the US$ (e.g.,
Prof. Schroth
because the US FED raises US$ interest rates)
Contents • Direct effects
FX Exposure
Economic exposure
• Sells more wine in US (its product is cheaper now)
Direct and indirect • Sells more wine in Europe (US wines become more
exposures
Measuring economic
exposure
expensive)
• Profits from US are worth more in Euros now but ...
IRM
Diversification • Selling in US is now more expensive
Natural hedges
Strategic hedging • Indirect Effects
IRM
• US-imported glass bottles are more expensive now
Risk
management • High interest rates depress US demand for wine
in practice
• ECB raises Eurozone interest rates to hold value of e,
reducing European demand for red wine
⇒ what is the total effect?
5 / 44
 Direct versus Indirect Exposures

Corporate
Risk
Management
@ EDHEC
• Suppose there is a US dollar appreciation wrt the e
Prof. Schroth
• How does this affect Eurozone-based companies with sales
Contents
in or purchases from the US?
FX Exposure
Economic exposure • Direct effects
Direct and indirect
exposures • Value of sales in US go up (good)
Measuring economic
exposure • Value of costs in US rise (bad)
IRM
Diversification
• Indirect Effects
Natural hedges
Strategic hedging
• competitors sourcing from US lose out (good)
IRM • suppliers that source from US lose out (bad)
Risk • Customers selling to US gain (good)
management
in practice • Customers sourcing from US lose (bad)

6 / 44
 Currency risk is global

Corporate
Risk
Management
@ EDHEC

Prof. Schroth
• Once we consider indirect effects there is no such thing as
Contents

FX Exposure
a ‘domestic firm’
Economic exposure
Direct and indirect
• Almost all companies compete with foreigners
exposures
Measuring economic
exposure
• Almost all companies have foreign sales and/or sources
IRM • Almost all companies’ market value would suffer if
Diversification
Natural hedges interest rates rose as a result of weak currency.
Strategic hedging
IRM How do we determine the bottomline exposure to FX?
Risk
management
in practice

7 / 44
 Measuring total exposure

Corporate
Risk
Management
@ EDHEC

Prof. Schroth

Contents

FX Exposure
As firm outsiders financial analysts often use regression analysis
Economic exposure to determine a stock’s exposure to a combination of risk
Direct and indirect
exposures factors:
Measuring economic
exposure
rt = a + b∆St + cXt + et
IRM
Diversification
Natural hedges
where c allows us to control for other factors.
Strategic hedging
IRM

Risk
management
in practice

8 / 44
 Example: Stock returns and oil and gas prices
Risk Management at Apache 201-113

t
(US 2001)

os
Exhibit 11 Sensitivity of the Firm's Stock Returns to Changes in Oil and Gas Futures Prices and
Market Movements:

Regression II: Firm Return = α + β 1(% change in oil price) + β 2(% change in gas price) + β 3(market return)
Corporate
Risk Panel A: Independent Oil Firms

rP
Management Regression Coefficients (t-statistics in parenthesis)

@ EDHEC % Change in Oil % Change in Gas Market Adjusted R2

Intercept Price Sensitivity Price Sensitivity Sensitivity from
Name of Firm α)
(α β 1)
(β β 2)
(β β 3)
(β Regression II
Prof. Schroth Anadarko Petroleum 0.00 0.37 0.33 0.72 45.9%
(-0.13) (3.03) (4.70) (2.90)

yo
Apache 0.00 0.20 0.43 0.59 44.9%
Contents (-0.13) (1.57) (5.83) (2.29)
Barrett Resources 0.00 0.15 0.47 0.63 33.3%
FX Exposure (-0.16) (0.87) (4.83) (1.85)
Belco Oil & Gas Corp. -0.02 0.05 0.28 0.96 15.5%
Economic exposure (-1.16) (0.28) (2.44) (2.44)
Direct and indirect Burlington Resources -0.01 0.06 0.40 0.58 46.4%
exposures (-1.01) (0.58) (6.38) (2.57)

op
Measuring economic Devon Energy Corp. 0.00 0.10 0.44 0.66 49.1%
(-0.32) (0.88) (6.51) (2.76)
exposure
EOG Resources 0.00 0.05 0.44 0.54 39.0%
(-0.17) (0.38) (5.69) (1.94)
IRM
Louis Dreyfus 0.00 0.02 0.50 1.05 39.5%
Diversification (0.01) (0.13) (5.23) (3.13)
tC
Natural hedges Magnum Hunter Resources 0.01 -0.14 0.42 0.89 19.2%
(0.54) (-0.65) (3.52) (2.11)
Strategic hedging
Newfield Exploration Co. 0.00 0.46 0.38 0.89 55.2%
IRM (-0.12) (3.77) (5.42) (3.59)
Noble Affiliates Inc. -0.01 0.33 0.36 0.70 37.1%
(-0.68) (2.21) (4.29) (2.36)
Risk
Occidental 0.00 0.03 0.20 0.47 14.9%
management
No

(-0.31) (0.27) (2.86) (1.92)

in practice Ocean Energy -0.02 0.45 0.53 0.80 50.5%
(-1.44) (2.81) (5.86) (2.48)
Patina Oil & Gas Corp. 0.00 0.51 0.50 0.91 52.4%
(-0.08) (3.11) (5.35) (2.81)
Pioneer Natural Resources -0.02 0.34 0.53 0.72 39.9%
(-1.1) (1.85) (5.10) (1.97)
Range Resources Corp. -0.02 0.82 0.62 0.62 34.6%
(-0.73) (2.92) (3.91) (1.10)

9 / 44
 Example: Stock returns and oil and gas prices
201-113 Risk Management at Apache

(US 2001)

t
os
Exhibit 11 (continued)

Corporate Panel A: Independent Oil Firms (continued)

Risk Regression Coefficients (t-statistics in parentheses)

Management % Change in Oil % Change in Gas Market Adjusted R

2

rP
Intercept Price Sensitivity Price Sensitivity Sensitivity from
@ EDHEC Name of Firm α)
(α β 1)
(β β 2)
(β β 3)
(β Regression II

St. Mary Land & Exploration Co. 0.00 0.22 0.45 0.94 41.3%
Prof. Schroth (0.30) (1.43) (5.09) (2.95)
Union Pacific Resources -0.01 0.24 0.39 0.66 20.1%
(-0.62) (1.07) (2.81) (1.49)
Contents Unocal Corp. -0.01 0.20 0.23 0.36 32.4%

o
(-0.57) (2.02) (4.07) (1.80)

FX Exposure Vastar Resources 0.01 0.05 0.26 0.39 16.7%

(0.83) (0.36) (2.82) (1.36)
Economic exposure Vintage Petroleum Inc. -0.01 0.80 0.46 1.37 47.9%
Direct and indirect (-0.7) (3.93) (3.94) (3.33)

py
exposures Panel B: Major Oil Firms
Measuring economic Chevron 0.00 0.05 0.12 0.49 23.8%
exposure (0.14) (0.67) (2.81) (3.22)
Exxon Mobil 0.01 0.04 0.05 0.32 11.0%
IRM (1.55) (0.64) (1.47) (2.52)

Diversification
Natural hedges
Strategic hedging
Texaco Co 0.00
(0.47)
0.15
(1.66)

Panel C: Firms outside the oil and gas industry

0.12
(2.37)
0.15
(0.83)
13.6%

Bethlehem Steel Corp -0.04 -0.09 0.12 1.33 20.8%

IRM (-2.36) (-0.55) (-1.27) (4.03)
Borg Warner Inc 0.00 -0.13 0.02 0.88 15.1%
Risk (0.00) (-1.08) (0.22) (3.59)
Ford 0.01 -0.24 -0.01 0.85 23.7%
management
t
(1.34) (-2.25) (-0.24) (4.06)
in practice General Electric 0.01 -0.02 0.02 1.09 49.2%
No

(1.52) (-0.34) (0.46) (7.65)

Goodyear Tire -0.02 -0.14 0.16 0.76 13.6%
(-1.4) (-1.06) (2.08) (2.83)
Pepsi Co. 0.00 -0.20 0.10 0.95 33.1%
(0.01) (-2.21) (2.02) (5.18)
Wal-Mart 0.03 -0.29 0.02 0.79 22.2%
(2.39) (-2.39) (0.41) (3.65)

10 / 44
 Example: FX exposure in the Canadian Paper
and Forest Industry
Corporate
Risk
Management
@ EDHEC

Prof. Schroth
• Take the regression of returns of a portfolio of Canadian
Contents manufacturers of paper and forestry on the exchange rates
FX Exposure
Economic exposure
and local stock market returns:
Direct and indirect
exposures
Measuring economic
exposure
rt = a + b1 ∆SCAD/USD,t + b2 ∆SCAD/GBP,t
IRM +b3 ∆SCAD/JPY ,t + cTSEt + et
Diversification
Natural hedges
Strategic hedging
IRM
⇒ We obtain the following OLS estimates:
Risk
b̂1 = 0, b̂2 = −0.31, b̂3 = 0.58, ĉ = 1.11, R 2 = 0.64
management
in practice

11 / 44
 Interpreting the results

Corporate
Risk
Management
@ EDHEC

Prof. Schroth

Contents
1 Stock returns are not exposed to (real) CAD/USD rate
FX Exposure 2 A 1% real depreciation of CAD against GBP is associated
Economic exposure
Direct and indirect with a 0.3% decrease in stock returns
exposures
Measuring economic
exposure
3 A 1% real depreciation of CAD against JPY is associated
IRM with a 0.6% increase in returns
Diversification
Natural hedges 4 TSE market index helps explain a lot more of the
Strategic hedging
IRM variation in returns.
Risk
management
in practice

12 / 44
 Interpreting the results (II)

Corporate
Risk
Management
@ EDHEC • Additional facts
Prof. Schroth
• 70% of Canadian paper is exported
Contents • 80% wood exported
FX Exposure • 80% of Canadian exports are to US
Economic exposure
Direct and indirect ⇒ Why is CAD/USD rate not important then?
exposures
Measuring economic
exposure

IRM
Diversification
Natural hedges
Strategic hedging
IRM

Risk
management
in practice

13 / 44
 Interpreting the results (II)

Corporate
Risk
Management
@ EDHEC • Additional facts
Prof. Schroth
• 70% of Canadian paper is exported
Contents • 80% wood exported
FX Exposure • 80% of Canadian exports are to US
Economic exposure
Direct and indirect ⇒ Why is CAD/USD rate not important then?
exposures
Measuring economic
exposure
• As an outsider to the firm, e.g., an analyst, we can either
IRM
conclude that
Diversification • the USD FX risk is systematic to this industry and
Natural hedges
Strategic hedging priced-in by diversified shareholders via the volatility in the
IRM
TSE market index.
Risk
management
in practice

13 / 44
 Interpreting the results (II)

Corporate
Risk
Management
@ EDHEC • Additional facts
Prof. Schroth
• 70% of Canadian paper is exported
Contents • 80% wood exported
FX Exposure • 80% of Canadian exports are to US
Economic exposure
Direct and indirect ⇒ Why is CAD/USD rate not important then?
exposures
Measuring economic
exposure
• As an outsider to the firm, e.g., an analyst, we can either
IRM
conclude that
Diversification • the USD FX risk is systematic to this industry and
Natural hedges
Strategic hedging priced-in by diversified shareholders via the volatility in the
IRM
TSE market index.
Risk
management
• the residual or idiosyncratic exposure to USD is
in practice hedged somehow (i.e., financially or operationally).

13 / 44
 Measuring total exposure (II)

Corporate
Risk
Management
@ EDHEC

Prof. Schroth
• As outsiders, we cannot really tell to what extent
Contents
Canadian paper and forestry firms are managing this risk
FX Exposure
Economic exposure
internally or whether its shareholders are fully diversified.
Direct and indirect
exposures • But insiders can run the following regression:
Measuring economic
exposure

IRM
Diversification
∆CFt = a + b∆St + cXt + et ;
Natural hedges
Strategic hedging in which c allows us to control for other factors and
IRM

Risk
⇒ b gives the percentage impact of currency changes.
management
in practice

14 / 44
 Hedging economic exposures

Corporate
Risk
Management
@ EDHEC

Prof. Schroth
• How can a company deal with the impacts of potentially
Contents huge swings in the value of currencies?
FX Exposure
Economic exposure
Direct and indirect
exposures
Measuring economic
exposure 1 Diversification;
IRM
Diversification
Natural hedges
2 Operating policies;
Strategic hedging
IRM

Risk 3 Financing policies.

management
in practice

15 / 44
 Diversification

Corporate
Risk
Management
@ EDHEC

Prof. Schroth
• Diversifying the operating base, combining
• sales locations;
Contents
• production locations;
FX Exposure
Economic exposure
• input sources locations.
Direct and indirect
exposures
Measuring economic
• Diversifying the financing base,
exposure
• using international sources of funds;
IRM
Diversification • choosing optimal mix of floating vs. fixed interest rate.
Natural hedges
Strategic hedging ⇒ Key is for management to expect shifts away from
IRM

Risk
equilibrium (6= predicting them), and to anticipate an
management
in practice
appropriate reaction.

16 / 44
 Risk-sharing agreements

Corporate
Risk
• Ford and Mazda agreed that all Ford purchases will be
Management • in Yen, at the full agreed price if the current rate is
@ EDHEC

Prof. Schroth
between [Y 115, Y 125] per US$, or
• Ford and Mazda would share the difference equally if prices
Contents fell outside the range.
FX Exposure
Economic exposure
Direct and indirect
exposures
Measuring economic
exposure

IRM
Diversification
Natural hedges
Strategic hedging
IRM

Risk
management
in practice

17 / 44
 Risk-sharing agreements

Corporate
Risk
• Ford and Mazda agreed that all Ford purchases will be
Management • in Yen, at the full agreed price if the current rate is
@ EDHEC

Prof. Schroth
between [Y 115, Y 125] per US$, or
• Ford and Mazda would share the difference equally if prices
Contents fell outside the range.
FX Exposure
Economic exposure
• In general, a stronger Yen increases Ford’s costs (Ford is
Direct and indirect
exposures short of Yen).
Measuring economic
exposure • With the agreement, Mazda shares the risk by absorbing
IRM
Diversification
half the losses to Ford if Yen strengthens too much, i.e.,
Natural hedges below Y115 per US$.
Strategic hedging
IRM

Risk
management
in practice

17 / 44
 Risk-sharing agreements

Corporate
Risk
• Ford and Mazda agreed that all Ford purchases will be
Management • in Yen, at the full agreed price if the current rate is
@ EDHEC

Prof. Schroth
between [Y 115, Y 125] per US$, or
• Ford and Mazda would share the difference equally if prices
Contents fell outside the range.
FX Exposure
Economic exposure
• In general, a stronger Yen increases Ford’s costs (Ford is
Direct and indirect
exposures short of Yen).
Measuring economic
exposure • With the agreement, Mazda shares the risk by absorbing
IRM
Diversification
half the losses to Ford if Yen strengthens too much, i.e.,
Natural hedges below Y115 per US$.
Strategic hedging
IRM • Suppose Ford has to pay Y25M to Mazda, and that at
Risk payment the rate is Y110 per dollar
management
in practice • Ford needs to pay only $222, 222(= Y25M/ 115+2 110 ), as
opposed to $227, 273(= Y25M/110).
• Mazda receives Y24.44M (= $222, 222 × Y110 per $)
instead of Y25M
17 / 44
 Risk-sharing agreements (II)

Corporate
Risk
Management
@ EDHEC

Prof. Schroth
Ford's payment to Mazda (in $ M) Mazda's revenue (in Y M)
Contents 0,25 26,5

0,24
FX Exposure 26
0,23
Economic exposure
25,5
Direct and indirect 0,22
exposures
0,21 25
Measuring economic
exposure 0,2
24,5
IRM 0,19
24
Diversification 0,18
Natural hedges
0,17 23,5
Strategic hedging 105 107 109 111 113 115 117 119 121 123 125 127 129 131 133 135 105 107 109 111 113 115 117 119 121 123 125 127 129 131 133 135
IRM
Pre-sharing Post-sharing Pre-sharing Post-sharing
Risk
management
in practice

18 / 44
 Risk-sharing agreements (II)

Corporate
Risk
• Note that, had the Yen depreciated to Y130 per US$,
Management
@ EDHEC
then the effective payment rate would have been Y127.5
Prof. Schroth (= 125+2 130 ) and Ford would have shared the gains with
25
Mazda, who now gets Y25.49M (= 127.5 × 130).
Contents

FX Exposure
⇒ risk sharing implies that both sides share some of the
Economic exposure gains but also some of the losses.
Direct and indirect
exposures • Why do this, and not just let FX swings drive changes in
Measuring economic
exposure
competitiveness and, therefore, business deals?
IRM
Diversification
Natural hedges
Strategic hedging
IRM

Risk
management
in practice

19 / 44
 Risk-sharing agreements (II)

Corporate
Risk
• Note that, had the Yen depreciated to Y130 per US$,
Management
@ EDHEC
then the effective payment rate would have been Y127.5
Prof. Schroth (= 125+2 130 ) and Ford would have shared the gains with
25
Mazda, who now gets Y25.49M (= 127.5 × 130).
Contents

FX Exposure
⇒ risk sharing implies that both sides share some of the
Economic exposure gains but also some of the losses.
Direct and indirect
exposures • Why do this, and not just let FX swings drive changes in
Measuring economic
exposure
competitiveness and, therefore, business deals?
IRM • Because as the yen appreciates,
Diversification
Natural hedges 1 Ford may look for EU or other Asian suppliers ⇒ Mazda
Strategic hedging
IRM
loses clients;
Risk 2 Ford is a big buyer
management 3 Ford also gains from the relationship if Mazda components
in practice
add value to Ford cars
⇒ in both firms’ interests to promote stable business
relationship
19 / 44
 Natural hedging: Example

Corporate
Risk
Management
• Suppose a US company has a long-term long euro
@ EDHEC exposure, e.g., from continuing exports to German clients
Prof. Schroth
• Accepts e as payment to remain competitive in the
Contents Eurozone
FX Exposure
Economic exposure
Direct and indirect
exposures
Measuring economic
exposure

IRM
Diversification
Natural hedges
Strategic hedging
IRM

Risk
management
in practice

20 / 44
 Natural hedging: Example

Corporate
Risk
Management
• Suppose a US company has a long-term long euro
@ EDHEC exposure, e.g., from continuing exports to German clients
Prof. Schroth
• Accepts e as payment to remain competitive in the
Contents Eurozone
FX Exposure
Economic exposure ⇒ Two approaches to manage this exposure are:
Direct and indirect
exposures
Measuring economic
A1 Short a series of e forwards (may be too short-term or
exposure
illiquid,) or futures (could be too expensive; margin) or
IRM
Diversification put options (pay premia)
Natural hedges
Strategic hedging
IRM
A2 A broad plan of natural hedges:
Risk
management 1 borrowing in e paying interest expenses with revenue;
in practice 2 Using currency swaps (e.g., CalTech and Nestlé);
3 source suppliers from the Eurozone, pay them in e (e.g.,
Irish, Dutch).

20 / 44
 Strategic Hedging

Corporate
Risk
Management
Suppose you run an airline, and you want to hedge fuel price
@ EDHEC risk ...
Prof. Schroth

Contents

FX Exposure
Economic exposure
Direct and indirect
exposures
Measuring economic
exposure

IRM
Diversification
Natural hedges
Strategic hedging
IRM

Risk
management
in practice

21 / 44
 Strategic Hedging

Corporate
Risk
Management
Suppose you run an airline, and you want to hedge fuel price
@ EDHEC risk ...
Prof. Schroth

Contents

FX Exposure
Economic exposure
Direct and indirect
exposures
Measuring economic
exposure

IRM
Diversification
Natural hedges
Strategic hedging
IRM

Risk
management
in practice

22 / 44
 Strategic Hedging (II)

Corporate
Risk
Management
@ EDHEC

Prof. Schroth
• At the time, American Airlines and Delta had a fixed
Contents policy to hedge fuel price risk
FX Exposure
Economic exposure
• In the case of American:
Direct and indirect
exposures
Measuring economic
Exposure horizon Policy target 2008 ratios
exposure

IRM
Diversification < 1 year 80% 75%
Natural hedges
Strategic hedging 1 to 2 years 50% 41%
IRM
2 to 3 years 25% 11%
Risk
management
in practice

23 / 44
 Strategic Hedging (III)

Corporate
Risk
Management
@ EDHEC
• Delta CEO admits to $4 bilion losses due to hedging jet
Prof. Schroth
fuel price over last 8 years.
Contents
• American abandons its fuel price hedging policy
FX Exposure
Economic exposure
Direct and indirect
exposures
Measuring economic
exposure

IRM
Diversification
Natural hedges
Strategic hedging
IRM

Risk
management
in practice

24 / 44
 Strategic Hedging (III)

Corporate
Risk
Management
@ EDHEC
• Delta CEO admits to $4 bilion losses due to hedging jet
Prof. Schroth
fuel price over last 8 years.
Contents
• American abandons its fuel price hedging policy
FX Exposure
Economic exposure • Other airlines (e.g., JetBlue) timed their hedges, hedging
Direct and indirect
exposures
Measuring economic
less (more) when they expected prices to fall (increase).
exposure
⇒ The previous figures shows that prices do not always
IRM
Diversification
revert to the mean.
Natural hedges
Strategic hedging
IRM

Risk
management
in practice

24 / 44
 Strategic Hedging (III)

Corporate
Risk
Management
@ EDHEC
• Delta CEO admits to $4 bilion losses due to hedging jet
Prof. Schroth
fuel price over last 8 years.
Contents
• American abandons its fuel price hedging policy
FX Exposure
Economic exposure • Other airlines (e.g., JetBlue) timed their hedges, hedging
Direct and indirect
exposures
Measuring economic
less (more) when they expected prices to fall (increase).
exposure
⇒ The previous figures shows that prices do not always
IRM
Diversification
revert to the mean.
Natural hedges
Strategic hedging ⇒ Your best decision to hedge depends on what you expect
IRM
your competitors to do!
Risk
management ⇒ The best hedge is therefore buying insurance against low
in practice
cash flows on an industry upside.

24 / 44
 Airlines: History repeats itself

Corporate
Risk
Management
@ EDHEC
‘We will humble them’: four fuel traders took on Wall Street and saved $1.2bn | Financial Times 29/09/2022 08:41
Prof. Schroth

Contents USGulfCoastspotprice,$/gallon

FX Exposure
Economic exposure
Direct and indirect
exposures
Measuring economic
exposure

IRM -0
2017 2018 2019 2020 2021 2022
Diversification
Source:ElA
Natural hedges OFT

Strategic hedging
IRM

Risk
management
With passengers returning to the skies, Southwest’s aeroplanes will guzzle 1.9bn gallons of jet fuel
in practice
this year, accounting for a third of the group’s total operating costs, which Raymond James
estimates will be $22.3bn. Just a one-cent increase per gallon can add $19mn to the annual fuel
bill.

Thanks to a 70-cent-a-gallon boost from hedging, Southwest expects to spend $3.30 to $3.40 a
gallon for jet fuel in the second quarter — far less than American Airlines, Delta Air Lines or United
Airlines.

“That’s a huge benefit for them,” said Helane Becker, analyst at Cowen. She noted Southwest
offered a 40-per-cent fare sale earlier this month, something other carriers are not doing.
25 / 44
 Airlines: History repeats itself

Corporate
Risk
Management
@ EDHEC
‘We will humble them’: four fuel traders took on Wall Street and saved $1.2bn | Financial Times 29/09/2022 08:41
Prof. Schroth

Contents USGulfCoastspotprice,$/gallon

FX Exposure
Economic exposure
Direct and indirect
exposures
Measuring economic
exposure

IRM -0
2017 2018 2019 2020 2021 2022
Diversification
Source:ElA
Natural hedges OFT

Strategic hedging
IRM

Risk
management
With passengers returning to the skies, Southwest’s aeroplanes will guzzle 1.9bn gallons of jet fuel
in practice
this year, accounting for a third of the group’s total operating costs, which Raymond James
estimates will be $22.3bn. Just a one-cent increase per gallon can add $19mn to the annual fuel
bill.

Thanks to a 70-cent-a-gallon boost from hedging, Southwest expects to spend $3.30 to $3.40 a
gallon for jet fuel in the second quarter — far less than American Airlines, Delta Air Lines or United
Airlines.

“That’s a huge benefit for them,” said Helane Becker, analyst at Cowen. She noted Southwest
offered a 40-per-cent fare sale earlier this month, something other carriers are not doing.
26 / 44
 Integrated Risk Management: A synthesis

Corporate
Risk
Management
@ EDHEC

Prof. Schroth

Contents • IRM is the identification and assessment of the collective

FX Exposure
Economic exposure
risks affecting firm value and the implementation of a
Direct and indirect
exposures
firm-wide strategy to manage those risks
Measuring economic
exposure • The goal of IRM is to maximise value by shaping the firm’s
IRM risk profile, shedding some risks while retaining others
Diversification
Natural hedges
Strategic hedging
• The aggregation of all risks to the total firm level
IRM

Risk
management
in practice

27 / 44
 IRM

Corporate
Risk
Management
@ EDHEC

Prof. Schroth

Contents
• Historically, too much RM has taken place in
FX Exposure non-systematic (tactical) ways within silos within a firm
Economic exposure
Direct and indirect • Communications and computing developments now mean
exposures
Measuring economic
exposure
IRM is practical
IRM • Innovations in financial instruments and markets have
Diversification
Natural hedges helped as have the establishment of legal and accounting
Strategic hedging
IRM
infrastructures around much of the world
Risk
management
in practice

28 / 44
 Integration of risks: Why?

Corporate
Risk • Suppose a firm faces risks 1, 2 and 3
Management
@ EDHEC • The firm could to bear up to $3m of total consolidated
Prof. Schroth
losses
Contents
Strategy 1: Insure against each risk separately, i.e., 3
FX Exposure
Economic exposure insurance policies with $1m deductible on each;
Direct and indirect
exposures
Measuring economic
Strategy 2: Buy combined insurance with a $3m deductible.
exposure

IRM
Diversification
Natural hedges
Strategic hedging
IRM

Risk
management
in practice

29 / 44
 Integration of risks: Why?

Corporate
Risk • Suppose a firm faces risks 1, 2 and 3
Management
@ EDHEC • The firm could to bear up to $3m of total consolidated
Prof. Schroth
losses
Contents
Strategy 1: Insure against each risk separately, i.e., 3
FX Exposure
Economic exposure insurance policies with $1m deductible on each;
Direct and indirect
exposures
Measuring economic
Strategy 2: Buy combined insurance with a $3m deductible.
exposure

IRM
⇒ With S1, the firm is over-insured (paying too much):
Diversification E.g., firm could bear a $2.5m loss on risk 2 if no losses occur
Natural hedges
Strategic hedging under risks 1 and 3.
IRM

Risk
⇒ If risks 1, 2 and 3 were imperfectly correlated, i.e., all
management worst-case scenarios cannot occur simultaneuolsy, then
in practice
aggregate insurance is cheaper than individual policies
⇒ Joint insurance gives the exact risk coverage required for a
lower fee!
29 / 44
 Challenges in IRM

Corporate
Risk
Management
@ EDHEC

Prof. Schroth

Contents
• Tendency to isolate and manage risks by type
FX Exposure
Economic exposure
• Treasury manages FX risk
Direct and indirect
exposures
• Operations manages production process risks
Measuring economic
exposure
• HR manages key personnel risks
IRM ⇒ Very akin to the over-insurance model above
Diversification
Natural hedges ⇒ IRM needs integration at firm level
Strategic hedging
IRM

Risk
management
in practice

30 / 44
 Challenges to IRM (II)

Corporate
Risk
Management
@ EDHEC • IRM is strategic, not tactical
Prof. Schroth • Considers how risk affects entire firm
Contents • Incorporates economic exposures, direct and indirect
FX Exposure
• Goes much beyond what is known to the firm or
Economic exposure
experienced directly by the firm
Direct and indirect
exposures
Measuring economic
• Since IRM is at the strategic level, responsibility lies with
exposure

IRM
senior management
Diversification ⇒ The Board need a thorough understanding of
Natural hedges
Strategic hedging operations and financing
IRM

Risk
⇒ Tactical implementation perhaps can be delegated to
management business units
in practice
• Strategic RM decisions cannot be delegated

31 / 44
 Risk management in practice

Corporate
Risk
Management
@ EDHEC • Question: How do firms actually approach risk
Prof. Schroth management?
Contents
• How do they determine their economic exposure
• What do they hedge?
FX Exposure
Economic exposure • How do they hedge?
Direct and indirect
exposures • Why do they hedge?
Measuring economic
exposure
• How do they organise risk management departments?
IRM • Source: 2009 Deutsche Bank/GARP survey of 4000
Diversification
Natural hedges non-financial companies from
Strategic hedging
IRM
• 49 countries conducted in 2005
Risk
• 334 responses
management
in practice
• 70% listed companies, 30% unlisted
• Median revenues $1.6bn

32 / 44
 Ranking of risk exposures
Figure 6 Risk Exposures
Corporate
Factors % 4 or 5 % 4 or 5 N
Risk
Management Foreign exchange risks 53% 239
@ EDHEC Strategic risks 47% 232

Prof. Schroth Financing risk 40% 233

Competitive risks 39% 237

Contents Failure of company projects 36% 236

Execution risks 35% 231

FX Exposure
Reputational risks 33% 232
Economic exposure
Direct and indirect Commodity price risks 32% 238
exposures
Operational risks 31% 232
Measuring economic
exposure Interest rate risks 31% 239

Credit risks 28% 237

IRM
Diversification Regulatory or government risks 26% 238
Natural hedges Loss of key personnel 26% 235
Strategic hedging
Property and casualty risks 22% 236
IRM
Litigation risks 21% 233
Risk Natural catastrophe risks 17% 237
management
Employee misdeeds 13% 234
in practice
Terrorism risks 13% 235

Political risks 11% 238

Pension or healthcare shortfalls 10% 228

Weather risks 9% 235

33 / 44
 Benefits of RM
Figure 8 Benefits of Risk Management Figure 9
Corporate
Risk
Management Factors % 4 or 5 % 4 or 5 Factors
@ EDHEC Improve company-wide decision making 63% Direct costs
Prof. Schroth Preserve company reputation 43% Direct costs

Reduce the volatility of earnings 37% Long-term o

Contents
Stabilize revenue stream 36% Costs of bus
FX Exposure
Economic exposure
Reduce the costs of financial distress 36% Difficulty in
Direct and indirect
Improve cash management decisions 28% Costs of run
exposures
Measuring economic Improve capital structure decisions 28% Short-term o
exposure

Plan and stabilize pattern of investments 27% Compliance

IRM
Diversification Improve pricing policy 26% Risk associa
Natural hedges
Demands by bondholders or lenders 25% Difficulty in
Strategic hedging
IRM Demands by shareholders 24% Resistance b
Risk Demands by regulators 24%
management
in practice Manage and lower tax payments 24%
Exploit profitable trade opportunities 17%
Risk M
We soug
ment gr
The ranking was on a six point scale going from Not Substan- risk
34 / man
44
 Drawbacks of RM

Corporate Figure 9 Drawbacks of Risk Management

Risk
Management
@ EDHEC
% 4 or 5 Factors % 4 or 5 % 4 or 5
63%
Prof. Schroth Direct costs of purchasing insurance 23%
43%
Contents Direct costs of risk management products 19%
37%
FX Exposure Long-term opportunity costs 16%
Economic exposure
36%
Direct and indirect Costs of business continuity services 15%
exposures

36%
Measuring economic Difficulty in explaining to board 13%
exposure

IRM28% Costs of running risk management group 13%

Diversification
28%
Natural hedges
Short-term opportunity costs 12%
Strategic hedging
IRM
27% Compliance and reporting costs 10%

Risk26% Risk associated with trading activities 9%

management
25%
in practice Difficulty in explaining to investors 7%
24% Resistance by investors 5%
24%

24%
35 / 44
 Tools to Measure Exposure
Figure 10 Tools in Risk Management Group Figur
Corporate
Risk
Management
@ EDHEC
Scenario 73% Cons
Prof. Schroth analysis
qua
Contents

FX Exposure VaR 45%

analysis Scenari
Economic exposure
Direct and indirect
exposures
Measuring economic
exposure
CaR 43%
analysis
IRM
Diversification S
Natural hedges
EaR 36%
Strategic hedging analysis
IRM

Risk
management SVA No con
6%
in practice analysis or qua

0% 20% 40% 60% 80%

36 / 44
 0% 20% 40% 60% 80%

Risk Management Instruments

Figure 12 Risk Management Products cases, if
Corporate
Risk
but the e
Management itself wit
Insurance
@ EDHEC
policies 83% the mos
Prof. Schroth FX rate
derivatives
82% presuma
Contents Interest rate 79% with gre
derivatives
FX Exposure Financial options
47%
Economic exposure
guarantees
possibly
FX denominated 45%
than jus
Direct and indirect
exposures debt
Operating
Measuring economic
exposure alternatives
44% currency
IRM Commodity
derivatives
32% sheet ris
Diversification
Structured 13%
perhaps
Natural hedges
products
Strategic hedging
Equity
margin
12%
IRM derivatives are not m
Credit
12%
Risk
management
derivatives Inte
in practice Multi-risk
products
8% est rate
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% managin
structur
deep an
FX rate derivatives (82%) or interest rate derivatives (79%) over-the
37 / 44
 Active position taking?
Figure 23 Active Position Taking Fi

Corporate
Risk
Management 60%
@ EDHEC FX Interest Rate Commodity
60
52% 52%
Prof. Schroth
50% 48%

Contents 50
FX Exposure
40%
Economic exposure
Direct and indirect 40
exposures
Measuring economic
exposure 30%

IRM 30
Diversification
Natural hedges 20% 19%
Strategic hedging 16% 16% 16%
20
IRM 12% 12% 12%
10%
Risk 10% 8%
management 6% 6%
5% 4% 10
in practice 4% 3%

0%
Never Often
0

38 / 44
 Areas of improvement for RM
Figure 25 Areas of Improvement for
Corporate
Risk Management Program
Risk
Management
@ EDHEC

Prof. Schroth Factors % 4 or 5

Employee understanding
Contents

FX Exposure Measurement of quantifiable risks

Economic exposure
Direct and indirect
exposures
Coverage (include broader set of risks)
Measuring economic
exposure Board understanding
IRM
Diversification Appreciation of unquantifiable risks
Natural hedges
Strategic hedging
IRM
Management of risks
Risk Shareholder & analyst understanding
management
in practice
Opportunistic trading activities

39 / 44
 Summary of Key findings (I)

Corporate
Risk
Management 1. CFOs see commercial, financing and FX risks as the three
@ EDHEC

Prof. Schroth
greatest threats to corporate performance
⇒ CFOs view risks within the broad context of business
Contents
environment
FX Exposure
Economic exposure 2. Less than 50% include risk analysis in strategic planning
Direct and indirect
exposures
Measuring economic
⇒ Many companies use scenario planning
exposure
⇒ integrating risk management into overall strategy and
IRM
Diversification
operations would be beneficial
Natural hedges
Strategic hedging 3. Main benefit: risk management improves company-wide
IRM
decision making
Risk
management ⇒ the firm CFOs wanted all levels of employees to
in practice
recognise the importance of those risks
⇒ Want to instil a “risk-awareness” culture

40 / 44
 Summary of Key findings (II)

Corporate
Risk
Management 4. Second benefit: via more stable earnings, RM provides
@ EDHEC
cleaner signal to investors/managers about company value
Prof. Schroth
⇒ enhances reputation
Contents
5. Key costs of RM: direct cost of instruments, the lost
FX Exposure
Economic exposure opportunity to benefit from beneficial moves, explaining it
Direct and indirect
exposures to the board.
Measuring economic
exposure ⇒ RM is not fully understood by senior managers!
IRM
Diversification 6. Almost half the companies had no measures to judge
Natural hedges
Strategic hedging
performance of the risk management function
IRM
⇒ 40% had no idea how much RM adds to the value of
Risk
management their firm
in practice
7. 75% of companies change timing or size of hedges based
on their view of likely market movements!

41 / 44
 Managing risk management

Corporate
Risk
Management
@ EDHEC

Prof. Schroth

Contents

FX Exposure
• The latest version of the Wharton survey dates from
Economic exposure
Direct and indirect
2011
exposures
• 1,161 responses
Measuring economic
exposure • 45% from US, 27% Asia, 20% Europe
IRM • 37% listed companies, 63% unlisted
Diversification
Natural hedges
Strategic hedging
IRM

Risk
management
in practice

42 / 44
 material risk in

7
% of firms 

66
65
40%

50%

46%

40%
The changing
20% use of derivatives

20%
0%
IR FX EN CM CR GP
Corporate Derivatives / Financial contracts
Risk Operational Structures and Decisions
Management  
@ EDHEC
 
Prof. Schroth
Figure 3: Concerns about derivatives – Comparison with Wharton 1998 survey responses

Contents

FX Exposure
Economic exposure
Direct and indirect
exposures
Measuring economic
exposure

IRM
Diversification
Natural hedges
Strategic hedging
IRM
   

Risk
management
in practice  

Figure 4: Percent of FX exposures hedged
n =138 
0% 20% 40% 60%

Recorded commitments  55%
Anticipated exposures within one year 43% 43 / 44
 New findings

Corporate
Risk
Management
@ EDHEC

Prof. Schroth
• The vast majority of firms that face material interest rate,
Contents
credit risk and foreign exchange risk are managing this
FX Exposure
Economic exposure
risk, more so with operational hedges than via is financial
Direct and indirect
exposures hedging.
Measuring economic
exposure • Financial derivatives are used by only 64% of the firms in
IRM
Diversification
the sample.
Natural hedges
Strategic hedging
• In contrast to studies from the 1990s, best practice risk
IRM
management policy and behavior has become global.
Risk
management
in practice

44 / 44