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418 Planning and Forecasting Air Canada (1999) Air T Inc. (2000) American Pacific Corporation (1999) Analog Devices Inc. (1999) Arch Chemicals Inc. (1999) Armstrong World Industries Inc. (1999) Arvin Industries Inc. (1999) Baldwin Technology Company (1999) Baltek Corporation (1999) Baxter International Inc. (1999) Beckman Coulter Inc. (1999) Becton, Dickenson & Company (1999) Black and Decker Inc. (1995) Blyth Industries Inc. (2000) California First Bank (1987) Compaq Computer Corporation (1999) Conoco Inc. (1999) DaimlerChrysler AG (1999) Delta Air Lines Inc. (2000) Dow Chemical Company (1999) E.I. DuPont de Nemours & Company (1999) Electricidade de Portugal SA (1998) Federal Express Inc. (1989) Galey & Lord Inc. (1999) Hartmarx Corporation (1999) H.J. Heinz Co. (1999) Henry Schein Inc. (1998) Illinois Tool Works Inc. (1999) Interface Inc. (1999) JLG Industries Inc. (2000) Johnson & Johnson, Inc. (1999) Olin Corporation (1999) Pall Corporation (2000) Pegasus Systems Inc. (1999) Philip Morris Companies Inc. (1999) Polaroid Corporation (1999) Praxair Inc. (1999) Quaker Oats Company (1999) Silgan Holdings Inc. (1999) Global Finance 419 Storage Technology Corporation (1999) Teleflex Inc. (1999) Tenneco Inc. (1999) Tiger International Inc. (1980) Titan International Inc. (1999) UAL Inc. (1999) Vishay Intertechnology Inc. (1999) Western Digital Corporation (2000) York International Corporation (1999) NOTES 1. Western Digital Corporation, annual report, June 2000, 25–26. 2. Baltek Corporation, annual report on Form 10-K to the Securities and Ex- change Commission, December 1999, 3. 3. It is unlikely that either side of the transaction would be indifferent to this matter. Insisting upon being invoiced by a foreign supplier in your own currency means that the supplier must bear the currency risk. The supplier will have a foreign- currency receivable. It is reasonable to expect the foreign supplier to attempt to be compensated for bearing this currency risk by charging a higher price for its product. 4. A U.S. electronics company recently attempted to eliminate currency risk by having its Japanese supplier invoice them in the U.S. dollar. The Japanese supplier agreed to do this and introduced a new schedule of prices in dollars. The U.S. company deemed the increases to be so high that they decided to continue to be invoiced in the Japanese yen and to manage the associated exchange risk. 5. Each of the actual case examples discussed in this section are treated in more detail, including income tax and cash-flow issues, in E. Comiskey and C. Mulford, “Risks of Foreign Currency Transactions: A Guide for Loan Officers,” Commercial Lending Review (summer 1990), pp. 44–60. 6. Air Canada, annual report, December 1999 (emphasis added). Information obtained from Disclosure, Inc., Compact D/SEC: Corporation Information on Public Companies Filing with the SEC (Bethesda, MD: Disclosure Inc., June 2000). 7. On January 1, 1999, 11 of the 15 member countries of the European Union adopted the Euro as their common legal currency and established fixed conversion rates between their sovereign currencies and the Euro. 8. Holding foreign currency cash, that is, an asset balance, would be consistent with the need to offset existing liability exposure in these foreign currencies. Alter- natively, borrowing in foreign currencies to produce a hedge implies existing asset exposure in these foreign currencies. 9. California First Bank, annual report, December 1987, 20. 10. Federal Express Inc., annual report, December 1989, 35. 11. The accounting treatment to insure that the offsetting gains and losses are included in the income statements at the same time was described by Federal 420 Planning and Forecasting Express. It reported that “Exchange-rate gains and losses on the term loan are de- ferred and amortized over the remaining life of the loan as an adjustment to the re- lated hedge (service) revenue.” Federal Express Inc., annual report, December 1989, 36. 12. This example is discussed in “FX Translation—Lyle Shipping’s Losses,” Ac- countancy, 110 (December 1984): 50. Lyle has an economic hedge of its dollar exposure. 13. See P. Maloney, “Managing Currency Exposure: The Case of Western Min- ing,” Journal of Applied Corporate Finance, 2 (winter 1990): 29–34, for an analysis of the effectiveness of this natural hedge during the eighties. 14. Survey data support this view. See G. Bodnar, G. Hayt, and R. Marston, “The Wharton Survey of Derivatives Usage by U.S. Non-Financial Firms,” Financial Man- agement, 25 (winter 1996): 113–133. 15. Spot and forward exchange rates normally differ. These rate differences are determined primarily by differences in interest rates in the respective countries of the domestic and foreign currency. 16. Beckman Coulter Inc., annual report, December 1999, 47. 17. An option that is acquired when the spot value for the currency and the strike price in the option contract are equal is said to have no intrinsic value. How- ever, such contracts routinely have positive values. The value of an at-the-money option contract is normally referred to as time value. 18. A currency option is similar to flight insurance. The option contract (insurance) only pays off if the plane crashes and the policyholder is injured or dies. That is, there is a gain only if the unfavorable event takes place. However, if the plane does not crash, the favorable outcome, the policyholder is simply out the amount of the insurance (option) premium. 19. Analog Devices Inc., annual report, December 1999. Information obtained from Disclosure Inc. 20. JLG Industries Inc., annual report, July 2000, 23. 21. Titan International Inc., annual report, December 1999. Information obtained from Disclosure Inc. 22. To be technically correct, a gain or loss from the translation of the statements of a foreign subsidiary does affect other comprehensive income. However, it does not affect net income, which continues to be the number which both company management and other users of financial statements emphasize. 23. E.I. DuPont de Nemours & Company, annual report, December 1999, 37. 24. Ibid., 37. 25. However, this hedging by Quaker Oats is not aimed at protecting either earnings or cash flow. Gains and losses from net-investment hedges, along with their offsetting translation losses and gains, are reported in shareholders’ equity. 26. Arch Chemicals Inc., annual report, December 1999, 34. 27. The equity method is usually employed when a voting stock interest of 20% or more is held in another company. The investor company recognizes its share of the investee company earnings or loss, without regard to whether any dividends are re- ceived. The receipt of dividends is treated as a reduction in the carrying value of the investment, and not as dividend income. Global Finance 421 28. Denmark has not yet (early 2001) adopted the Euro. Its currency exposure will be limited to the Euro to the extent that it trades mainly with Euro countries. 29. Information on Danish GAAP can be found in E. Comiskey and C. Mulford, “Comparing Danish Accounting and Reporting Practices with International Account- ing Standards,” in Advances in International Accounting, ed. Kenneth S. Most (Greenwich, CT: JAI Press, 1991), 123–142. 30. If there were differences between generally accepted accounting principles in the country of the foreign subsidiary and those in the U.S., then the statements would first have be adjusted to conform to U.S. GAAP before consolidation could take place. 31. Statement No. 52, Foreign Currency Translation, refers to this alternative pro- cedure as remeasurement and not translation. However, in the vast majority of cases, the remeasurement is from the foreign currency to the U.S. dollar. Therefore, remeasurement produces statements in the U.S. dollar that are ready to be consolidated with the statements of their U.S. parent. Remeasurement is tantamount to translation. 32. It is simply coincidental that a translation gain of $87 resulted under the all- current translation and a remeasurement loss of $87 resulted from remeasurement under the temporal method. 33. From this example, a fairly obvious case can be made for, other things equal, locating manufacturing in the same country where sales are made. 34. P. Collier, E. Davis, J. Coates and S. Longden, “The Management of Cur- rency Risk: Case Studies of US and UK Multinationals,” Accounting and Business Re- search, 24 (summer 1990): 208. 35. SFAS No. 8, Accounting for the Translation of Foreign Currency Transactions and Foreign Financial Statements (Stamford, CT: FASB, October 1975). 36. C. Houston and G. Mueller, “Foreign Exchange Rate Hedging and SFAS No. 52—Relatives or Strangers?,” Accounting Horizons, 2 (December 1988): 57. 37. SFAS No. 133, Accounting for Derivative Instruments and Hedging (Nor- walk, CT: FASB, June 1998). 38. A common feature of derivatives is that they have little or no initial value. This would not be true in the case of some option contracts where an option premium is paid, even in the case of at or out-of-the-money options. 39. For a reference on these matters, see E. Comiskey and C. Mulford, Guide to Financial Reporting and Analysis (New York: John Wiley, 2000), chapters 6 and 7. 40. International Accounting Standards Committee, Exposure Draft 32, Compa- rability of Financial Statements (January 11, 1989). 41. Ibid., paragraph 6. 42. International Accounting Standards Committee, Statement of Intent, Compa- rability of Financial Statements (July 1990). 43. For a standard-by-standard analysis of the differences between current U.S. GAAP and IASC standards, see The IASC-U.S. Comparison Project: A Report on the Similarities and Differences between IASC Standards and U.S. GAAP (Norwalk, CT: FASB, November, 1996). 44. To examine the complete reconciliation disclosures of Electricidade de Portu- gal, go to the SEC Web site (www.sec.gov) and search for the Electricidade filings. The current reconciliation will be found in the most recent 20-F filing for the company. 422 Planning and Forecasting 45. A further negative for a U.S. firm has been the fact that goodwill amortiza- tion was not deductible for tax purposes, whereas it was in some other countries. A 1993 change in the tax law, Internal Revenue Code, section 197, now makes it possi- ble to amortize goodwill in the tax return for qualifying acquisitions. 46. FASB, News Release, Financial Accounting Standards Board Announces Ad- ditional Decisions Relating to the Treatment of Goodwill (Norwalk, CT: FASB, De- cember 20, 2000). 47. SFAS No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions (Norwalk, CT: FASB, December 1990). 48. From a statement made by R. S. Miller Jr., executive vice president and chief financial officer of Chrysler Corporation, to the Financial Accounting Standards Board, Washington, DC, November 3, 1989, 3. 49. Removing the effects of exchange rate changes in cases where the subsidiary is using the temporal (remeasurement) translation method, as opposed to the all-current method, is a greater challenge and beyond the scope of this chapter. 50. Black and Decker Inc., annual report, December 1995, 35. 51. The following two references were of great assistance in preparing this dis- cussion of transfer pricing: Frederick D. S. Choi and Gerhard G. Mueller, An Intro- duction to Multinational Accounting (Englewood Cliffs, NJ: Prentice-Hall, 1978), chapter 9; and Jeffrey S. Arpan and Lee H. Radebaugh, International Accounting and Multinational Enterprises (New York: Warren, Gorham & Lamont, 1981), chapter 10. 52. SFAS No. 33, Financial Reporting and Changing Prices (amended and par- tially superseded) (Stamford, CT: FASB, September 1979). 53. SFAS No. 89, Financial Reporting and Changing Prices (Stamford, CT: FASB, December 1986). 54. Helpful in preparing this section was J. Largay and L. Livingstone, Account- ing for Changing Prices: Replacement Cost and General Price Level Adjustments (Santa Barbara, CA: John Wiley/Hamilton, 1976). This is an excellent and comprehensive treatment of this subject area that is recommended for readers interested in a more expansive treatment of the subject. 55. Tiger International Inc., annual report, December 1980, 39. 56. Ibid., 39. 57. Ibid., 40. 58. Incorporating gain and losses on the net monetary position into the computa- tion of restated results was not part of the SFAS No. 33 requirements. 59. SFAS No. 89, Financial Reporting and Changing Prices (Stamford, CT: FASB, 1986). 60. For further background on this topic see: K. Skousen, An Introduction to the SEC, 4th ed. (Cincinnati: South-Western, 1987), 32–35. 61. Report of the National Commission on Fraudulent Financial Reporting (Washington, DC, 1987), 44. 423 13 FINANCIAL MANAGEMENT OF RISKS Steven P. Feinstein For better or worse, the business environment is fraught with risks. Uncer- tainty is a fact of life. Profits are never certain, input and output prices change, competitors emerge and disappear, customers’ tastes constantly evolve, techno- logical progress creates instability, interest rates and foreign-currency values and asset prices fluctuate. Nonetheless, managers must continue to make decisions. Businesses must cope with risk in order to operate. Managers and firms are often evaluated on overall performance, even though performance may be affected by risky factors beyond their control. The goal of risk management is to maximize the value of the firm by reducing the negative potential impact of forces beyond the control of management. There are essentially four basic approaches to risk management: risk avoidance, risk retention, loss prevention and control, and risk transfer. 1 Sup- pose after a firm has analyzed a risky business venture and weighed both the costs and benefits of exposure to risk, management chooses not to embark on the project. They determine that the potential rewards are not worth the risks. Such a strategy would be an example of risk avoidance. Risk avoidance means choosing not to engage in a risky activity because of the risks. Choosing not to fly in a commercial airliner because of the risk that the plane might crash is an example of risk avoidance. Risk retention is another simple strategy, in which the firm chooses to engage in the project and do nothing about the identified risks. After weighing the costs and benefits, the firm chooses to proceed. It is the “damn the torpe- does” approach to risk management. For many firms, risk retention is the optimal strategy for all risks. Investors expect the company’s stock to be risky, and they do not reward managers for reducing risks. Investors cope with business 424 Planning and Forecasting risks by diversifying their holdings within their portfolios, and so they do not want business managers to devote resources to managing risks within the firm. Loss prevention and control involves embarking on a risky project, yet taking steps to reduce the likelihood and severity of any losses potentially re- sulting from uncontrollable factors. In the flying example, loss prevention and control would be the response of the airline passenger who chooses to fly, but also selects the safest airline, listens to the preflight safety instructions, sits near the emergency exit, and perhaps brings his or her own parachute. The passenger in this example has no control over how many airplanes crash in a given year, but he or she takes steps to make sure not to be on one of them, and if so, to be a survivor. Risk transfer involves shifting the negative consequences of a risky factor to another person, firm, or party. For example, buying flight insurance shifts some of the negative financial consequences of a crash to an insurance company and away from the passenger’s family. Should the airplane crash, the insurance company suffers a financial loss, and the passenger’s family is financially compensated. Forcing foreign customers to pay for finished goods in your home currency rather than in their local currency is another example of risk transfer, whereby you transfer the risk of currency fluctuations to your customers. If the value of the foreign currency drops, the customers must still pay you an agreed upon number of dollars, for example, even though it costs them more to do so in terms of their home currency. No one risk management approach is ideal for all situations. Sometimes risk avoidance is optimal; sometimes risk retention is the desired strategy. Recent developments in the financial marketplace, however, have made risk transfer much more feasible than in the past. More and more often now, espe- cially when financial risks are involved, it is the most desirable alternative. In recent years there has been revolutionary change in the financial marketplace. The very same marketplace that traditionally facilitated the transfer of funds from investors to firms, has brought forth numerous derivative instruments that facilitate the transfer of risk. Just as the financial marketplace has been innovative in engineering various types of investment contracts, such as stocks, bonds, preferred stock, and convertible bonds, the financial marketplace now engineers risk transfer instruments, such as forwards, futures, options, swaps, and a multitude of variants of these derivatives. Reading stories about derivatives in the popular press might lead one to believe that derivative instruments are dangerous and destabilizing—evil crea- tures that emerged from the dark recesses of the financial marketplace. The cover of the April 11, 1994, Time magazine introduced derivatives with the caption “High-tech supernerds are playing dangerous games with your money.” The use of derivatives has been implicated in most of the financial calamities of the past decade: Barings Bank, Procter & Gamble, Metallgesellschaft, Askin Capital Management, Orange County, Union Bank of Switzerland, and Long- Term Capital Management, to name a few. In each of the cases, vast sums of money quickly vanished, and derivatives seemed to be to blame. Financial Management of Risks 425 WHAT WENT WRONG: CASE STUDIES OF DERIVATIVES DEBACLES Derivatives were not responsible for the financial calamities of the 1990s. Greed, speculation, and probably incompetence were. But just as derivatives facilitate risk management, they facilitate greed and accelerate the consequences of speculation and incompetence. For example, consider the following case histories and then draw your own conclusions. Barings Bank On February 26, 1995, Baring PLC, Britain’s oldest merchant bank and one of the most venerable financial institutions in the world collapsed. Did this fail- ure follow years of poor management and bad investments. Hardly. All of the bank’s $615 million of capital had been wiped out in less than four months, by one employee, half way around the world from London. It seems that a Bar- ings derivatives trader named Nicholas Leeson, stationed in Singapore, had taken huge positions in futures and options on Japanese stocks. Leeson’s job was supposed to be index arbitrage, meaning that he was supposed to take low risk positions exploiting discrepancies between the prices of futures contracts traded in both Singapore and Osaka. Leeson’s job was to buy whichever contract was cheaper and sell the one that was more dear. The difference would be profit for Barings. When he was long in Japanese stock futures in Osaka, he was supposed to be short in Japanese stock futures in Singapore, and vice versa. Such positions are inherently hedged. If the Singapore futures lost money, the Japanese futures would make money, and so little money, if any, could be lost. Apparently, Leeson grew impatient taking hedged positions. He began to take unhedged bets, selling both call options and put options on Japanese stocks. Such a strategy, consisting of written call options and written put options is called a straddle. If the underlying stock price stays the same or does not move much, the writer keeps all the option premium, and profits hand- somely. If, on the other hand, the underlying stock price either rises or falls substantially, the writer is vulnerable to large losses. Leeson bet and lost. Japa- nese stocks plummeted, and the straddles became a huge liability. Like a pan- icked gambler, Leeson tried to win back his losses by going long in Japanese stock futures. This position was a stark naked speculative bet. Leeson lost again. Japanese stocks continued to fall. Leeson lost more than $1 billion, and Barings had lost all of its capital. The bank was put into receivership. Procter & Gamble Procter & Gamble, the well-known manufacturer of soap and household products, had a long history of negotiating low interest rates to finance opera tions. 426 Planning and Forecasting Toward this end, Procter & Gamble entered an interest rate swap with Bankers Trust in November of 1993. The swap agreement was far from plain- vanilla. It most certainly fit the description of an exotic derivative. The swap’s cash flows were determined by a formula that involved short-term, medium- term, and long-term interest rates. Essentially, the deal would allow Procter & Gamble to reduce its financing rate by four-tenths of 1% on $200 million of debt, if interest rates remained stable until May 1994. If, on the other hand, interest rates spiked upward, or if the spread between 5-year and 30-year rates narrowed, Procter & Gamble would lose money and have to pay a higher rate on its debt. Even in the rarefied world of derivatives, one cannot expect something for nothing. In order to achieve a cheaper financing rate, Procter & Gamble had to give up or sell something. In this case, implicit in the swap, they sold interest rate insurance. The swap contained an embedded option, sold by Proc- ter & Gamble. If the interest rate environment remained calm, Procter & Gamble would keep a modest premium, thereby lowering its financing costs. If interest rates became turbulent, Procter & Gamble would have to make big payments. Most economists in 1993 were forecasting calm. The bet seemed safe. But it was a bet, nevertheless. This was not a hedge, this was speculation. And they lost. The Federal Reserve unexpectedly raised interest rates on February 4, 1994. Procter & Gamble suddenly found themselves with a $100 million loss. Rather than lower their financing rate by four-tenths of 1%, they would have to pay an additional 14%! Rather than lick its wounds and retire from swaps, Procter & Gamble went back for more—with prodding, of course, from Bankers Trust. As losses mounted on the first deal, Procter & Gamble entered a second swap, this one tied to German interest rates. German medium-term interest rates are remark- ably stable, and so this bet seemed even safer than the first one. Guess what happened. Another $50 million of losses mounted before Procter & Gamble fi- nally liquidated its positions. Losses totaled $157 million. Procter & Gamble sued Bankers Trust, alleging deception, mispricing, and violation of fiduciary responsibilities. Procter & Gamble claimed that they did not fully understand the risks of the swap agreements, nor how to calculate their value. Bankers Trust settled with Procter & Gamble, just as they settled with Gibson Greeting Cards, Air Products and Chemicals, and other companies that lost money in similar swaps. Metallgesellschaft Experts are still divided over what went wrong in the case of Metall- gesellschaft, one of Germany’s largest industrial concerns. This much is certain: In 1993, Metallgesellschaft had assets of $10 billion, sales exceeding $16 billion, and equity capital of $50 million. By the end of the year, this industrial giant was nearly bankrupt, having lost $1.3 billion in oil futures. Financial Management of Risks 427 What makes the Metallgesellschaft case so intriguing, is that the company seemed to be using derivatives for all the right reasons. An American subsidiary of Metallgesellschaft, MG Refining and Marketing (MGRM) had em- barked on an ingenious marketing plan. The subsidiary was in the business of selling gasoline and heating oil to distributors and retailers. To promote sales, the company offered contracts that would lock in prices for a period of 10 years. A variety of different contract types was offered, and the contracts had various provisions, deferments, and contingencies built in, but the important feature was a long-term price cap. The contracts were essentially forwards. The forward contracts were very popular and MGRM was quite successful at selling them. MGRM understood that the forward contracts subjected the company to oil price risk. MGRM now had a short position in oil. If oil prices rose, the company would experience losses, as it would have to buy oil at higher prices and sell it at the lower contracted prices to the customers. To offset this risk, MGRM went long in exchange-traded oil futures. The long position in futures should have hedged the short position in forwards. Unfortunately, things did not work out so nicely. Oil prices fell in 1993. As oil prices fell, Metallgesellschaft lost money on its long futures, and had to make cash payments as the futures were marked to market. The forwards, however, provided little immediate cash, and their ap- preciation in value would not be fully realized until they matured in 10 years. Thus, Metallgesellschaft was caught in a cash crunch. Some economists argue that if Metallgesellschaft had held on to its positions and continued to make margin payments the strategy would have worked eventually. But time ran out. The parent company took control over the subsidiary and liquidated its positions, thereby realizing a loss of $1.3 billion. Other economists argue that Metallgesellschaft was not an innocent vic- tim of unforeseeable circumstances. They argue that MGRM had designed the entire marketing and hedging strategy, just so they could profit by speculating that historical patterns in oil prices would persist. Traditionally, oil futures prices are lower than spot prices, so the general trend in oil futures prices is upward as they near expiration. MGRM’s hedging plan was to repeatedly buy short-term oil futures, holding them until just before expiration, at which point they would roll over into new short-term futures. If the historical pattern had repeated itself, MGRM would have profited many times from the rollover strategy. It has been alleged that the futures was the planned source of profits, while the forward contracts with customers was the hedge against oil prices dropping. Regardless of MGRM management’s intent, the case teaches at least two lessons. First, it is important to consider cash flow and timing when con- structing a hedge position. Second, when a hedge is working effectively, it will appear to be losing money when the position it is designed to offset is showing profits. Accounting for hedges should not be independent of the position being hedged. . Currency Transactions: A Guide for Loan Officers,” Commercial Lending Review (summer 1990), pp. 44 60. 6. Air Canada, annual report, December 1999 (emphasis added). Information obtained from Disclosure,. the Similarities and Differences between IASC Standards and U.S. GAAP (Norwalk, CT: FASB, November, 1996). 44. To examine the complete reconciliation disclosures of Electricidade de Portu- gal, go to the. gain and losses on the net monetary position into the computa- tion of restated results was not part of the SFAS No. 33 requirements. 59. SFAS No. 89, Financial Reporting and Changing Prices (Stamford,