Description
PPT about the article "Rethinking Risk Management". It initially highlights the facts from the Wharton Survey and then goes on describes the gist of the article.
Rethinking Risk Management
Facts from the Wharton survey
• Corporations do not systematically hedge • Extent of hedging depends on their views on future price movements • Hedging focused on near term transactions • Use of derivatives more for larger firms than smaller ones
Modern Finance
• Efficient markets and Diversification
– Information that is freely available is incorporated – Shareholders can eliminate a company’s risks of interest rate, currency and commodity by holding a diversified portfolio
• Three costs of high variability
– Bankruptcy costs – Higher expected payments to corporate stakeholders – Higher expected tax payments
Costs
• The expected present values of bankruptcy costs are incorporated in the current market values • Shareholders can demand added compensation for the extra risk of a greater probability of financial distress • Convexity of tax code requires the firm to operate within the optimal range of tax rates
Comparative advantage
• Selective hedging
– Firm’s information may not be better than the market’s – Important to understand the source of comparative advantage
• Bank’s example – FX trading profits come from market-making, not position taking • Risk taking audit – which activities have added values w/o adding volatility
Capital Structure
• Risk management viewed as substitute for equity capital • Increases debt capacity • Practice risk management only to the extent that equity capital is more expensive than debt • Increased leverage
– strengthens management incentives to improve efficiency – tax advantage
Management Incentives
• Greater management’s stake, greater hedging (Gold mining industry) • Emphasize options or option like features associated with significantly less hedging
– Management gains much more from increases in firm value than losses from reduction
• Vice versa, risk management policy may have the companies to have significant managerial stock ownership
Measuring risk, VaR and more
• Rather than reducing variance, aim seems to be to avoid ‘lower-tail outcomes’ • VaR
– Calculating the maximum loss that can occur at a specified confidence interval (ex. 95%) – VaR, more appropriate for daily data than yearly – Reliance on normal curve
• tail probabilities are generally larger than implied by the normal curve
– ‘Serially independent’
• Cash flow simulations
Risk taking
• Focusing on lower-tail outcomes consistent with managing longer term exposures, as opposed to near term transaction exposures • Managers should be compensated only for earning more than what shareholders could earn by bearing the same amount of risk
Conclusion
• Apparent conflict between the theory and current practice of corporate risk management • Risk management to pursue goals other than reducing variance • Selective hedging as opposed to full cover • Actual motive should be ‘Elimination of costly lower tail outcomes’
– Reduce expected costs of financial distress – Comparative advantage in risk bearing
Conclusion
• As a tool to alter capital structure as well as ownership structure
– Increase debt capacity – Larger equity stakes for management
Thankyou
doc_842503879.ppt
PPT about the article "Rethinking Risk Management". It initially highlights the facts from the Wharton Survey and then goes on describes the gist of the article.
Rethinking Risk Management
Facts from the Wharton survey
• Corporations do not systematically hedge • Extent of hedging depends on their views on future price movements • Hedging focused on near term transactions • Use of derivatives more for larger firms than smaller ones
Modern Finance
• Efficient markets and Diversification
– Information that is freely available is incorporated – Shareholders can eliminate a company’s risks of interest rate, currency and commodity by holding a diversified portfolio
• Three costs of high variability
– Bankruptcy costs – Higher expected payments to corporate stakeholders – Higher expected tax payments
Costs
• The expected present values of bankruptcy costs are incorporated in the current market values • Shareholders can demand added compensation for the extra risk of a greater probability of financial distress • Convexity of tax code requires the firm to operate within the optimal range of tax rates
Comparative advantage
• Selective hedging
– Firm’s information may not be better than the market’s – Important to understand the source of comparative advantage
• Bank’s example – FX trading profits come from market-making, not position taking • Risk taking audit – which activities have added values w/o adding volatility
Capital Structure
• Risk management viewed as substitute for equity capital • Increases debt capacity • Practice risk management only to the extent that equity capital is more expensive than debt • Increased leverage
– strengthens management incentives to improve efficiency – tax advantage
Management Incentives
• Greater management’s stake, greater hedging (Gold mining industry) • Emphasize options or option like features associated with significantly less hedging
– Management gains much more from increases in firm value than losses from reduction
• Vice versa, risk management policy may have the companies to have significant managerial stock ownership
Measuring risk, VaR and more
• Rather than reducing variance, aim seems to be to avoid ‘lower-tail outcomes’ • VaR
– Calculating the maximum loss that can occur at a specified confidence interval (ex. 95%) – VaR, more appropriate for daily data than yearly – Reliance on normal curve
• tail probabilities are generally larger than implied by the normal curve
– ‘Serially independent’
• Cash flow simulations
Risk taking
• Focusing on lower-tail outcomes consistent with managing longer term exposures, as opposed to near term transaction exposures • Managers should be compensated only for earning more than what shareholders could earn by bearing the same amount of risk
Conclusion
• Apparent conflict between the theory and current practice of corporate risk management • Risk management to pursue goals other than reducing variance • Selective hedging as opposed to full cover • Actual motive should be ‘Elimination of costly lower tail outcomes’
– Reduce expected costs of financial distress – Comparative advantage in risk bearing
Conclusion
• As a tool to alter capital structure as well as ownership structure
– Increase debt capacity – Larger equity stakes for management
Thankyou
doc_842503879.ppt