Why Firms Use Currency Derivatives

Although derivatives have been criticized as inappropriate speculative vehicles that can have disastrous consequences, large corporations increasingly turn to derivatives to reduce their exposures to a variety of risks in global capital markets. According to a recent study conducted by Wharton’s Christopher Geczy and Catherine Schrand and Ohio State University’s Bernadette Minton, on average, many of the largest companies are using derivatives in an economically rational way in order to reduce volatility in their cash flows, which, if not otherwise reduced, might inhibit their investment in valuable projects.

According to the researchers, the majority of Fortune 500 companies have potential exposure to foreign currency risk from sources such as foreign operations, foreign-denominated debt, or exports. Almost half report using currency swaps, forwards, futures, options, or combinations of these tools.

Among the researchers’ findings: companies with relatively good opportunities for growth (those that have the most to lose from fluctuations in cash flows) or that are financially constrained with respect to short-term liquidity (those that already are short on cash) – or both – tend to use derivatives. In addition, firms with extensive foreign exchange-rate exposure and economies of scale in hedging activities are also more likely to use currency derivatives, and the source of foreign exchange rate exposure is an important factor in the choice among types of currency derivatives.

The researchers conclude that by hedging cash flow volatility, firms may increase the probability of having cash available for investment projects should the need arise. These results, say the authors, are consistent with the experiences of pharmaceutical companies like Merck, which report that when they do not hedge, fluctuations in cash flows resulting from foreign currency movements can have strong adverse effects on important R&D projects. Given that the evidence in the study supports models of the rational use of derivatives for hedging purposes, the authors also suggest that the largest companies in the U.S. are, on average, not engaging in wholesale speculation with derivative instruments as much as recent media coverage implies.

Christopher Geczy, Bernadette Minton & Catherine Schrand; Why Firms Use Currency Derivatives – Journal of Finance V52, 9/97, No. 4

Rating Morningstar

Look carefully at most advertisements for mutual funds and you will likely find the fund trumpeting its Morningstar ratings. According to a new study by Wharton’s Marsall Blume, Morningstar’s rating method is flawed and does not represent an accurate way to distinguish among the thousands of choices available in the mutual fund market. Morningstar rates investment performance of mutual funds on a scale of one to five stars, with five stars as the highest rating and one as the lowest. For the past decade, households have been net buyers of equities through mutual funds. Ratings and rankings that help potential investors distinguish among the thousands of choices available have become essential.

In analyzing Morningstar’s rating methodology, Blume found that a fund with a long history is less likely to receive a five-star rating than a fund with a short history. He also found that Morningstar’s system tends to favor no-load funds over load funds: Morningstar assigns its highest two ratings to nearly half of the no-load domestic diversified equity funds it evaluates while it assigns its lowest two ratings to just over a quarter of these funds.

Marshall E. Blume; An Anatomy of Morningstar Ratings

Core Competencies: Are They a Fad, or Just Misunderstood?

The term “core competence” has been praised as an outstanding idea and derided as just another management fad. Many companies that have tried to identify their core competencies have had a difficult time doing so and have had even more difficulty translating those competencies into new products, markets, or services.

In a recent report that sheds new light on the relevance and value of competencies, Wharton’s Ian C. MacMillan and Columbia’s Rita Gunther McGrath describe their new approach to competitive competence development: Accelerating Competitive Effectiveness (ACE). The authors, following five years of data collection covering more than 1,000 projects in all major industries worldwide, have developed a new definition of competencies that combines an organization’s skills, assets and systems in a way that allows the firm to achieve a performance profile that distinguishes it from its competitors. They take a fresh look at how successful teams maximize their effectiveness and identify four widely held misconceptions about the relationship between teamwork and organizational competence. They also provide tools to help executives create competence-driven competitive advantages that can be measured, monitored, and, most important, managed.

Ian C. MacMillan and Rita Gunther McGrath; Accelerating Competitive Effectiveness: Discovering the Competencies that Fuel Future Growth

Natural Disasters: Who’s Going to Pay?

In the wake of numerous recent floods, earthquakes, hurricanes and other natural disasters, losses in the billions have staggered property owners, caused some insurer insolvencies and triggered large amounts of disaster assistance which have created budgetary concerns at the federal level. While some loss is inevitable, a study by Wharton’s Paul Kleindorfer and Howard Kunreuther has found that the economic devastation can be lessened through risk mitigation measures (RMMs) such as bolting a house to its foundation in an earthquake-prone area or anchoring the roofing for structures located in hurricane-prone regions.

In their study, the researchers worked with three prominent natural hazard modeling firms and evaluated the impact of mitigation in several “model” cities which are subject to earthquake and hurricane damage. In the analysis of two of those model cities — Oakland (subject to earthquakes) and Miami/Dade County (subject to hurricanes) — the researchers found that mitigation is beneficial in reducing losses to both the insurers and property owners. The benefits to insurers come not only through reductions in expected claims, but also through significant decreases in worst case losses and resulting costs of financial distress.

Despite potentially large reduction in losses to property owners, the research shows that many are reluctant to invest in cost-effective risk mitigation measures. Some reasons which may explain this are an “it cannot happen to me” attitude, budget constraints and a myopic view of the future, making property owners much more sensitive to the upfront costs of mitigation than to the potential future benefits of the mitigation measure.

Kleindorfer and Kunreuther suggest three types of public-private partnership programs that can encourage mitigation: (1) well-enforced building codes, (2) insurance premium reductions linked with long-term loans for mitigation and (3) insurers offering lower deductibles for those investing in mitigation. The authors suggest that these same programs, together with adequate risk-based insurance premiums, can also help to promote innovations involving new capital market instruments to cover a substantial portion of future catastrophic losses from natural hazards.

Paul Kleindorfer and Howard Kunreuther; The Complementary Roles of Mitigation and Insurance in Managing Catastrophic Risks, a paper presented at the Public Private Partnership 2000 Conference on “The Uncertainty of Managing Catastrophic Risks” in Washington, D.C. on December 11th

To Build or Not to Build: Does America Have Enough Office Space?

For years, many experts have predicted that telecommuting, downsizing and technology will reduce the demand for office space. But according to research by Peter Linneman, director of the Wharton Real Estate Center, the demand for office space in the U.S. will grow substantially over the coming decade in spite of significant real rent increases (ultimately reaching replacement cost levels) and continued managerial and technological advances. Based on his calculations that nearly 5.4 million new office sector jobs will be created over the next decade, Linneman figures that the demand for office space will conservatively grow by an annual rate of 1.25 percent in the next 10 years. This means that each year the U.S. will absorb roughly the entire office stocks of the Philadelphia and Orlando metropolitan areas combined. In the next decade, an amount equal to two New York City metropolitan areas plus one Chicago metropolitan area will be absorbed. The total increase in office demand, figures Linneman, will range from 800 million to 1.5 billion square feet over the coming decade with the bulk of this new development occurring after 1999. “The challenge facing the office real estate sector will be to bring new space on line only as it is economically justified,” Linneman says.

Peter Linneman; Will We Need More Office Space?