Academic journal article Federal Reserve Bank of St. Louis Review

The New Risk Management: The Good, the Bad, and the Ugly

Academic journal article Federal Reserve Bank of St. Louis Review

The New Risk Management: The Good, the Bad, and the Ugly

Article excerpt

In a 1997 Review article, the authors described the good, the bad, and the ugly features of what they called the new risk management, which is the use of financial derivatives to hedge risk in firms. Since the article was first published, the "new" risk management has become commonplace and indeed played a big role in the financial crisis. As a result, the original article is more relevant today than when it was first published. This updated version of the article contains the same examples and critical analysis as in the original article but includes an updated description of the accounting rules and suggestions for designing a risk management policy. (JEL D81, G32, L21, M21, M41)

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At one time, risk management meant buying corporate insurance, implementing procedures to avoid lawsuits and accidents, and installing safety equipment. The new risk management uses financial markets to hedge different sources of risk within the firm. Companies can use trading in financial markets to hedge against the risk of changes in interest rates, input prices, or currency fluctuations. While hedging per se is not new, the scale and diversity of hedging are far greater than they used to be. When executed properly, the new risk management can be good and even essential for competition. Unfortunately, the new risk management can also be bad, wasting resources without reducing risk and perhaps even increasing it. The new risk management can be ugly, generating large losses such as those in widely publicized cases at Barings (in 1995), Metallgesellschaft (in 1993), Procter and Gamble (in 1994), and other firms. In these and many other firms, employees relatively far from the top of the hierarchy of control had the authority to take financial positions large enough to generate losses that could bankrupt the firm. Thus, risk management policies should be put in place at the highest level of a firm and provide for monitoring and internal control of the amount of risk taken. The purpose of this article is to provide an introduction to the new risk management and some policy choices firms should be considering.

We start with a discussion of the option-pricing tools that make the new risk management possible and follow with a stylized example of how the new risk management ought to work. Then we consider implementation issues, including some general policy questions as well as some accounting issues.

TOOLS FOR THE NEW RISK MANAGEMENT

Starting with the famous work of Black and Scholes (1973; see the boxed insert on page 275), option-pricing theory has been very successful in pricing various financial claims. The Black-Scholes model was designed to price standard call and put options, and it has been extended to price all sorts of financial claims. The Black-Scholes model and its extensions form the theoretical foundation for the new risk management.

There were option-pricing models prior to the work of Black and Scholes, including some models with formulas similar to Black-Scholes. What makes the Black-Scholes model different is that it provides a hedging strategy that is an investment policy with an investment equal to the model's option price and a terminal value equal to the terminal value of the option. Knowing the hedging strategy is powerful since we can use this knowledge to make an arbitrage profit if market prices are out of line with the model. If the model price is lower than the price in the economy, we can sell the option, pocket the excess over the model price, and invest in the hedging strategy to cover the terminal value of the option we have sold. If the model price is higher than the price in the economy, we can follow the hedging strategy in reverse, taking a short position instead of a long position and lending instead of borrowing. In the model, the hedge replicates the option value perfectly; in practice, the hedge is not perfect, but it works remarkably well, which is why the Black-Scholes model and its progeny are widely used in business. …

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