If nothing else, the past few years have shown us just how volatile prices, demand, and exchange rates, to name just several variables, can be. A few examples: The U.S. dollar has fluctuated by about 20 percent against the euro over the past year, while crude oil topped $140 per barrel in mid-2008, only to fall to about $60 in early 2009.

On top of that, the changing nature of many firms’ business models means that they’re taking on additional risk, says Amol Dhargalker, director of corporate advisory services with Chatham Financial. For instance, firms whose markets and suppliers used to be primarily based in North America now may be spread across several continents. The additional exposure to fluctuating exchange rates may not have been a significant cause for concern while sales were increasing at a heady pace. However, when many customers began slamming on the breaks a few years ago, the risks became harder to overlook, Dhargalker notes. Firms realized that “this is an area where we can make an impact and that we need to pay attention to.”

As a result, many CFOs and treasurers are starting to take a broader, more sophisticated approach when analyzing their risk exposures and developing programs to protect against them. To be sure, large multinationals have been doing this awhile. Now, even relatively smaller firms – say, those with market caps of $1 billion to $10 billion – want to apply best practices when it comes to hedging exposures, Dhargalker says.

Not surprisingly, this is easier said than done. Identifying exposures quickly gets complicated when a firm has sales and suppliers in several countries and operates in several currencies. Dhargalker uses this example: A U.S. firm has a Japanese subsidiary that purchases material from Thailand for which it is invoiced in Thai bahts. The subsidiary then sells its wares in Japanese yen. To complicate things even more, some of the company’s contracts allow it to change the prices it pays for supplies if the relevant currency moves past certain thresholds. It’s certainly possible to pinpoint the risks, but it requires time and effort and the ability to work across different areas of the organization. Multiply one scenario like this by several, and the workload and complexity increase exponentially.

This is where Monte Carlo simulations can provide value. Monte Carlo refers to “an analytical technique in which a large number of simulations are run using random quantities for uncertain variables, and looking at the distribution of results to infer which values are most likely,” according to InvestorWords.com. Monte Carlo analyses can be completed using spreadsheets; in addition, any number of software packages can help you develop Monte Carlo simulations.

The simulations allow you to evaluate any number of combinations – say, an exchange rate shifting unfavorably by 10 percent while your raw materials costs drop by 3 percent and interest rates move up 100 basis points. You can include scenarios that seem ridiculously far-fetched, such as the price of your raw materials doubling within 6 months. Although unlikely, such an event can be included in the analysis, “properly weighted based on current market expectations and volatility,” Dhargalker says.

Along with identifying exposures, it’s also necessary to decide how much your firm wants to protect against them. With what level of risk is senior management comfortable? For instance, they might decide the company needs a certain level of liquid assets available no matter what. So, say an analysis shows that a large move in the euro combined with a spike in commodity prices leads to a 10 percent chance of the company’s reserves dropping below the minimum desired. Is everyone OK with that? If not, what steps are needed to hedge against it happening?

The idea isn’t to quantify an exposure out to 17 decimal points, Dhargalker points out. Instead, the goal is to identify the significant business risks and determine the steps needed to effectively manage them. ###