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January 18, 2012

Managing the Unmanageable

It's time to get a grip on financial risk in the global marketplace. Professor Robert Hodrick, coauthor of a new textbook on the subject, tells you how.


When Professors Robert Hodrick and Geert Bekaert first wrote their milestone textbook, International Financial Management, the world was a more predictable place. The global financial meltdown hadn’t yet happened. The eurozone was thriving. Credit default swaps were little-known, exotic instruments. That all changed, of course, so the authors, both Chazen Senior Scholars, updated the material for a just-released second edition. Here, Professor Hodrick offers his thoughts on the new, sobering realities of managing international finance.

One of the dominant themes of your book is that risk can be identified and managed. Is there one risk in the international marketplace that’s particularly dangerous right now?

It depends on where you are doing business. For developed countries and the mature emerging markets, currency risk is a big factor right now with the potential for large movements especially in the euro. As we saw in fall 2008, if Europe plunges us into another financial crisis, the exchange rate changes could be quite dramatic. In the less mature emerging markets, the biggest risk is always expropriation, which can occur in a variety of ways. For example, Venezuela, under President Chavez has systematically expropriated investments made by the major international oil companies. In 2011 Bolivia, under President Morales, announced that the government was taking over the mining industry.

Is risk always a bad thing?

Yes! Risks arise from the uncertainty associated with the possible changes in asset prices, commodity prices, and other factor prices that give rise to losses. So by definition these are bad shocks. But many risks are manageable, and if you manage risk better than your competitors, you can have a competitive advantage.

Okay, so how do you do that?

The first thing to do is to understand the sources of fluctuations in income. That defines your exposure. Then, you have to find the right derivative instrument to offset that exposure. The book discusses how to use forward contracts, options, and swaps to mitigate the fluctuations in income that arise from exchange rates and other asset prices. We have a chapter on how such activities can increase the value of a corporation.

Your book talks about anti-globalists, but the Occupy Wall Street movement developed after your book came out. What’s your feeling about anti-globalists, and about OWS in particular?

The globalization genie is out of the bottle. The forces that created it, which are primarily reduced communication and transportation costs, are only going to continue to make it easier to globalize.

Having said that, most countries, and the United States in particular, have done a poor job of sharing the gains from international trade. We need to retrain people that are thrown out of work by the forces globalizing our world economy. We also need to do a better job educating people when they are young so that they can function well in such a world.

Where does Occupy Wall Street fit in?

I see the Occupy Wall Street movement somewhat differently. With OWS, people are lashing out at the notion of “too big to fail.” Saving the banking system from collapse was certainly the right policy decision, but there is something terribly wrong with a system that lets people become incredibly wealthy by betting other peoples’ money, keeping the winnings if things turn out well, but sticking the tax payer with the losses if things turn out poorly.

We can’t ignore the euro crisis. You point out that there are two ways the euro could go: it could unravel or it could force member countries into great cooperation and integration. Which scenario do you think is more likely?

I’m currently quite pessimistic about the euro. I think it would be disastrous for a weak country like Greece to reintroduce the drachma, but the austerity that will be required for Greece to become competitive and balance its budget could take a decade. At some point, the political forces inside Greece may decide that inflation and currency devaluation are the best paths forward. I also think the strong countries like Germany may lose their political will to keep transferring wealth to the poorer countries to keep them in the euro. A banking crisis in Italy and Spain, for example, could lead to default on government bonds, which could make the ECB insolvent and precipitate a run on the euro. Germany would be forced to reintroduce the Deutsche Mark to prevent inflation.

Currently, the political forces are causing increased cooperation and integration, but the countries of Europe are not as homogeneous as the states of the United States, and such fiscal integration may not sit well with the voters.

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