The Rise of Risk Management

by
David Cummins, R Phillips, and Stephen Smith
(1998)
 Corporate Finance

Corporate Finance
Decision

Risk
Investment Financing Management
Identification
Assessment
Tools
 Types of Risks
Systematic vs unsystematic risks
Business vs financial risks
Total risks
Credit, market, operational risks (financial
institutions)
Price, pure, credit risks (non financial
institutions)
 What Constitutes
Risk-Management Activities?
Risk management is activities to alter the
risk/return profile of future cash flows
arising from the primary lines of business.
The purposes of RM are:
Reduce risks - hedging
Increase risks - speculating
Accept risks- do nothing
 When Firms Should Engage in
Risk Management
Commodity Price Risk

Large Corporation
Traditional Farmer (Extraction and Sale of
versus
Copper)

manager

shareholders
 What Constitutes
Risk Management Activities?
The use of derivative securities
Diversifying the product line
Manage its expenditures by changing its operating
leverage
Reduce its leverage
ROE=ROIC + (ROIC-i) D/E
The use of accounting practices – income
smoothing
 Recent Advances in
Theory of Risk Management
Managerial Motives for Risk Management
Generating positive cash flows during the bad
times at the cost of reducing cash flows in the
good times.
Job protection
 Recent Advances in
Theory of Risk Management
Rationales for Risk Management that
Enhances Value
Traditional finance theory: systematic risk only
that concerns shareholders – No need risk
management.
Some of the non informational frictions that
might lead to a demand for risk management.
 Managerial Risk Aversion
Hypothesis of Risk Management

Compensation through vs Compensation through

Acquiring shares Granting of stock options
Value Maximization Rationales
of Risk Management
Mitigation of financial distress costs (mixed
evidence).
Use of risk management to lower expected tax
burdens (convincing evidence).
Avoiding costly external financing (strong
evidence).
The Use of Risk Management
is
to enhance value in underlying securities
markets?
Or
to provide benefits to parties other than the
shareholders of the firm?
requires
further research