24. Rethinking risk management

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Topics

• 24. Rethinking risk management
• R. M. Stulz

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Risk Management Practice

• Wharton-Chase survey
• 530 responded
• 1/3 used futures, forwards, options, or swaps
• Large companies used more
• 65 for firm market value gt 250 million
• 13 for firm market value lt 50 million
• Puzzle
• Large firms has lower probability of default

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Risk Management Practice

• Wharton-Chase survey
• Usage
• Only usage over ½ firms Hedge contractual
  commitments or transaction anticipated within 12
  months.
• 2/3 never used derivatives to reduce funding
  costs, to hedge B/S or economic exposures
• Over 1/3 take positions that reflect their market
  view of interest rates and FX
• Metallgesellschaft
• Daimler-Benz

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Risk Management Theory - Reasons not to use
derivatives

• Efficient market
• Do executives have predicting ability?
• Do they have comparative advantage?
• FX dealers profits come from market-making, not
  position making (Article 4)
• Understanding the source of comparative
  advantages helps to allocate resources and design
  incentives.
• High return high risk

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Risk Management Theory - Reasons not to use
derivatives

• Efficient market
• Should firms hedge financial exposures through
  normal business operations?
• Can hedge reduce the cost of capital?
• Are risks of interest rate, currency, and
  commodity diversifiable or non-systematic?

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Risk Management Theory - Reasons to use
derivatives Reduce bankruptcy costs

• Bankruptcy costs (cost of financial distress)
• Direct cost
• Indirect cost
• Lower revenue, higher cost
• Agency cost
• Asset substitution
• Underinvestment

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Risk Management Reduce bankruptcy costs

• Implications
• Risk management link with risk-taking and capital
  structure
• Low debt ratio firms dont need hedge
• Risk management is a substitute for equity
• Risk management is useful when the cost of equity
  is higher than the cost of debt

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Risk Management Reduce bankruptcy costs

• AAA firm
• Least likely to default, can afford to bet
• BBB firm
• It is likely to default, should hedge
• SL firm
• Almost surely to default, should bet

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Risk Management Theory - Reasons to use
derivatives Reduce required returns to
undiversified stakeholders

• Reduce required returns to undiversified
  stakeholders
• Owners of closely held firms
• Holders of firm-specific investments
• Employees
• Customers
• Suppliers

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Risk Management Reduce required returns to
undiversified stakeholders

• Link with management incentives
• Evidence
• 48 gold mining companies
• High ownership, more hedging
• Serves to remove noise (gold price movement)
• More options features, less hedging

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Risk Management Theory - Reasons to use
derivatives Reduce expected tax

• Example

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Risk Management Theory - Reasons to use
derivatives Reduce expected tax

• Reduce tax

Income after tax
Income before tax
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Risk Management Measuring risk

• Variance
• We only care about lower-tail outcomes
• VAR
• Maximum extent of the loss within 95 level on a
  given period
• Default probabilities
• Using cash flow simulations to estimate

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Risk Management Measuring risk