Description
A brief documentation describes on the article "Rethinking Risk Management"
Rethinking Risk Management
Rethinking Risk Management
By Rene M. Stulz
Risk basically exists because of the existence of uncertainty about future outcomes. Companies invest in projects which have variable cash flows. Hence they do risk analysis to hedge against the variability of this cash flow which further enables them to reduce costs associated with financial distress. This article basically takes the view point that the general motive of use of derivatives is not theoretical as mentioned above but most companies pursue risk management to pursue goals rather than reduce variance. Risk of an investment is assessed based on the distribution of potential outcomes and their relative probability of occurrence. Thus the range of outcome compares the riskiness of two projects having same expected return. Also it was understood that though predicting individual outcome is not possible but one can often predict the distribution. This prediction will lead to quantification of risk premium and determine the capital structure of the firm. Companies vary their debt to equity ratio which determines their probability of insolvency. In addition to varying the proportions of the equity and debt in their capital structure, firms can also affect their probability of insolvency by mitigating the risk exposures they face. This article argues against the popular misconception that the objective of risk management is to eliminate risk. In fact it propounds that firms appear to pick and choose among the types and degrees of exposures, assuming those that they believe they have a competitive advantage in managing and laying others off into the capital markets, or accepting small or moderate exposures while insuring against catastrophic ones. Author also talks about certain other aspects of firm’s operations, such as the convexity of tax schedules, the ability of owner/managers to diversify their portfolios, and the proportion of the intangible assets, can also affect the extent to which managers attempt to mitigate risks (Tufano study). Article also argues that risk management like technology or distribution is a source of comparative advantage but the company must understand correctly the source of the comparative advantage. In addition to this company is required to implement the risk mitigation efforts properly neither it can lead to major losses (Case of German firm Metallgesellschaft). It is understood from the article that if a firm fails because of unexpected losses, the failure is due to one of the three causes. The firm may have accurately estimated the loss distribution (its exposure), but has insufficient capital to absorb the draw from the distribution, usually because the losses are
catastrophic and exceed the hurdle for insolvency. The second cause is that they have estimated the distribution of outcomes incorrectly. The third is caused due to the managers’ negligence in estimating exposures existence and predicting forward trends. The second and third causes are seen far more in real life than the first cause of failure. Model errors occur because of the difficulty in predicting the distribution of potential outcomes. One can assume it to be normal which makes prediction of loss easier. Unfortunately, many studies have concluded that most asset returns are not normally distributed but instead are fat tailed and skewed to the left. Here one can use non-parametric tests which do not depend on such assumptions like normal distribution, but that model would require more data than are available. Another source of error is that the outcomes are serially independent which does not hold true for non financial firms. On the contrary outcomes are positively serially correlated i.e. a poor outcome today will increase the probability of having a poor outcome tomorrow. Value at Risk (VaR) which can be used to measure risk as suggested in article suffers from both the problems (model error and assumption of serially independent outcomes). Thus the writer suggests an alternative to VaR: Using Cash Flow Simulations to estimate the default probabilities. Article also throws light on the fact that risk measurement error can also occur if the firm fails to recognize it has any exposure whatsoever which can be called as risk ignorance. Another factor which governs and plays a primary role in the success of risk mitigation efforts is the principal-agent problem. It is the risk that a manager or employee, inadvertently or purposefully, will fail to follow the policies or procedures designed to mitigate risk. In the end writer concludes that by hedging management may be able to reduce the cash flow variability but an appropriate benchmark like expected gain adjusted for risk should be used to calculate the value added to the shareholders. He also suggests devising a compensation scheme which encourages managers to take only those bets that are expected to increase the shareholder wealth. Thus risk management can help a company in eliminating downside risk, reducing costs of financial trouble, maintaining an optimal capital and ownership structure.
doc_470457976.doc
A brief documentation describes on the article "Rethinking Risk Management"
Rethinking Risk Management
Rethinking Risk Management
By Rene M. Stulz
Risk basically exists because of the existence of uncertainty about future outcomes. Companies invest in projects which have variable cash flows. Hence they do risk analysis to hedge against the variability of this cash flow which further enables them to reduce costs associated with financial distress. This article basically takes the view point that the general motive of use of derivatives is not theoretical as mentioned above but most companies pursue risk management to pursue goals rather than reduce variance. Risk of an investment is assessed based on the distribution of potential outcomes and their relative probability of occurrence. Thus the range of outcome compares the riskiness of two projects having same expected return. Also it was understood that though predicting individual outcome is not possible but one can often predict the distribution. This prediction will lead to quantification of risk premium and determine the capital structure of the firm. Companies vary their debt to equity ratio which determines their probability of insolvency. In addition to varying the proportions of the equity and debt in their capital structure, firms can also affect their probability of insolvency by mitigating the risk exposures they face. This article argues against the popular misconception that the objective of risk management is to eliminate risk. In fact it propounds that firms appear to pick and choose among the types and degrees of exposures, assuming those that they believe they have a competitive advantage in managing and laying others off into the capital markets, or accepting small or moderate exposures while insuring against catastrophic ones. Author also talks about certain other aspects of firm’s operations, such as the convexity of tax schedules, the ability of owner/managers to diversify their portfolios, and the proportion of the intangible assets, can also affect the extent to which managers attempt to mitigate risks (Tufano study). Article also argues that risk management like technology or distribution is a source of comparative advantage but the company must understand correctly the source of the comparative advantage. In addition to this company is required to implement the risk mitigation efforts properly neither it can lead to major losses (Case of German firm Metallgesellschaft). It is understood from the article that if a firm fails because of unexpected losses, the failure is due to one of the three causes. The firm may have accurately estimated the loss distribution (its exposure), but has insufficient capital to absorb the draw from the distribution, usually because the losses are
catastrophic and exceed the hurdle for insolvency. The second cause is that they have estimated the distribution of outcomes incorrectly. The third is caused due to the managers’ negligence in estimating exposures existence and predicting forward trends. The second and third causes are seen far more in real life than the first cause of failure. Model errors occur because of the difficulty in predicting the distribution of potential outcomes. One can assume it to be normal which makes prediction of loss easier. Unfortunately, many studies have concluded that most asset returns are not normally distributed but instead are fat tailed and skewed to the left. Here one can use non-parametric tests which do not depend on such assumptions like normal distribution, but that model would require more data than are available. Another source of error is that the outcomes are serially independent which does not hold true for non financial firms. On the contrary outcomes are positively serially correlated i.e. a poor outcome today will increase the probability of having a poor outcome tomorrow. Value at Risk (VaR) which can be used to measure risk as suggested in article suffers from both the problems (model error and assumption of serially independent outcomes). Thus the writer suggests an alternative to VaR: Using Cash Flow Simulations to estimate the default probabilities. Article also throws light on the fact that risk measurement error can also occur if the firm fails to recognize it has any exposure whatsoever which can be called as risk ignorance. Another factor which governs and plays a primary role in the success of risk mitigation efforts is the principal-agent problem. It is the risk that a manager or employee, inadvertently or purposefully, will fail to follow the policies or procedures designed to mitigate risk. In the end writer concludes that by hedging management may be able to reduce the cash flow variability but an appropriate benchmark like expected gain adjusted for risk should be used to calculate the value added to the shareholders. He also suggests devising a compensation scheme which encourages managers to take only those bets that are expected to increase the shareholder wealth. Thus risk management can help a company in eliminating downside risk, reducing costs of financial trouble, maintaining an optimal capital and ownership structure.
doc_470457976.doc