Three Approaches to Risk Management—and How and Why Swedish Companies Use Them

Abstract

Companies can manage risk by using derivatives or through operational hedging. But there is a third possibility: to leave their operating cash flows unhedged while ensuring that the firm has access to external finance in adverse states of the world. This article reports the findings of a recent survey of over 800 Swedish companies that aims to shed light on the relative importance of these three risk management methods, as well as how they interact in corporate risk management programs. The results show that risk management practices aimed at ensuring access to external finance are the main method used by the largest number of companies, followed by operational hedging methods and financial hedging with derivatives. Large companies hedge using both operational methods and derivatives, whereas small firms are less likely to use derivatives but nevertheless attach great importance to the other two ways of managing risk. Even among the largest companies, operational hedging tends to deemed more important than hedging with derivatives—a finding that, although perhaps a surprise to financial professionals, underscores the authors’ finding that operational and derivative‐based hedges function as complements rather than substitutes. Indeed, the authors report that the most financially sophisticated companies tend to use all three of these common forms of risk management.

Corporate Risk Management, Firms’ Characteristics and Capital Structure: Evidence from Bombay Stock Exchange (BSE) Sensex Companies

“…One is to use derivatives such as futures and options to hedge their exposures, and the other one is, alongside such financial hedging, companies can also engage in operational hedging. There is also a third, less obvious way for companies to manage their exposures: they can leave them largely or completely unhedged, while seeking to ensure their access to external financing in the event of worst-case scenarios (Amberg & Friberg, 2016). Froot, Scharfstein, and Stein (1993) have argued that risk management can be worthwhile to the firms with positive net present value investment projects but has constraints on external funding due to information asymmetry associated with the complex and non-conventional projects.…”

“…Bock (2013) provides evidence from German companies on the impact of risk management on a firm’s capital structure, cash flow volatility and cost of capital. Amberg and Friberg (2016) provide evidence on whether operational and financial hedging are substitutes—that is mutually exclusive alternatives designed to accomplish the same objective—or complements that are used together to accomplish the goal.…”

Exchange rate risk and the skill composition of labor

“…Several other means by which firms manage risk are likely to be more challenging for smaller firms-with a weaker bargaining position it may for instance be harder to shift suppliers and smaller firms are substantially less likely to use derivatives to manage risk [see e.g. Allayannis et al (2012) or, for Swedish evidence, Amberg and Friberg (2016)]. Finally, the estimated elasticity for manufacturing firms is similar in magnitude to the average effect in this tercile.…”

Challenges in Applying Risk Management Concepts in Practice: A Perspective

“…() conclude that at least for foreign currency exposure, operational hedges that involve dispersion of operations across multiple countries do not reduce exchange‐rate exposure. Amberg and Friberg () conclude that sophisticated firms not only use operational and financial hedges, but also external financing as a means to manage risk. The nature of the risk the firm is facing, as well as the capabilities of the firm, seem to jointly determine the choice of risk management instruments.…”

“…Furthermore, in the reality of any firm, the effective chief risk officer is the firm's CEO as only the CEO has the needed decision‐making authority over the firm's operations, financial hedges, and capital structure. As Doherty () and Amberg and Friberg () show, all three need to be used in coordination to optimize corporate risk.…”