SVKM S NMIMS UNIVERSITY

School of Business Management

STRATEGIC FINANCIAL MANAGEMENT

Rethinking Risk Management

Synopsis:

Submitted By:
Sumit Bhatia (08) Varun Doshi (19) Maheshwar Nataraj (41) Mandar Nimgaonkar (42) Janmin Shah (53)

8/17/2010

Risk Management in Practice The author puts forward several surveys and examples that show the differences in practical hedging strategies against the classical theories. The author argues that the goal of risk management is to eliminate the probability of financial distress. Thus. or hedge only some of its risks or not hedge at all in order to increase firm value. Thus. If risk management was followed according to the academic theories to minimize risks.to show how firms have lost large amounts of money as a result of risk management programs.INTRODUCTION The article ¶Rethinking Risk Management¶ by Rene Stulz presents a modified theory of risk management. many companies use derivatives as a tool to exploit the comparative advantage in risk bearing by µselective hedging¶. a firm should devote resources to reduce risks only if the cash flow variability imposes the following µreal¶ costs on the firm: (i) (ii) (iii) Higher expected bankruptcy Higher expected payments to stakeholders Higher expected tax payments . Culp and Miller show that most value maximizing firms never hedge. The author provides examples of two real cases. in his survey of Fortune 500 companies shows that large firms hedge more than small firms even though cash flows of smaller firms are more volatile. in practice. While academic theory proposes that derivatives should be used to reduce variance in cash flow.Metallgesellschaft and DaimlerBenz . these firms didn¶t follow the theoretical approach but instead tried to manage risks by predicting future price movements Modern Finance Theory and Risk Management If the modern finance theory holds. Based on their survey of 530 companies in the Wharton-Chase study. However. he suggests that companies should either hedge their risks fully. Provided that the downsie risk is minimized. the concept of market efficiency should discourage corporations from creating corporate exposures through speculation while the concept of diversification should discourage companies from hedging since well diversified portfolios eliminate exposure risks. corporations do not systematically hedge their exposure but they hedge depending upon their views of future price movements in the near term. These surveys showed that 90% companies that used derivatives took a stand depending on their expectations of rate movements in the future. It looks at the differences between the theoretical and practical approaches to corporate risk management. then this shouldn¶t have happened. Walter Donde.

. Risk Management to reduce payments to stakeholders Stakeholders of companies with more uncertain prospects require higher payments. By eliminating the possibility of bankruptcy. So it is pertinent for the firm to understand its source of comparative advantage. The Link between Risk Management. Hedging should e used to minimize versatilities that lead to such uncertainties in order to increase firm value. Using risk management effectively increases a firm¶s debt capacity. Firm with high debt rating: There is no need to hedge financial exposure.1. Risk-taking & Capital Structure The more a firm hedges its financial exposures. 1. The author discusses whether a company should take advantage of such comparative advantages by taking up speculative positions. 3. managing fluctuations in taxable income by managing risks can lead to lower payment of taxes. The author suggests with the help of three scenarios that firms with different capital structures should use risk management differently. Higher debt ratio gives tax advantage and increases operational efficiency and thus increases share holder value. 2. risk management increases the value of the firm. Hence. Thus. they might be better off increasing their debt ratio and then use risk management. But the major risk associated with selective hedging is that the firm¶s information may not be better than the market¶s. Risk Management to reduce taxes Higher tax rate is imposed on higher income but tax rebates are lower for large losses. Firm with lower debt rating: Such a firm should hedge its exposure and must not take a view to exploit occasional opportunities to profit from market inefficiency as it may result into financial distress. 3. the less equity it requires. However. Risk Management to reduce bankruptcy costs Hedging should be used to reduce variability in cash flow to a degree where bankruptcy is not possible. 2. many companies in the course of their normal operations acquire non-public information that can give them a comparative advantage over other players. However. Firm already experiencing financial distress: Management of such firms would seek new bets in order to introduce new sources of volatility in the hope of somehow getting out of the financial distress. the risk management decision and the capital structure of the company are interdependent.

higher will be the percentage of exposure that is hedged. higher incentives should be given to those managers who bring in a profit by taking a risk considering the compensation for the risk and not just the normal returns rate. as more the volatility. It is easy to calculate VaR when being used on a daily or monthly basis but not for longer periods. while deciding compensation plans for managers. the measurement of risk is variance. there should not be a common risk management strategy for all firms. it is inconsistent with corporate practice. more would be the chances that their options would pay off. Similarly. However. The author also believes that management incentives play a significant role in the risk taking behavior by firms. Another measure is known as Value at Risk (VaR). VaR at 5% level of significance gives the maximum amount of losses in 95 cases out of 100. Otherwise. risk management should be used for hedging only. as a significant chunk of their own wealth is tied to the value of the firm.Thus. Management possessing stock options which are at the money or out of money would be willing to take more bets. The author suggests using simulation techniques like Monte Carlo as an alternative to VaR wherein cash flows are estimated such that all the risks have been met by the estimated cash flows Conclusion A firm should take only those risks that generate more than the normal returns and a suitable compensation but does not increase the probability of distress. The right corporate risk management strategy depends on the capital structure of the company. Greater the managerial equity ownership. . How to measure risk Theoretically.

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