Question

Discuss an example of how a firm may deal with risk and uncertainty.

Answer 1

Consider risk and uncertainty in the airline business and ways that firms deal with them. Some, such as Southwest Airlines, have made extensive use of financial instruments to hedge fuel risks, whereas others leave positions open. Delta Airlines recently purchased an oil refinery with hedging as a motivation. The list of shocks that might affect profitability for airlines stretch well beyond fuel prices and include natural disasters, such as the eruption of the Icelandic volcano in 2010 or apparent pilot suicide as on the German Wings flight that crashed in the Alps in March 2015. Entry by low price competitors on key routes, changes in environmental regulation or airport landing rights are other examples of events that have the possibility to hurt profitability. How should firms manage such risks and uncertainties?

A simple view of the received wisdom on firm strategy in the face of risk is that firms should strive to maximize expected profits. If there are some reasons for firms to limit variability in profits, such as taxes or binding credit constraints, corporations should then use derivatives instruments to hedge against risks. For bankers, this view then provides a clear motivation for promoting the use of derivatives instruments

Examples of certainty include the need to meet customer, contract or regulatory requirements. The outcomes (consequences) are known to you should you fail to comply. When we are faced with certainty in outcomes, our strategy is fairly simple: comply. When you know the requirements, you know also to whom you are vulnerable, those authorities, whether customer or agency that mandate the requirements. Failing to meet requirements on print or delivery time, failing to run a safe shop or failure to submit a mandatory government report will have known consequences (negative consequences) for your business and future relationship with the other party involved.

Assigning responsibilities, authorities and robust contract review to assure that you know the known requirements is how you can best organize to handle the “known knowns.”

How do we make decisions when we know the risks? Risk is when we know that the outcomes may fall within a range of expectations. Variation in shops and the materials
used to produce products are examples of “known unknowns.” The tolerances on raw material or of our process are in a range of possibilities, so it is up to us to control the variability to reduce our risk of nonconformance. In this area, we are vulnerable to rejection from our customers (for variation) and to process problems in our shops (due to suppliers’ variation). To intelligently manage risk in this area, we can employ statistical methods to control outcomes and limit them to an acceptable range.

How do we make decisions when we face uncertainty? Uncertainty, Rumsfeld’s “unknown unknowns” cannot be successfully met with the tools that are effective in dealing with certainty and risk. In 2008, many shops were in compliance with their banking agreements, yet found the bank no longer willing to support them due to unforeseen changes in the broad economy and automotive market. Controlling financial positions to stay in control on banking covenants did no good if the bank was suddenly finding itself “overexposed” to the bankrupt automotive sector in its lending portfolio.