Guest editorial

Citation

(2007), "Guest editorial", Managerial Finance, Vol. 33 No. 4. https://doi.org/10.1108/mf.2007.00933daa.001

Guest editorial

A challenge for corporate senior leaders is to more fully understand how to identify, evaluate, and manage the risks and uncertainties facing the corporation. Yet the complexity of many industries makes this task difficult. A thorough understanding of the risk factors that short-term contribute to the variability in a firm's earnings, and long-term can determine the survivability of the firm, will enhance the abilities of executives to anticipate competitive, environmental, regulatory, and legislative changes and their impact upon the firm. Firm executives are increasingly being called upon to meet financial expectations, manage risk thus stabilizing earnings, and increase the firm's potential survivability. In this era, managing the firm's risk, and the firm, under conditions of uncertainty becomes critical.

The field of finance has contributed much in this regard. The appropriate synergistic use of available decision-making and analysis tools will assist executives in coping with the inevitable acceleration in 21 century uncertainties and risks. Risk means being exposed to the possibility of a bad outcome. Risk management is taking deliberate action to shift the odds away from the bad outcome. It is through the use of derivatives that management works to hedge the firm's risk exposure.

This special issue identifies risk management strategies for four aspects of a firm: managing the risk of the environment, hedging a firm's exposure to commodity price movement, creating a compensation program that leads to the desired employee behavior, and using employee stock options to reduce the effect of financial leverage.

Ten years ago, the idea of reducing a firm's exposure to earnings fluctuations caused by temperature or precipitation extremes couldn't be done. However, the introduction of weather derivatives allows firms to purchase contracts to manage weather changes. In "Using weather derivatives to hedge precipitation exposure", Karyl Leggio shows how a golf course can reduce its exposure to excessive rain that keeps golfers off of the course and cuts the firms revenues.

In "Designing natural gas utility hedge programs with call options", John Cita, Soojong Kwak, and Donald Lien show how regulators can determine if utilities are intending to hedge with the use of derivatives. Regulators must guard against the speculative use of derivatives in order to protect the customer. The authors evaluate several hedge programs designed to minimize the risk of an extreme monthly heating bill. They find hedge programs using price caps are superior in managing customer bills than in not having a hedge program.

Many energy firms compensate risk managers with bonuses based on their ability to outperform a budget benchmark. While this might have been appropriate when traders were speculating, in the era of hedging, this compensation system creates the incentive to "Let it ride" when prices move adversely to the benchmark. This leads the firm to exposure to further adverse movements. In "Eliminating the incentive to `Let it’ride': a suggested approach for compensating energy risk managers", Anand Balakrishnan, John M. Clark, and Sean P. Salter present an alternative compensation model designed to reward the risk manager for staying within the prescribed risk limits, which effectively rewards the manager for decreasing the deviation from the budget benchmark.

Finally, Gerald T. Garvey and Amin Mawani show that compensation plans can impact a firm's capital structure. In, "executive stock options and dynamic risk-taking incentives" the authors find that stock options plans granted approximately at-the-money encourage maximum risk-taking by managers in a dynamic setting. By adjusting the exercise prices of executive stock options, firms can mitigate the risk incentive effects of financial leverage.

I wish to thank all of the authors who submitted manuscripts for this special issue, and for the editors for their assistance with its production. The use of derivatives to hedge firm risk exposure continues to expand into an ever increasing array of firm activities. It becomes clear that the board of directors' fiduciary responsibility to oversee the corporation will continue to include the use of derivative instruments to hedge the firm's risk exposure, and this will lead to the continued development of as yet unknown hedging instruments.

Karyl B. LeggioGuest Editor