Robert C. Merton

Ask a senior corporate executive of a typical manufacturing or service company about the firm’s derivatives activities, and you’ll probably be referred to the treasurer. While companies in the financial sector and those producing or trading commodities have long been familiar with derivatives as strategic tools, top executives in most other industries persistently regard the application of derivatives as essentially tactical, unrelated to the core management challenge of creating and sustaining competitive advantage. That’s why they cheerfully delegate the management of the company’s derivatives portfolio to in-house financial experts.

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Reprint: R0511E
Senior executives typically delegate the responsibility for managing a firm&#8217;s derivatives portfolio to in-house financial experts and the company&#8217;s financial advisers. That&#8217;s a strategic blunder, argues this Nobel laureate, because the inventiveness of modern financial markets makes it possible for companies to double or even triple their capacity to invest in their strategic assets and competencies.
Risks fall into two categories: either a company adds value by assuming them on behalf of its shareholders or it does not. By hedging or insuring against non-value-adding risks with derivative securities and contracts, thereby removing them from what the author calls the risk balance sheet, managers can release equity capital for assuming more value-adding risk.
This is not just a theoretical possibility. One innovation&#8212;the interest rate swap, introduced about 20 years ago&#8212;has already enabled the banking industry to dramatically increase its capacity for adding value to each dollar of invested equity capital. With the range of derivative instruments growing, there is no reason why other companies could not similarly remove strategic risks, potentially creating billions of dollars in shareholder value. The possibilities are especially important for private companies that have no access to public equity markets and therefore cannot easily increase their equity capital by issuing more shares.
The author describes how derivative contracts of various kinds are already being employed strategically to mitigate or eliminate various risks. He also shows how companies can use the risk balance sheet to identify risks they should not bear directly and to determine how much equity capacity they can release for assuming more value-adding risk.

You Have More Capital Than You Think

Reprint: R0511E Senior executives typically delegate the responsibility for managing a firm’s derivatives portfolio to in-house financial experts and the company’s financial advisers. That’s a strategic blunder, argues this Nobel laureate, because the inventiveness of modern financial markets makes it possible for companies to double or even triple their capacity to invest in their strategic assets and competencies. Risks fall into two categories: either a company adds value by assuming them on behalf of its shareholders or it does not. By hedging or insuring against non-value-adding risks with derivative securities and contracts, thereby removing them from what the author calls the risk balance sheet, managers can release equity capital for assuming more value-adding risk. This is not just a theoretical possibility. One innovation—the interest rate swap, introduced about 20 years ago—has already enabled the banking industry to dramatically increase its capacity for adding value to each dollar of invested equity capital. With the range of derivative instruments growing, there is no reason why other companies could not similarly remove strategic risks, potentially creating billions of dollars in shareholder value. The possibilities are especially important for private companies that have no access to public equity markets and therefore cannot easily increase their equity capital by issuing more shares. The author describes how derivative contracts of various kinds are already being employed strategically to mitigate or eliminate various risks. He also shows how companies can use the risk balance sheet to identify risks they should not bear directly and to determine how much equity capacity they can release for assuming more value-adding risk.

You Have More Capital Than You Think

Summary.

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