In graduate school, I conducted research on managing risk in the forest industry. My working assumption was and remains that vigorous management of organizations requires the deliberate identification, assessment, and management of risks. In forestry, these include, for example, those in operations (e.g., equipment breakdowns), distributions (e.g., transportation delays), and human resources (e.g., hiring and retaining personnel). 

My research, however, focused on financial risks, which comprise those risks that a firm is not typically in the business of bearing. For a forestry firm or timberland investor, these may include the impacts of exchange rates, energy prices, and interest rates. Within this area, I studied the potential for timberland investors and forest owners to use financial contracts, operational hedges, and “options.” 

Options Have Value

Options? Yes, some view forest management as a series of real options. For capital budgeting and strategic planning, real option theory addresses limitations with net present value (NPV), which does not account for flexibility, volatility, and contingency with potential investments, whether in forestry or any other industry.

Flexibility. Volatility. Contingency. In the context of forestry, flexibility refers to the manager’s ability to defer, abandon, expand or reduce a silviculture investment or harvest schedule due to new information or investment opportunities. Volatility references changing market conditions – particularly changing timber prices – or new technologies that affect our view of potential investments. Contingency refers to situations where future investments depend on investments made today. Presumably, these options provide value and should be accounted for, or at least considered. 

Options, Flexibility, and the Risk of Missing Out

In practice, not all investors have the same levels of flexibility, exposure to volatility, or concerns about contingency. In many cases, traditional analytic approaches like NPV, which views decisions as fixed, is sufficient for making decisions. This makes real options analysis a whiteboard discussion for comparing and discussing a dynamic view of future choices for strategic planning, and less about risk mitigation.

For a firm focused on downside risk, risk management and hedging programs transform undesirable risks into acceptable and manageable forms by increasing certainty and decreasing volatility. The management of risk helps firms achieve their optimal risk profile by balancing the costs of hedging with the protection offered. 

While some view risk management defensively, others may incorporate risk management into a process of appraising investment opportunities, as risk features both potential upsides and downsides. The view of managing risk to protect the firm from catastrophes or losses ignores the risk of missing out on profitable or strategic opportunities with upside potential.  

In short, the risk of missing or underinvesting in promising projects represents a risk unto itself. Risk management can play a role in protecting and increasing the bundle of cash flows that make up the corporation, and the associated opportunities for future investments that require these cash flows. Rather than husbanding resources exclusively for precautionary safety nets or insurance-like reserves, risk management can include the allocation of capital among competing investment alternatives.

Conclusion

At a certain level, executives and investors manage risk instinctively. In forestry, this occurs through the normal calculus of assessing the risks and rewards associated with silvicultural treatments and timber sales. Executive professionals identify, assess, and manage the risk and uncertainty encountered by their operational activities in business environments subject to financial risks emanating from outside of their sectors, and in doing so preserve the ability, the option, to make opportunistic investments.