Ebook The Value of Real and Financial Risk Management
The objective, function and value of financial risk management remain debated issues. In 1993, the Group of 30 recommended that market and credit risk management should be functions conducted independently of the day-to-day operations of a firm. Twenty years earlier, Mehr and Forbes (1973) argued the exact opposite. Today, Holton (2004) claims that the risk management function within a firm is too close to operations.
The modern academic view of risk management or hedging activities is mainly financial in nature and does not involve operations. However, chief risk officers are increasingly working alongside chief operating officers to maximize firm value, thus making risk management a central function. We propose a model where risk management activities are put alongside operations with the explicit goal of maximizing firm value.
In perfect financial markets, hedging risk cannot increase firm value. Smith and Stulz (1985) discuss a hedging irrelevance proposition as an extension of the leverage irrelevance theorem of Modigliani and Miller (1958). In the absence of market inefficiencies, investors can undo any financial transaction undertaken by a firm so that firm value is independent of the risk management strategy (Titman, 2002). Put differently, a firm cannot create value by hedging risks since investors bear the same cost of risk as the firm. Therefore, taxes, financial distress costs and agency costs are the reasons most frequently invoked to justify hedging in a value-maximizing firm. A firm facing a convex tax schedule increases its value by reducing the variability of its taxable earnings through risk management. Hedging can lower the cost of financial distress since it reduces the probability of unfavorable left-tail outcomes. If hedging makes earnings less volatile, it lessens the information asymmetry and reduces agency costs (managers vs. shareholders, shareholders vs. bondholders, internal vs. external finance).
Our representation of operations and risk management within a firm supports the view that financial risk management can add value even in a world with no taxes, no financial distress costs, and no information asymmetry. We start by describing a firm as a nexus of projects with their associated cash flows. Projects are characterized by their respective level of expected cash flows and risk, which captures the correlation structure between the cash flows and risk factors faced by a firm. In this context, the object of production and operations management (POM) is to raise expected cash flows while the object of real risk management (RRM) is to lower risk. Based on this representation, we derive an efficient frontier in a space with expected cash flows and risk as coordinates, representing the set of efficient combinations or portfolios of feasible projects and activities selected by the real asset management (POM and RRM) functions of a firm.
Given the market prices of risk associated with risk factors, one can find the value of all feasible combinations of projects and arrive at the combination that maximizes firm value. Note that there is still no role for financial risk management in maximizing value. However, as the market prices of risk change, a firm must adjust its portfolio of projects to achieve a new optimal position on its transformation possibility frontier. Coordination between the different real functions in adapting to changes in the market prices of risk will typically be difficult and costly. Movement towards the new optimal combination may lead to disagreements between the POM and the RRM units when expected cash flows must be reduced or risk increased. This is where financial risk management contributes to firm value by bringing flexibility. Coordination is facilitated at little or no cost and provides a large saving with respect to real costs that will otherwise be incurred. Even in a world with no taxes, no bankruptcy or financial distress costs and no agency conflicts between the different classes of stakeholders, this value-adding role for financial risk management has definite empirical implications. We provide new testing grounds on the value of financial risk management for an organization.
Empirical evidence supporting the traditional reasons for corporate risk management remains rather weak. For example, the evidence presented by Graham and Smith (1999) is not very supportive of the tax savings argument. With respect to bankruptcy and financial distress costs, larger firms should need less risk management than smaller firms because their expected bankruptcy costs are relatively lower. However, larger firms seem to hedge more through the use of derivatives than smaller firms. Our coordination argument is compatible with this evidence. Larger corporations and corporations where more executives are involved in investment decisions will be heavier users of financial management instruments. Multinational firms and conglomerates, which have a more diverse project mix than single-industry single-country firms, should be greater users of derivatives.
Our setup establishes a definite link between hedging activities and changes in market parameters, namely the risk free rate, market volatility and the expected market returns. The use of financial instruments to hedge risk will be more pronounced when the efficient frontier is weakly concave since a small movement in the market parameters will then lead to an important adjustment in the optimal combination of projects. Therefore, a direct test will be to relate a measure of the concavity of the efficient frontier to the use of financial instruments across firms.
Another implication concerns firms subject to regulatory or self-imposed cash flow-at-risk (CaR) or value-at-risk (VaR) constraints. We show that a firm can, through appropriate financial risk management operations, meet these financial constraints without affecting its value maximizing activities and therefore its market value. In other words, CaR and VaR constraints can be met without changing the optimal mix of real activities. Hence, we can predict that, because of the VaR and CaR constraints they face, firms in sectors such as financial services, energy, gambling, utilities, and the like, will be among the heaviest users of derivatives and other financial risk management instruments.
The remainder of the paper is organized as follows. We present the model of the efficient frontier in Section 2. Section 3 discusses coordination problems between RRM and POM activities and stresses the important role that financial risk management plays in alleviating these coordination problems. In Section 4, we perform a comparative statics analysis relative to changes in parameters of the market price of risk. In Section 5, we spell out empirical implications of the model and discuss several issues related to the actual implementation of our approach to financial and real risk management in firms. We also extend the basic framework to an intertemporal setting. We conclude in Section 6.
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