20 Mar 2006  Research & Ideas

Unlocking Your Investment Capital

By reassessing risk exposure, many companies can create more equity capacity to fund investments, says Harvard Business School professor Robert C. Merton. Just don't leave it up to the Finance Department.

 

Many companies can double or even triple their capacity to invest in strategic assets and competencies by properly managing their "risk balance sheet," argues Harvard Business School professor Robert C. Merton. In a provocative article on the subject in the November 2005 issue of Harvard Business Review, Merton, a Nobel laureate, urges senior corporate executives and boards to view derivative applications not just as tactical measures but as strategic tools that convey competitive advantage. A first step is distinguishing between a company's value-adding risks and its passive risks—a process that can release more equity capacity.

Finally, Merton argues, the job of managing the company's derivatives portfolio should not be delegated to in-house financial experts. The strategic importance of how a company manages risk requires executive understanding and attention from the top down.

In this e-mail Q&A, Merton discusses the non-financial executive as risk manager, value-added versus passive risks, and the effective use of credit-default swaps.

Ann Cullen: What are the dangers of managers delegating and not taking an active role in the way their company manages financial risks?

Robert C. Merton: The measurement and management of risk permeates all corporate activities and thus it is central to strategic decisions as well as tactical ones. The management of financial risks is not just a matter of "protecting" the firm against adverse events, but it is also a powerful tool for value creation. For senior management neither to understand the risks being taken by the firm nor to understand how the risks that were selected not to be taken are being eliminated is to delegate a crucial part of implementation and oversight of the firm's strategy.

At the extreme, poorly implemented risk management can lead to the firm's demise. Under Sarbanes-Oxley 404, both the CEO and CFO have to attest with personal liability to the accuracies of the financial statements (including footnotes with respect to potential risks).

Q: You say that in modern financial markets, managers can engineer a company's capital structure so that the only liabilities borne by the company are value-added risks. What are value-added risks and how are they different from passive risks?

A: "Value-added" risks are those risks that must be borne by the firm in order for it to undertake positive net present value projects. These projects typically reflect the comparative advantages of the firm and are the raison d'être of the firm. "Passive" risks are risks associated with investments when returns are not influenced by the firm owning them.

An example would be if the firm held a diversified equity portfolio like the Standard & Poor's 500. Assets with only passive risks are typically zero-net-present-value investments.

Q: Why does the required amount of equity cushion that a company should have be based on its Value at Risk, instead of by cost or the size of the company's assets?

The management of financial risks is not just a matter of "protecting" the firm against adverse events.

A: As an accounting identity, the total value and the total risk of the assets of the firm must equal the total value and the total risk of its liabilities and equity. Thus, the dollar amount of equity needed to ensure a specified credit rating of the firm is completely determined by the riskiness (measured by the dollar amount of volatility) of the firm's assets. The greater is the risk of the firm's assets, the larger is the amount of equity needed. Neither an asset's cost nor its size specifies its riskiness.

For example, consider two assets, $1 billion of a single-drug biotech stock and $1 billion of U.S. Treasury bonds: Each has the same cost and size but they have radically different risk characteristics. Value at Risk is one of the standard measures used by banks, insurance companies, and asset management pools to describe the risk differences among assets. It measures how much the asset value could decline within a specified future time period and within a certain probability (e.g., with 95 percent probability, the largest decline in value of this asset over the next twelve months is $125 million). Thus, the larger is the Value at Risk of the assets of the firm, the larger must be the equity cushion to protect the liability holders of the firm against loss within a probability limit that will support a given credit rating.

Q: How can the equity swap help alleviate the common mismatch between pension assets and liabilities that companies often carry?

A: If the pension fund holds equities, then these assets have a "risk mismatch" with the corresponding pension liabilities whose value fluctuates in a fashion similar to long-maturity fixed-rate debt. If the pension fund enters into an equity asset swap in which it pays the total return on a standard index of the stock market (e.g., S&P 500) and receives in return a fixed rate of interest, then it will eliminate a large portion of its equity market risk and replace it with a fixed-rate debt-like return that matches the risk characteristics of the pension liabilities. Since the typical large pension fund equity portfolio has a very high correlation with the general equity market returns, this swap strategy is a quick, noninvasive (to the portfolio), and reversible way to reduce significantly the passive risk to the firm from this mismatch.

I believe that the benefits of using credit derivative swaps will dwarf the costs of mistakes.

Q: There has been a lot of scary news recently about hedge funds. Given these disturbing stories, how does a CEO warm shareholders to the benefits of the risk management tools you suggest?

A: Whenever the firm is undertaking new strategic directions, including implementing strategic risk management that may use derivatives, it is wise to communicate the benefits of those changes and their implementation to the shareholders, equity analysts, credit rating agencies, and other representatives of risk-sensitive stakeholders of the firm. If that implementation includes derivatives, management should provide assurances that the necessary expertise and oversight are in place to ensure their intended use in a prudent manner.

On the matter of the connection with the "scary news" about hedge funds, it is certainly correct that they use derivatives. However, so does almost every other type of financial institution in the world including banks, investment banks, pension funds, mutual funds, insurance companies, and central banks. Other large users are governments, corporations, and supranational agencies such as the IMF and the World Bank. Derivatives have been widely used for more than a quarter century. As of June 2005, the Federal Reserve estimated that $273 trillion of notational amount of derivatives were outstanding worldwide. So derivatives are hardly new and untested financial tools, even if the CDS (credit derivative swaps) type is relatively more recent.

Q: It's truly amazing to think that companies can eliminate passive risk through credit default swaps. However, isn't there always the potential of a sort of death spiral taking place with these instruments if the market they're in turns sour?

A: What I find more amazing is the extraordinary global progress that has been made over the past twenty-five years in creating cost-efficient and effective tools for managing financial risks with targeted focus and great effectiveness. Contractual agreements, principally futures and swaps as well as options, have been central tools. Just as interest rate swaps have transformed what passive risks that banks, other financial institutions, and firms must bear to perform their business functions over the past two decades, so credit derivative swaps are going to carry that transformation to a new level.

As in any activity involving large numbers in both participants and size, there have been misuses and errors in the use of CDS resulting in material losses as there has been with other derivatives. Those will continue to occur. However, I believe that the benefits of using CDS will dwarf the costs of mistakes, just as has been the case for interest rate, equity, and currency derivative contracts.

As we know, the only thing worse than not being insured when a feared risk event is realized is to believe that you are insured when you are not. Therefore, the users of all financial contracts including CDS must be diligent in understanding and monitoring the performance risk of counterparts to their risk-reducing contracts, especially whether the counterparts are highly rated, and the nature of any collateralization of the obligation. Shocks can hit the credit markets as they do other financial markets and cause a drying up of liquidity and large price dislocations for credit-sensitive assets.

I, however, take the term "death spiral" in your question to describe a resulting decline in credit ratings that will impose financial stress on those institutions that have written credit protection, which will in turn cause their credit ratings to decline and thus create further stress to other institutions and so on, spiraling toward a complete meltdown. There are, however, important structural offsets: oversight and interventions by government and industry overseers, and most importantly, collateral posting. As we know, in the case of contracts traded on exchanges, the daily required margin posted by the participants buttressed with the capital of the exchange members offers an important degree of protection of performance, even under adverse conditions. Similarly, in the CDS and other OTC (over-the-counter) derivative markets, two-way mark-to-market daily collateralization of exposures is virtually universal for contracts between financial firms, including banks, investment banks, dealers, hedge funds, and insurance companies, which make up the bulk of the notional exposures in financial derivatives, including CDS.

About the author

Ann Cullen is a business information librarian at Baker Library, Harvard Business School, with a specialty in finance.