Question

3. What institutions have developed over the years to minimize uncertainty and shocks? Why is this important to do?

Answer 1

Economic uncertainty implies the future outlook for the economy is unpredictable. When people talk of economic uncertainty, they usually imply there is a high likelihood of negative economic events. Economic uncertainty could involve.

• Predictions of a higher and more volatile inflation rate. (inflation uncertainty)
• Concerns over economic downturn – lower economic growth or full-blown recession (negative economic growth)
• People fear the prospect of being made unemployed.
• Concerns over prospects for exchange rate – e.g. rapid devaluation of the currency.
• Concerns over government borrowing – e.g. markets unwilling to finance more debt, leading to default.
• Major change in economic structure

Benchmark Strategy

This strategy would be optimal if risky variables were close to their expected values and uncertainty shocks don’t present a threat to firm survival. Not only the magnitude of shocks but also the firm’s possibility to raise capital in adverse states of the world will be crucial. The better access to capital that a firm has, the greater the shocks that it will be able take on the chin. A firm following this strategy would be doing sensitivity tests but if the firm in the end doesn’t let risk and uncertainty considerations affect fundamental decisions of what it produces and sells, the firm follows the benchmark strategy.  

Financial Hedging Strategy

The core of the financial hedging strategy is that it makes the value of the firm less sensitive to changes in risk factors. We assume that there is a small cost of setting up the ability to engage in financial hedging. If risk factors hover around their expected value the profits are thus lower under the financial strategy but if lower tail outcomes triggered by risk factors are a concern the financial hedging strategy will become more attractive.

Contrary to predictions hedging is concentrated among large firms and the size of contracts are often too small to have an important overall impact on firm risk.

The academic literature in financial economics has identified some conditions under which hedging can add value to a firm – for instance if credit constraints imply a need for sufficient funds to finance investments, tax payments that are increasing in cash flow volatility or ill-diversified owners. The empirical literature that examines financial hedging practices has resulted in several puzzles. Contrary to predictions hedging is concentrated among large firms and the size of contracts are often too small to have an important overall impact on firm risk.⁷ To reconcile the evidence and theory I propose that it may be highly useful to distinguish between two reasons for derivatives use. The financial hedging strategy is to create insurance on costly lower tail outcomes that have a major impact on firm value and survival. Another motivation for using derivatives is to make it easier to manage liquidity in the short to medium run. While the latter explanation has not been the focus of the academic literature I venture that the empirical evidence is consistent with this being an important motivation for derivatives use.

Flexible Strategy

Flexible strategy recognises that risk factors can take on different values. Firms following this strategy design operations and processes so as to be able to quickly respond and make the best of the conditions.

The strategy that we call “flexible” explicitly recognises that risk factors can take on different values and that there will be shocks due to uncertainty. Firms following this strategy design operations and processes so as to be able to quickly respond and make the best of the conditions. With a technical term we would say that they strive to make profits into a convex function of the risk factor. Thus profitability for a flexible firm increases as conditions become more variable. Flexibility can for instance come about via production processes (designing operations such that there are low increases in costs as volumes surge or having an ability to rapidly suppliers), labour (short term labour), leasing rather than owning capacity, or via marketing related strategies (such as an ability to segment different national markets). Organising lines of control in the firm to be more flexible is another hallmark of this strategy. All good things come at a cost however and it is not likely to be worth it for a firm in a very stable environment to invest in flexibility.

Operational Hedging

Finally we draw attention to the “operational hedging” strategy. This refers to ways of adjusting operations or management processes so as to make the profits of the firm less sensitive to changes in risk factors and uncertainty shocks. One example of an operational hedging strategy would be to diversify, for instance a car producer might also own a brewer that faces less and different shocks than the car producer. For another example consider an airline that buys very fuel efficient planes. If planes are costlier to purchase they might be less profitable when fuel prices are around average but they make profits less sensitive to swings in the fuel price. The more uncertainty and the harder it is to access capital in adverse states of the world the more attractive will the operational hedging strategy be. A car producer striving to naturally hedge, for instance a European producing for the US market locally in the US would be another example. A firm would be sacrificing some profitability in normal times for increased survival in bad times.

When comparing strategies one must have some metric to use for comparison. We assume that the target is to maximise expected profits (mainly affected by risk) subject to a constraint that the firm is able to survive also a worst case. In a very schematic way one might then suggest that strategies are especially worth pondering for firms in the following way.