Not too long ago, top managers might have paid little attention to the experts on their finance staff who oversaw the risks created by unpredictable swings in currencies, interest rates, and commodities. Those days are long gone.

As HBS associate professor Peter Tufano has shown in recent academic papers and in a course he developed for MBA students and Executive Education participants at the School, volatile and fast-changing financial markets have created such enormous risks -- and rewards -- that senior executives must now pay close attention to how their companies manage risk.

	Firms voluntarily take on risk when they see that it will be of value to their customers, business partners, or employees

"The decision regarding what kinds of risk firms should shed, which ones they will voluntarily take on, and how they might choose to fashion their risk exposures is increasingly a senior-level decision," says Tufano. "Value is created in risk management not by betting on where markets are going but by using an understanding of risk to help an organization carry out -- or enhance -- its basic business strategy."

How can managers use the arcane science of risk management -- with its array of financial instruments such as "puts," "calls," and "swaps" -- to advance something as far reaching as corporate strategy? Tufano presented his initial answer in a 1996 Harvard Business Review article titled "How Financial Engineering Can Advance Corporate Business Strategy," in which he describes how five companies use creative risk management solutions -- financial engineering -- to solve basic business problems like creating new products or developing new methods for motivating employees.

Tufano shows, for example, how Enron Capital and Trade Resources (ECT), a natural gas marketer, used risk management techniques to solve two long-standing customer problems: unpredictable prices and fluctuating supply. To do so, ECT created a menu of gas supply contracts that allowed customers to lock in the quantity, price, and time of delivery they wanted. The company was thus able to differentiate itself from competitors.

But, unless it was careful, ECT would bear the risk of gas price increases and encounter the mismatch of assets and liabilities that had nearly done in the U.S. savings and loan industry several years earlier when interest rates soared. Financial engineering provided the solution. ECT bought gas in the futures markets, over-the-counter swaps, and long-term supply agreements to "hedge" the risk posed by its customer agreements.

"Firms voluntarily take on risk when they see that it will be of value to their customers, business partners, or employees," Tufano explains. "They can differentiate themselves by bearing risk for others. On the vanguard of corporate practice, some companies around the world assume other people's risks and use that approach as the basis for their business strategy."

In Tufano's more recent work, the gold mining industry has proved to be a hotbed of hedging activity -- and a perfect site for further research. "This is an industry where firms face real and significant risk in the form of changing gold prices, where capital markets have created financial products to manage that risk, and where companies have adopted very different hedging strategies," he says. "In addition, the level of financial disclosure is extraordinary since analysts follow these companies so closely."

Using this wealth of information, Tufano has published a number of papers on the causes and consequences of risk management. One of them, "Who Manages Risk: An Empirical Examination of Risk Management Practices in the Gold Mining Industry," has raised quite a few eyebrows in the academic world. In that paper, cowinner of the Journal of Finance's Smith Breeden Prize for best paper of 1996, Tufano presents evidence that some managers may be making risk management decisions to enhance the value of the stock and options they hold in their own companies. He found that managers who owned a large amount of stock were more likely to manage the firm's exposure to gold price risk, whereas option holders tended to prefer greater risk. Such managerial behavior is more in line with enhancing personal holdings than advancing shareholders' interests. "This is an important finding for senior executives and board members who oversee the risk management function," says Tufano. His other research in this industry studies how risk management affects stock prices and economic performance and how firms manage risk through their operating decisions.

Tufano digs deeper into the question of managerial incentives in "Agency Costs of Corporate Risk Management," an article appearing in the spring 1998 issue of Financial Management. Examining whether managers use risk management techniques to protect projects that will advance their careers but not necessarily the welfare of their company, Tufano discovered that risk management can be improperly used to shield managers from markets. "While risk management is generally a means to improve firm value, directors must appreciate that it can be misused to protect a manager's favorite project -- one from which the manager derives personal benefits but which might be judged more critically by shareholders," he says.

Tufano's research shows that risk management has taken its place alongside other major topics in modern finance, such as tax policy, capital structure, and dividend policy. Those executives who don't heed his work may literally do so at their own risk.

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