Fluctuation in Economic and Financial Variables
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
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