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Financial Risk Management as a Source of Competitive Advantage

 

The traditional view of financial risk management, especially in non-financial businesses, is that it is a necessary but non-core activity, playing a supporting role to the ‘stars’ of corporate strategy such as manufacturing, logistics and marketing.   However, as price volatility and uncertainty increase in markets such as foreign exchange (FX) and commodities, a strong financial risk management capability can increasingly become a source of competitive advantage in its own right.

 

In order to be considered a true source of competitive advantage, a financial risk management strategy must enable a company to outperform its competitors and create economic value.  This is a clearly a high bar to clear – if it were easy, every treasurer would do it, and it would cease to become a potential source of competitive advantage at all.  There are, however, a number of specific characteristics that can facilitate in the conversion of a financial risk management programme from a back-office ‘cost-centre’ into a source of sustainable commercial benefit.  Specifically, financial risk management activities should be:

 

1) empirically designed and consistently applied;

2) integrated with core underlying business functions; and

3) adaptive to changes in both the financial markets and the internal commercial environment.

 

A competitive advantage must be able to improve business performance in some way, and do so consistently over time.  In order to ensure that financial risk management activities (such as FX and commodity hedging, for example) are actually able to improve business performance, it is therefore necessary to rigorously assess the impact of the underlying risk exposure on a specific commercial metric (e.g. cost of sales, revenue etc.).  The impact of managing the risk in different ways (e.g. hedging, netting, exploiting diversification benefits etc.) can be carefully and empirically studied (often using statistical methods such as Monte Carlo analysis) to allow the selection of the most effective and efficient risk management approach.  The chosen strategy must then be applied consistently to ensure the benefits are fully realized.

 

Integrating financial risk management strategy with the underlying business processes which generate the risk exposures is essential if risk management is to provide a competitive advantage.  A segregated hedging programme, for example, which takes risk from the business and manages it on an ‘arms length’ basis, will rarely provide any commercial benefits.  The single most effective way for financial risk management to generate competitive advantage is by enabling the business to take on business risks that it might not otherwise be able to bear.  A strong risk management competency could allow a company to successfully enter into new markets for example (without potentially sacrificing profit margins to currency risk), or to source components for products whilst insulating itself from the potential problems associated with volatile commodity prices.      

 

In addition to improving business performance, a true competitive advantage must also be sustainable; if a company’s risk management capability is only effective under certain conditions, it cannot be relied upon to consistently provide an advantage over the competition.   As such, it is essential that the financial risk management function is adaptable to changes in both the internal commercial environment (e.g. changes in the supply chain, or sales cycle) and in the external market environment (i.e. changes in market conditions and / or practices). To ensure that financial risk management strategy remains dynamic and reflects the true risk exposures facing the company, it is helpful to use key risk indicators (KRIs) and key performance indicators (KPIs), which can be continuously monitored to ensure that the sources and magnitudes of financial risk can be constantly assessed, and that the strategies employed to mitigate risk can be calibrated to reflect changing market dynamics.

 

According to Professor Michael Porter of Harvard Business School, there are two principal ways in which a competitive advantage can be achieved: cost advantage (having a lower cost base than the competition) and differentiation (creating additional value for customers).  Financial risk management can be used to achieve either objective.  It can create a cost advantage by enabling a company to source the factors of production more efficiently by managing the associated price risk caused by market volatility.  It can also enable differentiation, by providing the ability to deliver an enhanced customer experience through a more stable pricing environment, or an ability to offer more advantageous business terms (e.g. pricing in domestic currency).  By using financial risk management capabilities to enhance commercial operations, corporate treasurers can play an important strategic role in improving business performance, in addition to their more traditional role as stewards of corporate capital.  

Comments

Trilogy Ltd
Title: Accountancy Services
Company: Trilogy Ltd
(Accountancy Services, Trilogy Ltd) |

Very informative, Alexander
I wasn't much aware of this risk management. But after going through the article. I am also taking some measures for my company too.
Nice Job !!!