Can Risk Management Help Prevent Bankruptcy?

1
Can Risk Management Help Prevent Bankruptcy?

• Monica Marin
• Ph.D. Candidate, Finance

2
Motivation

• Warren Buffett
• "Derivatives are financial weapons of mass
  destruction, carrying dangers that, while now
  latent, are potentially lethal.
• (2002 Berkshire Hathaway Annual Report)

3
Question and Hypothesis

• QUESTION
• Are risk management instruments used for risk
  reduction or for speculation purposes?
• HYPOTHESIS
• The use of risk management instruments reduces
  the probability of default.

4
Related Literature

• Arguments for the use of risk management
  instruments to
• REDUCE RISK
• Smith and Stulz,1985
• Limited empirical evidence on the relationship
  between risk management and bankruptcy
• no relationship (Nance, Smith Jr.,
  Smithson(1993), Mian(1996))
• weak relationship (Fok, Carroll, and Chiou,
  1997)
• strong relationship (Judge, 2006)
• SPECULATE
• Faulkender, 2005 interest rate risk management
  is driven by speculation

5
Approach I Duration Model

• A discrete time duration model (complementary
  log-log regression)
• Takes account of
• the sequential nature of the data
• censoring
• time-varying covariates

6
Approach II Distance to Default

• Structural model (the Black-Scholes-Merton option
  pricing model)
• Advantages
• extracts information from market prices
• computes the probability of default / distance to
  default independently for any firm
• Disadvantages
• assumes
• market efficiency
• perfect liquidity
• lack of arbitrage conditions
• does not incorporate financial restructuring

7
Approach II Distance to Default (Contd.)

• Firm equity a call option on the assets of the
  firm
• strike price equals the value of zero coupon debt
  with maturity at time T
• If at time T, then exercise else let option
  expire and default
• The value of the call option is equal to

8
Approach II Distance to Default (Contd.)

• The value of the firm
• The market value of common equity
• Equity volatility Asset volatility

9
Approach II Distance to Default (Contd.)

• Distance to Default
• Expected Default Probability

10
Data

• 344 firms 172 pairs (bankrupt and non-bankrupt)
• Time period bankruptcies occurring between 1998
  and 2005, followed between 1994 and 2004
• Matching criteria asset size and industry in the
  fiscal year before bankruptcy

11
GMM Results (Duration Analysis)
12
GMM Results (Distance to Default)
13
GMM Results (Asset Volatility)
14
GMM Results Changes in DD
15
GMM Results Changes in AV
16
Conclusion

• Risk management is associated with
• lower probability of bankruptcy
• higher distance to default
• lower asset volatility
• The benefit of using risk management instruments
  is greater when
• interest rate hedging needs are high
• foreign currency hedging needs are high
• commodity price hedging needs are low