Definition of Risk – Part 2

 

*/By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc./*

What is the definition of risk?  This is the question that we started to
explore in Part 1.  There I claimed that there were two basic, yet very
different definitions of risk.

The first definition is:

·        "Risk is the possibility of adverse events that prevent an
organization from achieving its goals"

A second definition is:

·        "Risk is the possibility of events that prevent an
organization from achieving its expected outcomes"

In Part 1, I gave one illustration of how the choice of the definition
changes how an entity should measure risk.  In this installment I will argue
that the choice of definition determines whether an entity decides to use
options or forward (swap)[1] [1] type contracts to hedge its financial risks.

To illustrate this point I will take a well-known example from the airline
industry – namely Southwest Airlines.  Southwest has been frequently
lauded for many of its management practices, including its risk management. 
Prior to 2009, Southwest "locked" in its fuel costs with a series of
rolling swap contracts.  As the price of oil rose, so did fuel costs.  The
hedges gave Southwest a significant competitive advantage as when fuel costs
rose, so did the value of its hedge contracts – offsetting the rise in fuel
prices.  Southwest was well hedged against the "bad" risk of rising fuel
costs.

However fuel costs then fell dramatically along with other commodity
prices.  While a somewhat welcome relief on fuel costs for most airlines,
the falling fuel costs created a real problem for Southwest.  It was
"locked-in" to long term hedges that protected against rising fuel prices
but the swap contracts also prevented Southwest from taking advantage of the
"good" risk of falling fuel prices.  There was also a secondary effect
– namely as long as the economic crisis continued, airline travel will be
distressed and consumers will be more price conscious than ever.  Thus just
when Southwest needed to be most price competitive, its "bad" risk only
hedges caused it double grief.

The morale of this story is that forward contracts are fine if the
corporation is only concerned about "bad" risk.  However if a
corporation wants to be strategically prepared in cases of both "good"
risk and "bad" risk, then options are usually a better choice.  This is
not to say that options are always the best alternative for hedging.  In
another installment I will demonstrate the well-known adage that "the only
perfect hedge is in a Japanese Garden".

We are not done though with illustrating how the definition of risk permeates
the most important risk decisions of a company.  In the next installment of
this series we will see that the definition of risk defines how the risk
management team should be evaluated.

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[1] [2] Swaps can be shown to be economically equivalent to a series of
forward contracts.  Therefore this analysis uses swaps and forwards
interchangeably.

 


[1] #_ftn1
[2] #_ftnref1