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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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MANAGING TO A BENCHMARK

Benchmarks must be set once risks have been mapped, measured, and modeled. Managers analyze these risks and set risk mitigating benchmark targets to track deviations from benchmarks. From a policy perspective, this is where the real difficulties begin.

In practice, we find considerable variation and uncertainty with respect to benchmarks, a practice unlikely to continue to be tolerated in today’s post-SOX environment. Key questions, not being answered by the experts, remain:

  • Should we measure the risk drivers or the impact of these exposures?
  • What are the best measures?
  • What are the right benchmarks?
  • Where do others fall on these benchmarks?

Though the answers to these fundamental questions vary on a case-by-case basis, there are a few common themes to keep in mind. But first, we outline the most common metrics and benchmarks in use today.

  • Annual hedge ratio and size of commodity or currency hedge each year. Generally lacking any optimal benchmark or economic rationale, this measure describes the size of a financial or physical hedge transaction. This also ignores correlations and natural hedges.
  • Fixed–floating (%)mix dominates interest rate management discussions even though it does not capture the impact of duration, asset and other natural interest rate exposures, or currency issues. Anecdotal benchmarks prevail (e.g., 30 percent) but lack any economic rationale, are insensitive to changes in rate conditions, and are never updated to accommodate dynamic ...

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