The reins on risk.

• Position: Risk management - Includes related articles - Cover Story

Many financial executives are tight-lipped about their risk-management programs (if they even have them), especially since the derivatives bullet dropped several big-name companies to their knees. But, here, four risk-management pros divulge how they forge the risk-taking rules in their companies - and how they inspire their colleagues to abide by them.

THE RESPONSIBLE PARTY

by David A. Rusate Assistant Treasurer General Electric Fairfield, Connecticut

If you're the treasurer of a company that deals in derivatives, are you comfortable with your role in managing the exposure? In GE's treasury department, we take on the risk-management responsibility using six approaches. First, we help our business units understand both their direct and indirect currency exposures. Second, we provide technical and fundamental analyses to the business units. The fundamental analysis is our macro-economic view of a country and its currency and interest-rate environments; the technical analysis is our detailed look at the technical support and resistance levels for particular currencies, since hedge funds are so systems-driven.

We also recommend hedging strategies to our businesses, and then we execute the strategies. By centralizing the exposures, we leverage the purchasing power of GE, get better control and realize more efficiencies.

The GE treasury staff manages the company's positions. Every day, we mark to market our exposures - and we can do so even more frequently if a currency significantly moves during the day. We outsource our foreign-exchange confirmation process to a vendor that electronically confirms our trades on a real-time basis with our 10 foreign-exchange banks.

Finally, we identify internal offsets and netting opportunities. For example, if our NBC affiliate has a yen receivable and our appliances group has a yen payable, we'll consider an internal offset.

GE's risk-management policies are fairly typical. We're risk averse, and we don't speculate. We use the FASB's definition to avoid speculation: Are we hedging without a firm commitment? Are we overhedging, or doubling up, a position? Are we managing the position? We believe if we're managing a position with an instrument other than a hedge (for example, a stop/loss order), that's not speculation.

We use a portfolio approach, combining 50 percent forward contracts, 25 percent currency options and 25 percent stop/loss take-profit orders, although we do adjust the formula slightly if we have a strong view on a currency, a larger margin on a particular product or a different competitive situation.

The forward contract is an agreement with a bank - a derivative - that allows us to sell the bank our future yen flow, for example. The bank in turn pays us in dollars, because that's our functional currency, on a future date. No monies change hands on day one. The bank gives us an exchange rate for the future date, which is the interest-rate differential between the U.S. dollar and the Japanese yen for a specified time period. One caution here: The forward rate we get from the bank is not the bank's forecast. Some companies have this misconception.

More complex than forward contracts, currency options offer tremendous flexibility. For instance, if you hedge your yen receivable at 100 yen per dollar with a forward contract, you'll get $1 for every 100 yen you deliver to the bank in, say, six months. If you hedge your yen receivable with a put option at 100 yen per dollar and, at the option expiration date, the market-exchange rate is 92 yen per dollar, you'd let the option mature while you convert your yen to dollars at 92 yen. This would result in more dollars for you because it would require eight fewer yen to buy that $1. Note, however, that you do need to pay a premium upfront for the option, but you can amortize it over the life of the exposure or expense it in the month you incur the cost.

Some U.S. companies find it cheaper to borrow in a foreign currency and convert the proceeds to U.S. dollars. We've evaluated that approach but believe, in general, that the markets are so perfectly arbitraged that unless we can pinpoint particular market inefficiencies, we'll spend more time chasing those opportunities than managing our exposure. On the other hand, we have taken that tack in emerging markets, like Indonesia, if we see an arbitrage opportunity.

When we can identify a trending market, we like to use stop/loss take-profit orders and have done so successfully with the Japanese yen over the last two years. We forecast the yen would continue to strengthen and applied this to our portfolio approach to managing currencies by placing a stop/loss order. Here was our reasoning: If the yen spot rate was 125, which it was on January 1, 1993, and we received a customer's purchase order to create a yen receivable, we would place our stop/loss order at 127 yen per dollar. If the yen moved down, say to 100, our stop/loss order would never execute because it trailed the market. But if the yen weakened initially and rose to 128, we would have purchased, at 127, a forward contract or an option to hedge the yen receivable.

The beauty of the stop/loss order is many of our businesses have views on currencies and, because we're a decentralized company, we want to make them owners of the currency-management process. So we've helped the businesses develop strategies to justify the margin of the transaction - in this case, at 127 yen per dollar, by allowing two yen of flexibility, we could potentially gain 10 or more yen. As the yen moves down to, say, 115 and becomes stronger, we trail the stop/loss, adjusting it to 120. The stop/loss order costs nothing, and the banks follow it 24 hours a day, passing it through their branch networks. If there's a catastrophe while you sleep, you have a safety net protecting you.

And our final risk-management policy, typical of most firms, is to manage transaction exposures.

So what's the safe-and-sound approach? Conventional theory tells us to avoid all risk by transacting in U.S. dollars - bill in dollars and take payment in dollars. Period. The fallback is to bill customers in their local currency and hedge 100 percent of it with a forward contract. But isn't that speculation? You'll either hit a homerun or strike out. There's no middle ground. If you're wrong on a significant exposure, you could severely damage your business.

Say you were selling widgets in Japan in yen. Your competition in the United States was also selling widgets...