I once participated in the negotiation of a decently large franchisee renewal. The franchisee was solid enough and was renewing its contract with corporate to continue operate in a few smaller countries. However, the negotiations got hung up on one crucial point. The franchisee was not willing to assume unlimited currency risk. Or, let me put it another way, the corporation was insisting on having a minimum annual guarantee in a currency foreign to the region where the franchisee operated. By the time I got involved both sides were issuing ultimatums and unwilling to back down. I was embarassed of my employer and the vice-president refusing to budge on an issue in which he was clearly out of his element (his primary experience was US only operations). After failing to convince this executive how... imprudent... the position was, I decided to subtlety cut down his position by explaining to and convincing some of the executive's colleagues that this decision was "unwise to pursue at this juncture." At the end of this process, there were two key lessons for me: 1) be willing to be wrong and solicit the feedback of those more knowledgeable than myself, and 2) a lack of understanding of a simple concept (an unforced error, as I like to call them) can consume significant amount of time at all levels of the organization.
Tuesday, April 29, 2014
Thursday, April 17, 2014
Show Me the Money II - Statistics
I wrote a couple weeks ago on short-sighted corporate cultures. However, 20/400 near-sightedness is not just a "some corporate cultures" type of problem. It's a human problem. We see it when those who eat the marshmallow now seem so cool, exciting, and hip as they munch that delicious morsel and get invited to all the parties. I would take a swipe at politicians, but that's too easy, so I'll go one step above and go for myself -- those of us who rely on aggregated statistics and believe that they are comparable and assume everything else we haven't included in our models isn't very significant anyway. I'll use GDP as an example.
Besides GDP being an estimate of economic well-being, it's also an accounting identity. GDP = C + I + G + (X-M). Just add up consumption, gross investment, government spending, and net exports. There are many criticisms (most of them are marginalized) of GDP. I'll focus on just one: G, or the government spending component.
GDP is supposed to accurately depict the economic well-being of a society. Voluntary transactions, consumption, even the (quite subjective in my opinion) human development index can be a gauge of well-being. Government spending, however, is not. Here are a few examples:
1) A government spends $10M developing a new bomb. That money is now added into GDP. The economy is supposed to be better off by $10M.
Some people erroneously believe that war helps the economy (e.g., "World War II got us out of the Great Depression!"). Large amounts of spending on war simply manipulates GDP to no longer represent the economic well-being of a society. People producing large amounts of tanks, bombers, and guns don't make a society "richer" than when those same people produce butter, hair cuts, and buildings. Now, of course survival makes one better off than death and defense is a crucial part of this. However, GDP equates bombs with corn flakes. I'd prefer to not need the bomb and eat my corn flakes, but GDP states that I'm just as well off if I have no corn flakes and the bomb is made. Of course I prefer survival, but survival and corn flakes is even better than survival and no corn flakes. GDP doesn't make this distinction.
2) A farmer receives a $5M subsidy to plant nothing. The economy is supposed to be better off by $5M. The result is higher agriculture prices and a deadweight social loss that comes from the transfer of money through government There also might be secondary effects as savings drop as more income is spent on food. The economy is better off according to GDP.
3) A state spends $15B on the biggest public works project in the state's history. It's the biggest public works project in history because it went triple over budget and time. Let's call it a Dig that is Big. The fact that it went over budget is a plus for GDP, not a minus. Cases like this beg the question, "How much quality am I receiving per dollar spent?" Tyler Cowen makes the convincing case in The Great Stagnation that the marginal dollar of government spending is very important. The first 10% of GDP in government spending of GDP is generally spent on courts, police, and preventing starvation. The final 50-60th % of GDP in government spending is spent on subsidies, four year unemployment benefits, bike paths, and free stuff. When GDP is calculated, involuntary transactions are weighted equally with voluntary transactions. We then take these GDP numbers and compare them across countries with very different levels of government spending and assume that they are equivalent.
And, yet, I turn around and use the metric because... what else do I use? What else is available? I use the tools that I have even though my results are likely systematically biased. This is the principal reason why I love to dive, without the narrative of others, into the random minutiae in a process or among operational or "line" teams. I have the chance to see some of the ways it can all go wrong when we aggregate it up and take decisions. It forces cluelessness, and, hopefully, humility.
Besides GDP being an estimate of economic well-being, it's also an accounting identity. GDP = C + I + G + (X-M). Just add up consumption, gross investment, government spending, and net exports. There are many criticisms (most of them are marginalized) of GDP. I'll focus on just one: G, or the government spending component.
GDP is supposed to accurately depict the economic well-being of a society. Voluntary transactions, consumption, even the (quite subjective in my opinion) human development index can be a gauge of well-being. Government spending, however, is not. Here are a few examples:
1) A government spends $10M developing a new bomb. That money is now added into GDP. The economy is supposed to be better off by $10M.
Some people erroneously believe that war helps the economy (e.g., "World War II got us out of the Great Depression!"). Large amounts of spending on war simply manipulates GDP to no longer represent the economic well-being of a society. People producing large amounts of tanks, bombers, and guns don't make a society "richer" than when those same people produce butter, hair cuts, and buildings. Now, of course survival makes one better off than death and defense is a crucial part of this. However, GDP equates bombs with corn flakes. I'd prefer to not need the bomb and eat my corn flakes, but GDP states that I'm just as well off if I have no corn flakes and the bomb is made. Of course I prefer survival, but survival and corn flakes is even better than survival and no corn flakes. GDP doesn't make this distinction.
2) A farmer receives a $5M subsidy to plant nothing. The economy is supposed to be better off by $5M. The result is higher agriculture prices and a deadweight social loss that comes from the transfer of money through government There also might be secondary effects as savings drop as more income is spent on food. The economy is better off according to GDP.
3) A state spends $15B on the biggest public works project in the state's history. It's the biggest public works project in history because it went triple over budget and time. Let's call it a Dig that is Big. The fact that it went over budget is a plus for GDP, not a minus. Cases like this beg the question, "How much quality am I receiving per dollar spent?" Tyler Cowen makes the convincing case in The Great Stagnation that the marginal dollar of government spending is very important. The first 10% of GDP in government spending of GDP is generally spent on courts, police, and preventing starvation. The final 50-60th % of GDP in government spending is spent on subsidies, four year unemployment benefits, bike paths, and free stuff. When GDP is calculated, involuntary transactions are weighted equally with voluntary transactions. We then take these GDP numbers and compare them across countries with very different levels of government spending and assume that they are equivalent.
And, yet, I turn around and use the metric because... what else do I use? What else is available? I use the tools that I have even though my results are likely systematically biased. This is the principal reason why I love to dive, without the narrative of others, into the random minutiae in a process or among operational or "line" teams. I have the chance to see some of the ways it can all go wrong when we aggregate it up and take decisions. It forces cluelessness, and, hopefully, humility.
Tuesday, April 1, 2014
Show Me the Money - Corporate Cultures
As a friend was engrossed in reviewing the execution of a failed initiative, an executive walked over to his desk, mentioned a few things, then stated "It's the 25th and we need to find more money for the month. I'm heading to Accounting." ... Let that soak in. The first time you hear it, the alarm bells should start going off. The twentieth time, you think it's funny and laugh about it with some colleagues. The hundredth time? You might be responding, "How can I help?"
“Vice is a monster of so frightful mien, As to be hated needs but to be seen; Yet seen too oft, familiar with her face, we first endure, then pity, then embrace”
-Alexander Pope
Short-sighted corporate cultures don't focus on value creation. Managing by the quarter (or month) is like driving a car with the top two-thirds of your windshield blacked out in a snowstorm. Once you get to the point that executives have no fear of reprisal and say it out loud, you realize that everyone else on the freeway had their windshield blacked out as well. Some of your top-performers end up heading for the exit lane. Some potential top-performers never become such because they're stunted or take the exit as well. Others find a niche of the company where hopefully they can hide out until after the massive pileup. It's a culture where, like political dictatorships, the worst tend to make it to the top. Is the ensuing crash inevitable? Will it be public? Who will make it out? If you're asking the question, your answer will probably be, "I'm not going to wait around to find out."
“Vice is a monster of so frightful mien, As to be hated needs but to be seen; Yet seen too oft, familiar with her face, we first endure, then pity, then embrace”
-Alexander Pope
Short-sighted corporate cultures don't focus on value creation. Managing by the quarter (or month) is like driving a car with the top two-thirds of your windshield blacked out in a snowstorm. Once you get to the point that executives have no fear of reprisal and say it out loud, you realize that everyone else on the freeway had their windshield blacked out as well. Some of your top-performers end up heading for the exit lane. Some potential top-performers never become such because they're stunted or take the exit as well. Others find a niche of the company where hopefully they can hide out until after the massive pileup. It's a culture where, like political dictatorships, the worst tend to make it to the top. Is the ensuing crash inevitable? Will it be public? Who will make it out? If you're asking the question, your answer will probably be, "I'm not going to wait around to find out."
Friday, March 14, 2014
Labor Union Strategies for the 21st Century
Organized labor’s continued pursuit of a strategy created in the early-mid 20th century has decimated—and will eventually finish off—organized labor’s remaining influence in the 21st
century. Labor’s influence increased dramatically starting the 1920’s,
peaked in the 1950’s, and is now at its weakest level in more than a
century.
Source: http://unionstats.gsu.edu/
The private sector labor movement is dying. The 20th century model of labor unions destroys the employees in the 21st century. The 20th century model writes work rules that prevent the worker from performing multiple tasks. The 20th century model creates very high overtime costs or forbids working more than a set number of hours. The 20th century model couples high pensions with extracting as much immediate monetary compensation for the worker as possible, creating a burden that puts a company at a disadvantage compared to its non-union rivals. This model dooms the 21st century employee because it prevents employees from being flexible, autonomous, and skilled in a variety of tasks. Instead of negotiating for training that would enhance a worker’s productivity and marketability, unions negotiated for a compensation and work rules package that emphasizes the wrong set of benefits.
Devoid of revenue, unions turned to the growing government sector to maintain at least some level of support. At face value, this strategy would seem to make sense. A union shop can go bankrupt when faced with non-union competition, but a city/state/country has plenty of revenue streams and almost no competition. However, this strategic shift was a mistake. A unionized government sector combined with shrinking private sector influence places the unions on the opposing side of the general public.
2009 was the first time government sector employees exceeded the number of private sector employees.1 This is a psychological tipping point for the general population. For example, when the Department of Labor or the AFL-CIO tries to sell the labor movement to the general public, they use graphs such as this one:
Source: http://www.aflcio.org/Learn-About-Unions/What-Unions-Do
This graph appears to be a selling point. The hope is that the public might think, “If only I were in a union, then I would be making more money.”
However, once the tipping point between government and private sector employees has been reached, the labor movement is painted in a completely different light. The public begins to think, “Look at all the government employees taking money from my paycheck, working fewer hours, taking more vacation days, and making more than me.” Equating unions with public employees will continue to push public opinion against the labor movement.
Turning to the public sector allows the dinosaur labor model to survive, with no innovation necessary. However, the labor unions are now on the other side of the negotiating table from taxpayers. Every dollar is extracted from taxpayers’ pockets. Additionally, unions want trade barriers, which also harm the public. This creates a tight spot for the unions. An entirely different marketing strategy must be adopted. How do you not get everyone to hate you?
At this point the labor movement is left to appealing to emotion. In the last decade this message has distilled into two forms, a positive and negative message. The positive message focuses on a positive emotional tie to the public. For example, “[Insert public occupation with positive image] are priceless!” Regardless of performance or current rate of pay, vacation, hours, etc., more funds are needed. The other message is to marginalize or demonize opponents. For example, “[Insert political target or wealthy] hate [public occupation from first message].” Maintaining these two types of messages is costly and can still lose in the long run as the public realizes that a zero-sum game is essentially in effect.
What Other Option is Available?
First, a successful labor movement strategy must include the private sector in order to avoid the trap outlined above. Second, a successful strategy must prepare its members for employment in the 21st century. This means that its members must learn to be flexible, autonomous, and skilled in a variety of tasks. In the long run, the labor movement will die out in the private sector if this is not the case. Non-union corporations will drive out the union corporations with greater productivity and better talent. Third, the labor movement must identify areas where it can utilize its core competencies of leverage and employee goodwill.
It is not in the best interest of a company to provide skills and training to employees that are not directly applicable to their current position and that would make the employees more marketable to outside firms. However, a worker needs to continually expand her skill set to succeed in the 21st century. The labor movement would be in an ideal position to bridge this gap.
Instead of the anti-productivity slogan “People over profits!” the labor movement can adopt the pro-productivity slogan “Promoting people promotes profits!” This can be accomplished by the union voluntarily tying one of its hands behind its back. The union can reserve the right to represent, intercede on behalf of, and provide a channel of grievance from the employee, but the union can also include in its charter that it does not reserve the right to negotiate compensation or work rules. The union does not even need to refer to itself as union, but rather as a learning and training federation. The union can negotiate training funding and hours during the work day for training from the corporation, while at the same time requiring nominal union dues from members who wish attend the training. Employees will enjoy the break from work and appreciate the training and skills. The outcome for the corporation may be neutral or positive, as training and employee morale increase productivity. The labor movement can continue to live up to its mission as the supporter of “the working man/woman.” The public enjoys a positive economic benefit from a workforce that enjoys lifelong training and improvement. The transformation of the union into an educational enterprise will produce the positive message and impact that the public needs and wants.
“Promoting people promotes profits” is a radically different approach from the current strategy. However, the current trajectory of the labor movement will leave a handful of legacy industries and public servants demanding the general public to pay up and implement net negative economic policies. A positive transformation and strategic shift will create a lasting labor movement for the 21st century.
1http://www.bls.gov/news.release/archives/union2_01222010.pdf.
Source: http://unionstats.gsu.edu/
The private sector labor movement is dying. The 20th century model of labor unions destroys the employees in the 21st century. The 20th century model writes work rules that prevent the worker from performing multiple tasks. The 20th century model creates very high overtime costs or forbids working more than a set number of hours. The 20th century model couples high pensions with extracting as much immediate monetary compensation for the worker as possible, creating a burden that puts a company at a disadvantage compared to its non-union rivals. This model dooms the 21st century employee because it prevents employees from being flexible, autonomous, and skilled in a variety of tasks. Instead of negotiating for training that would enhance a worker’s productivity and marketability, unions negotiated for a compensation and work rules package that emphasizes the wrong set of benefits.
Devoid of revenue, unions turned to the growing government sector to maintain at least some level of support. At face value, this strategy would seem to make sense. A union shop can go bankrupt when faced with non-union competition, but a city/state/country has plenty of revenue streams and almost no competition. However, this strategic shift was a mistake. A unionized government sector combined with shrinking private sector influence places the unions on the opposing side of the general public.
2009 was the first time government sector employees exceeded the number of private sector employees.1 This is a psychological tipping point for the general population. For example, when the Department of Labor or the AFL-CIO tries to sell the labor movement to the general public, they use graphs such as this one:
Source: http://www.aflcio.org/Learn-About-Unions/What-Unions-Do
This graph appears to be a selling point. The hope is that the public might think, “If only I were in a union, then I would be making more money.”
However, once the tipping point between government and private sector employees has been reached, the labor movement is painted in a completely different light. The public begins to think, “Look at all the government employees taking money from my paycheck, working fewer hours, taking more vacation days, and making more than me.” Equating unions with public employees will continue to push public opinion against the labor movement.
Turning to the public sector allows the dinosaur labor model to survive, with no innovation necessary. However, the labor unions are now on the other side of the negotiating table from taxpayers. Every dollar is extracted from taxpayers’ pockets. Additionally, unions want trade barriers, which also harm the public. This creates a tight spot for the unions. An entirely different marketing strategy must be adopted. How do you not get everyone to hate you?
At this point the labor movement is left to appealing to emotion. In the last decade this message has distilled into two forms, a positive and negative message. The positive message focuses on a positive emotional tie to the public. For example, “[Insert public occupation with positive image] are priceless!” Regardless of performance or current rate of pay, vacation, hours, etc., more funds are needed. The other message is to marginalize or demonize opponents. For example, “[Insert political target or wealthy] hate [public occupation from first message].” Maintaining these two types of messages is costly and can still lose in the long run as the public realizes that a zero-sum game is essentially in effect.
What Other Option is Available?
First, a successful labor movement strategy must include the private sector in order to avoid the trap outlined above. Second, a successful strategy must prepare its members for employment in the 21st century. This means that its members must learn to be flexible, autonomous, and skilled in a variety of tasks. In the long run, the labor movement will die out in the private sector if this is not the case. Non-union corporations will drive out the union corporations with greater productivity and better talent. Third, the labor movement must identify areas where it can utilize its core competencies of leverage and employee goodwill.
It is not in the best interest of a company to provide skills and training to employees that are not directly applicable to their current position and that would make the employees more marketable to outside firms. However, a worker needs to continually expand her skill set to succeed in the 21st century. The labor movement would be in an ideal position to bridge this gap.
Instead of the anti-productivity slogan “People over profits!” the labor movement can adopt the pro-productivity slogan “Promoting people promotes profits!” This can be accomplished by the union voluntarily tying one of its hands behind its back. The union can reserve the right to represent, intercede on behalf of, and provide a channel of grievance from the employee, but the union can also include in its charter that it does not reserve the right to negotiate compensation or work rules. The union does not even need to refer to itself as union, but rather as a learning and training federation. The union can negotiate training funding and hours during the work day for training from the corporation, while at the same time requiring nominal union dues from members who wish attend the training. Employees will enjoy the break from work and appreciate the training and skills. The outcome for the corporation may be neutral or positive, as training and employee morale increase productivity. The labor movement can continue to live up to its mission as the supporter of “the working man/woman.” The public enjoys a positive economic benefit from a workforce that enjoys lifelong training and improvement. The transformation of the union into an educational enterprise will produce the positive message and impact that the public needs and wants.
“Promoting people promotes profits” is a radically different approach from the current strategy. However, the current trajectory of the labor movement will leave a handful of legacy industries and public servants demanding the general public to pay up and implement net negative economic policies. A positive transformation and strategic shift will create a lasting labor movement for the 21st century.
1http://www.bls.gov/news.release/archives/union2_01222010.pdf.
Tuesday, February 11, 2014
Lessons from Consultancy Project Evaluation
As a part of my work, I have had the opportunity to evaluate the
completed projects of a variety of external consultancies. The principal
purposes of this evaluation were to identify the value of, 1) realized
benefits, 2) untapped opportunities, and 3) overpromised benefits.
And there were a lot of overpromised benefits. Although I learned many things in the course of this project, I would like to discuss two points in relation to these overpromised benefits:
1) Consultant emphasizes immediate monetary benefits to sell the project, while the project actually results in strategic or long-term gains.
Some projects were hampered by a lack of concrete objectives or steps to attain the stated objective of monetary benefits. For example, one of the projects evaluated considerably overestimated projected benefits. I found the following quote by the consultant project manager describing the purpose of the project:
“Project Imperative: Design the organization structure and the cross-functional collaboration process that will be core to building a self-sustaining high-performance management team.”
Now, a sentence like the above could be fine if in the five minutes following that statement, the consultant describes what that exactly means and how it will apply in a concrete way to the organization. However, the quote was one sentence among many describing in elaborate consultant jargon what exactly the project would entail, while also describing how incredible the monetary benefits of the project would be in the near-term. From a theoretical perspective, the stated objective made perfect sense, but most clients would tune it out unless the consultant expanded upon the objective to create realistic goals and expectations. Unsurprisingly, the client and consultant had different concepts of “success” in the project. The client was disappointed by the lack of monetary benefits, while the consultant believed the client had achieved its long-term strategic goals.
I do not intend to be overly judgmental of a single line. However, that line was a symptom of the general problem – overpromising near-term visible profits when actually presenting a long-term strategy.
2) Quick wins were presented and promised without a reality check.
Frequently “quick wins” were included in the final presentation of a project. Providing quick wins is a simple method for a consultant to demonstrate value and provide a more concrete signal of the team’s abilities. Quick wins also offer the client improvement in its near-term profitability and the recovery of the consultant’s billing cost, thereby providing an added incentive for repeat business. However, quick win recommendations were frequently infeasible in the short-term, absurd, or of questionable strategic value.
- Short-term Infeasibility – Many quick wins required expensive and/or lengthy system implementations in order to achieve the value of the recommendation. By definition, quick wins must be quick. Many clients assume that implementation and benefits will occur in less than one year.
- Absurd – Some quick wins would not have passed the “smell test” for an employee at almost any level in the organization. Bundling seemingly unrelated products and offering ancillary services with which the client has no experience belong in this category. The consultancies did not appear to have received feedback concerning these quick wins from lower level employees or individuals within senior management before presenting to senior management. “Way outside the box” thinking has its place, but it generally should not fall in the category of a quick win.
- Questionable strategic value – The most common type of recommendation with questionable strategic value that fell into this category, which was true for a variety of consulting groups, was charging customers for services or products that were currently being offered for “free.” While there are many reasons to bundle or unbundle a product, the tradeoffs involved in this decision were ignored or discounted. It was common to assume that the number of transactions would not be negatively impacted, that no competitive reaction would occur, and that all incremental charges would be bottom-line profit.
Bottom line
Selling the client on wishful near-term results of a long-term strategic shift and including unrealizable quick wins demonstrate a lack of care on the part of the consultancy and consequently damage the results of the overall project and the client relationship.
And there were a lot of overpromised benefits. Although I learned many things in the course of this project, I would like to discuss two points in relation to these overpromised benefits:
1) Consultant emphasizes immediate monetary benefits to sell the project, while the project actually results in strategic or long-term gains.
Some projects were hampered by a lack of concrete objectives or steps to attain the stated objective of monetary benefits. For example, one of the projects evaluated considerably overestimated projected benefits. I found the following quote by the consultant project manager describing the purpose of the project:
“Project Imperative: Design the organization structure and the cross-functional collaboration process that will be core to building a self-sustaining high-performance management team.”
Now, a sentence like the above could be fine if in the five minutes following that statement, the consultant describes what that exactly means and how it will apply in a concrete way to the organization. However, the quote was one sentence among many describing in elaborate consultant jargon what exactly the project would entail, while also describing how incredible the monetary benefits of the project would be in the near-term. From a theoretical perspective, the stated objective made perfect sense, but most clients would tune it out unless the consultant expanded upon the objective to create realistic goals and expectations. Unsurprisingly, the client and consultant had different concepts of “success” in the project. The client was disappointed by the lack of monetary benefits, while the consultant believed the client had achieved its long-term strategic goals.
I do not intend to be overly judgmental of a single line. However, that line was a symptom of the general problem – overpromising near-term visible profits when actually presenting a long-term strategy.
2) Quick wins were presented and promised without a reality check.
Frequently “quick wins” were included in the final presentation of a project. Providing quick wins is a simple method for a consultant to demonstrate value and provide a more concrete signal of the team’s abilities. Quick wins also offer the client improvement in its near-term profitability and the recovery of the consultant’s billing cost, thereby providing an added incentive for repeat business. However, quick win recommendations were frequently infeasible in the short-term, absurd, or of questionable strategic value.
- Short-term Infeasibility – Many quick wins required expensive and/or lengthy system implementations in order to achieve the value of the recommendation. By definition, quick wins must be quick. Many clients assume that implementation and benefits will occur in less than one year.
- Absurd – Some quick wins would not have passed the “smell test” for an employee at almost any level in the organization. Bundling seemingly unrelated products and offering ancillary services with which the client has no experience belong in this category. The consultancies did not appear to have received feedback concerning these quick wins from lower level employees or individuals within senior management before presenting to senior management. “Way outside the box” thinking has its place, but it generally should not fall in the category of a quick win.
- Questionable strategic value – The most common type of recommendation with questionable strategic value that fell into this category, which was true for a variety of consulting groups, was charging customers for services or products that were currently being offered for “free.” While there are many reasons to bundle or unbundle a product, the tradeoffs involved in this decision were ignored or discounted. It was common to assume that the number of transactions would not be negatively impacted, that no competitive reaction would occur, and that all incremental charges would be bottom-line profit.
Bottom line
Selling the client on wishful near-term results of a long-term strategic shift and including unrealizable quick wins demonstrate a lack of care on the part of the consultancy and consequently damage the results of the overall project and the client relationship.
Sunday, January 12, 2014
Applying Value-at-Risk to Corporate Treasury Departments
Currency risk, and risk in general,
is usually measured by standard deviations (i.e., variability). Many believe
that the purpose for hedging is to reduce these standard deviations, and
therefore the risk is reduced. However, this assumes an incorrect understanding
of risk. Risk cannot simply be measured by standard deviation. For example, you
can play a game where you can either have a 100% chance of winning $5, or a
50/50 chance of either winning $10 or $100. The latter choice plainly has
a much greater degree of variance. However, one cannot say it is more risky.
Risk addresses the uncertainty of achieving an objective.
Returning to currency risk with a
better understanding of what exactly risk is, what then is the objective of the
corporation? For the sake of simplicity, assume the objectives are survivorship
of the company (due to violations of assumptions found in the
Modigliani-Miller1) and maximizing after-tax cash flow. Currency
risk can increase the probability of bankruptcy and can impede managers’
flexibility in having sufficient capital to make positive investments. Does
hedging reduce this risk? If there is a manager who has better-than-the-market
forecasting abilities, she is highly unlikely to be found in a non-financial
industry, considering the degree of remuneration for such knowledge.
Accordingly, a non-financial firm should assume the currency futures markets
are priced at the best available risk-neutral rate. Therefore, because of
premiums, currency hedging has a negative NPV. How does a treasury department
make a “negative NPV” non-risk-neutral decision in order to outweigh what can
seem like a very nebulous concept of risk?
This concept can be laid out in
matrix format:
If the company remains solvent
independent of the currency exposure, the premiums for the hedge are lost and
the firm is worse off. If the company hedges, and this hedge saves it from
insolvency or a significant impairment to operations, the firm is clearly
better off. If the company hedges, and the currency gain is significant enough
to save the firm, or if the cost of the premium is sufficient to impair the
firm in a given scenario, the firm is clearly worse off. A few lessons can be
drawn from this simple matrix:
For a given currency risk, if the probability of the “Insolvent caused by hedge” cell exceeds the probability of the “Solvent because of hedge” cell, any hedging both increases risk and is an NPV negative decision. For example, a multinational company provides a $100M intercompany loan from its United States operations to a subsidiary in Mexico. Before making the decision to hedge the “currency exposure,” at the cost of millions of dollars, how many treasury departments would first create a variance analysis that compares the potential currency exchange loss with overall company cash flows in a recessionary or depression environment? If the currency loss and company cash flows when the firm is under duress are negatively correlated, a hedge of the intercompany loan actually increases the risk of the company, and it does so at the cost of millions of dollars. Many treasury departments engage in wasteful hedging activities because of a fundamental misunderstanding of risk.
For a given currency risk, if the probability of the “Insolvent caused by hedge” cell exceeds the probability of the “Solvent because of hedge” cell, any hedging both increases risk and is an NPV negative decision. For example, a multinational company provides a $100M intercompany loan from its United States operations to a subsidiary in Mexico. Before making the decision to hedge the “currency exposure,” at the cost of millions of dollars, how many treasury departments would first create a variance analysis that compares the potential currency exchange loss with overall company cash flows in a recessionary or depression environment? If the currency loss and company cash flows when the firm is under duress are negatively correlated, a hedge of the intercompany loan actually increases the risk of the company, and it does so at the cost of millions of dollars. Many treasury departments engage in wasteful hedging activities because of a fundamental misunderstanding of risk.
Even if the probability of the
“Solvent because of hedge” cell exceeds the probability of the “Insolvent
caused by hedge” cell, it does not mean a full or even a partial hedge should
be used, considering the loss of the premiums and the fact that hedging is a
negative NPV non-risk neutral decision. Essentially a treasury department must
decide that given the violations to the assumptions to Modigliani-Miller, to
what extent should hedging be used? If the probability of the red cell is remote,
even if it exceeds that of the green cell, hedging might not make sense given
the premiums. If the probability of the “Insolvent caused by hedge” cell is
significant, hedging begins to make more sense. For example, the significant
probability of the “Insolvent caused by hedge” cell event explains why hedging
is prevalent in the finance industry. However, outside of the financial
industry, hedging makes less sense as the probability of the “Insolvent caused
by hedge” event falls.
Bottom line:
This type of methodology and risk
analysis, a form of Value-at-Risk, applies to non-financial firms and can
assist corporate treasury departments make optimal decisions for currency risk,
as well as apply this methodology to other treasury functions.
Operating an effective corporate
treasury department in a multinational company requires theoretical knowledge,
strong internal review and control, and solid execution. Blanket policies
concerning hedging can cost the company millions in unnecessary premiums and
increase the risk of financial impairment and insolvency.
1 http://faculty.haas.berkeley.edu/parlour/Teaching/corp_intro.pdf
A brief but sufficient outline of Modigliani-Miller assumptions.
Monday, January 6, 2014
Latin America Demographics - The Economist
I'm working on a few other items at the moment, but as I was flipping through an old Economist and found back to back articles on demographics in Latin America that related to my recent post on demographics.
Fast changing demographics in Latin America - "Autumn Patriarchs"
and,
Public policy move in an to attempt to spur Chile's birth rate
Fast changing demographics in Latin America - "Autumn Patriarchs"
and,
Public policy move in an to attempt to spur Chile's birth rate
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