To illustrate, if a company expects operating cash ﬂow of $200 million for the year and instead reports a loss of $50million, a cash shortfall of this size can be far more costly tothe ﬁrm than just the missing $250 million. First of all, tothe extent it affects the market’s expectation of future cashﬂows and earnings, such a shortfall will generally be associ-ated with a reduction in ﬁrm value of much more than $250million—a reduction that reﬂects the market’s expectationof lower growth. And even if operating cash ﬂow reboundsquickly, there could be other, longer-lasting effects. Forexample, assume the company has a number of strategicinvestment opportunities that require
funding.Unless the ﬁrm has considerable excess cash or unused debtcapacity, it may be faced with the tough choice of cutting back on planned investments or raising equity in difﬁcultcircumstances and on expensive terms. If the cost of issuing equity is high enough, management may have little choicebut to cut investment. And unlike the adjustment of marketexpectations in response to what proves to be a temporary cash shortfall, the loss in value from the ﬁrm having to passup positive-NPV projects represents a
reductionin value.For most companies, guarding against this corpo-rate “underinvestment problem” is likely to be the mostimportant reason to manage risk. By hedging or otherwisemanaging risk, a ﬁrm can limit (to an agreed-upon level)the probability that a large cash shortfall will lead to value-destroying cutbacks in investment. And it is in this sensethat the main function of corporate risk management canbe seen as protecting a company’s ability to carry out itsbusiness plan.But which risks should a company lay off and whichshould it retain? Corporate exposures to changes in curren-cies, interest rates, and commodity prices can often behedged fairly inexpensively using derivatives such asforwards, futures, swaps, and options. For instance, a foreign exchange hedging program using forward contractstypically has very low transaction costs; and when the trans-fer of risk is inexpensive, there is a strong case for laying off economic risks that could otherwise undermine a compa-ny’s ability to execute its strategic plan.On the other hand, companies in the course of theirnormal activities take many strategic or business risks thatthey cannot proﬁtably lay off in capital markets or otherdeveloped risk transfer markets. For instance, a company with a promising plan to expand its business typically cannot ﬁnd an economic hedge—if indeed there is any hedge at all—for the business risks associated with pursu-ing such growth. The company’s management presumably understands the risks of such expansion better than any insurance or derivatives provider—if they don’t, thecompany probably shouldn’t be undertaking the project.If the company were to seek a counterparty to bear suchbusiness risks, the costs of transferring such risks wouldlikely be prohibitively high, since they would have to behigh enough to compensate the counterparty for trans-acting with a better informed party and for constructing models to evaluate the risks they’re being asked to hedge.For this reason, we should not be surprised that insurancecompanies do not offer insurance contracts that providecomplete coverage for earnings shortfalls or that there isno market for derivatives for which the underlying is a company’s earnings. The insured companies would be ina position not only to know more than the insurers aboutthe distribution of their future earnings, but to manipulatethat distribution to increase the payoffs from such insur-ance policies. A ﬁrm that entered into a derivatives contractwith its earnings as the underlying would have a similaradvantage over a derivatives dealer.More generally, in making decisions whether to retain ortransfer risks, companies should be guided by the principleof
comparative advantage in risk-bearing
A company thathas no special ability to forecast market variables has nocomparative advantage in bearing the risk associated withthose variables. In contrast, the same company should havea comparative advantage in bearing information-intensive,ﬁrm-speciﬁc business risks because it knows more aboutthese risks than anybody else. For example, at NationwideInsurance, exposures to changes in interest rates and equity markets are managed in strict ranges, with excess exposuresreduced through asset repositioning or hedging. At the sametime, Nationwide retains the vast majority of its insurancerisks, a decision that reﬂects the ﬁrm’s advantage relative toany potential risk transfer counterparty in terms of experi-ence with and knowledge of such risks.One important beneﬁt of thinking in terms of compar-ative advantage is to reinforce the message that companiesare in business to
take strategic and business risks
. The recog-nition that there are no economical ways of transferring risks that are unique to a company’s business operationscan serve to underscore the potential value of reduc-ing the ﬁrm’s exposure to other, “non-core” risks.
Oncemanagement has decided that the ﬁrm has a comparativeadvantage in taking certain business risks, it should userisk management to help the ﬁrm make the most of thisadvantage. Which brings us to a paradox of risk manage-ment: By reducing non-core exposures, ERM effectively enables companies to take more strategic business risk—and greater advantage of the opportunities in their corebusiness.
Journal of Applied Corporate Finance
Volume 18 Number 4 A Morgan Stanley Publication
2. For an extended treatment of this concept, see René Stulz, “Rethinking Risk Man-agement,”
Journal of Applied Corporate Finance
, Vol. 9 No. 3, Fall 1996.3. For a discussion of core and non-core risks, see Robert Merton, “You Have MoreCapital Than You Think,”
Harvard Business Review