The article emphasis the need for aligning risk management practices with organisational vision and

foresight and states that without a clear set of goals risk management can be dangerous e.g.- Procter
and Gamble- sold 1 billion $ because it took positions in derivatives that did not fit well with their
corporate strategies. The goal in this article is to present a framework to guide top-level managers in
developing a coherent risk-management strategyin particular, to make sensible use of the risk-
management firepower available to them through financial derivatives.
The risk-management paradigm rests on three basic premises:
The key to creating corporate value is making good investments.
The key to making good investments is generating enough cash internally to fund those
investments; when companies dont generate enough cash, they tend to cut investment more
drastically than their competitors do.
Cash flowso crucial to the investment processcan often be disrupted by movements in
external factors such as exchange rates, commodity prices, and interest rates, potentially
compromising a companys ability to invest.
The article talks about the origins of risk management from The Old Testaments story of the Egyptian
Pharaoh to the more recent price risk insulation in case of crops. The key insight of Franco Modigliani
and Merton Miller, each of whom won a Nobel Prize for his work in this area, is that value is created
on the left-hand side of the balance sheet when companies make good investmentsin, say, plant
and equipment, R&D, or market sharethat ultimately increase operating cash flows. If one accepts
the view of Modigliani and Miller, it follows almost as a corollary that risk-management strategies are
also of no consequence.
Over the past two decades, however, a different view of financial policy has emerged that allows a
more integral role for risk management. This postmodern paradigm goes further by treating
financial policy as critical in enabling companies to make valuable investments. And it recognizes that
companies face real trade-offs in how they finance their investments. The bottom line is that financial
markets do not work as smoothly as Modigliani and Miller envisioned. The costs the article outlines
make external financing of any formbe it debt or equitymore expensive than internally generated
funds
It cites the case of a hypothetical multinational pharmaceutical company, Omega Drug, and an oil
company Omega oil to answer the question of whether to hedge an in what situation. It then goes on
to make the assertion that a proper risk-management strategy ensures that companies have the cash
when they need it for investment, but it does not seek to insulate them completely from risks of all
kinds.
The article has six broad guidelines for mangers in risk management which forms the crux
Companies in the same industry should not necessarily adopt the same hedging strategy
Companies may benefit from risk management even if they have no major investments in plant and
equipment
Even companies with conservative capital structuresno debt, lots of cashcan benefit Risk
management enables companies to become better at aligning the demand for funds with the
internal supply of funds from hedging.
Multinational companies must recognize that foreign-exchange risk affects not only cash flows but
also investment opportunities.
Companies should pay close attention to the hedging strategies of their competitors
The choice of specific derivatives cannot simply be delegated to the financial specialists in the
company.
In the Indian context, after the liberalization of Indian economy in the year 1991 opened windows for
global business in India, many global multi-national corporations (MNCs) entered Indian markets;
similarly, many Indian companies cashed this opportunity to enter foreign countries. Because of this
the firms were exposed to a FX risk which was not there when they were operating in the domestic
country. However, the magnitude of FX risk was very less, with the operation of Bretton Woods
Agreement signed by most of the economically powerful countries in the year 1944. With the fall of
Bretton Woods System and introduction of flexible exchange rate regime in the year 1972 and
subsequent reforms, the movement of the exchange rates became very volatile as the exchange rate
between the currencies of two countries was determined by market forces. This development in the
global economy, lead to the increased importance to FX risk management. Let us look at two examples
of Ranbaxy(failure) and LNT(success) to understand risk management strategies of Indian companies
To improve its foreign exchange processes Larsen & Toubro was looking to insulate its imports in US
dollar against the functional currency of the company, the Indian rupee (INR). Imports involved in the
project were to the tune of US$150m that required insulation for possible devaluation of INR against
the US dollar. The treasury team at Larsen & Toubro took on new dimensions by facilitating and
structuring a critical hedge solution for the project. This enhanced role that treasury played in
structuring this transaction was the result of years of efforts on multiple areas such as building the
requisite commercial and risk management econometrics expertise as part of a bid advisory function
in treasury, establishing a well-oiled business finance collaborating channel and building a knowledge
base beyond financial risk management covering business knowledge and competitor intelligence. The
potential depreciation of its functional INR and putting in place an optimal hedge solution. Subsequent
depreciation of INR currency of around 20% (due to the headwinds that emanated out of the macro-
economic risk arising out of US Feds announcement of a taper of its QE programme) was completely
insulated due to the commercial solution that was implemented. Tail risks that materialised were fully
clipped off in the project.
In a high-value developmental metro project of the group, the solution brought in a unique forex risk
architecture which optimised the payoff between risk reduction vis--vis the cost involved in putting
in the risk insulation programme. The unconventional yet scientific approach taken to address the
financial risks involved in the project make it a remarkable and unique solution. The solution largely
insulated the project from potential large currency depreciation moves while also optimising on the
costs involved in putting in place a currency hedge framework.
Ranbaxy entered into foreign currency derivate transaction with various banks but the objective here
was not to protect themselves against foreign currency fluctuations but to gain out of foreign
exchange fluctuations. In 2009 with the effects of economic recession creeping in the results were not
very encouraging. Ranbaxy found itself deep into losses of 1.4 billion dollars on outstanding hedges
and total losses of 9 billion. The losses were accentuated by the loss of patents and thus share prices
fell by 4.7%.
What went wrong with Ranbaxys strategy?
It entered into a no of forex strip options and speculated that the rupee would appreciate further (at
that time rupee value was 1 dollar=39.9 rupees). It hedged its dollar receivables at 43.5 at an average
of 1:2.5. Thus, Ranbaxy basically bought put option from banks and sold call option to banks. It
lost because dollar appreciated against Ranbaxys expectations and banks exercised the call option.
Ranbaxy strategy was at odds with the guidelines given in the case and it had to pay the price for it. It
entered into speculation and used traditional instruments not customised for the objectives given in
the case.