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Quantifying risks for internationally trading firms

Contact Stockholm School of Economics for this project

Richard Friberg
Associate Professor
Department of Economics
Stockholm School of Economics
PO Box 6501
SE-113 83 Stockholm

Stockholm School of Economics

Exchange rates and prices of commodities are examples of variables that can be highly volatile and of crucial importance to the profits and production of manufacturers. To avoid the negative consequences of disfavourable exchange rates or input prices, and allow time for adjustment, various financial and operational hedging strategies are available. However, the methods that the literature in finance and economics has on offer to quantify the underlying risks each have important limitations.

The main methods today are ¿back-of-the-envelope¿ calculations using spreadsheets and analysis of historical cash flow data. The aim of this project is to develop and apply a new set of tools to quantify risks for firms that trade internationally or face foreign competition. We build on a class of simulation models that have recently been developed within the field of Industrial Organization. With such tools we are able to use Monte Carlo simulations and get distributions of profits and risk profiles for different firms. We will also be able to evaluate the impact of various strategies for dealing with volatility ¿ flexible sourcing of inputs, extensive use of financial instruments or production in several currency areas for instance. We will apply and evaluate the simulation models using actual data from a number of markets. Work is ongoing to apply these tools to the automobile industry.

Relevance to future of European societies
While firms and investors are the parties with the most direct potential benefits it is clear that the repercussions of risk management may also be felt at a national level or European level. Airbus is one of the European producers that has felt an important effect of exchange rate movements on profits for instance and appears to have been caught offhand. The tools that we apply and develop in this project are increasingly applied in studies of productivity and in the welfare analysis of mergers and other policy changes. At present competence in these areas lags the United States Universities by far and developing competence in these areas are important if Europe wants to be at the research frontier in empirical studies of markets and simulation work on such markets.
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