Ebook The Value of Risk Management: A Frontier Analysis
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 independent of the day-to-day operations of the firm. Twenty years earlier, however, Mehr and Forbes (1973) argued the exact opposite. Today Holton (2004) argues that the risk management function within the firm is too close to operations, thus failing miserably the Group of 30’s recommendations.
The modern view of risk management or hedging activities, and the standard representation of risk management as a value-adding activity, is mainly financial in nature. Under the general supervision and responsibility of chief executive officers (CEO), chief risk officers (CRO) are now working alongside chief operating officers (COO) to maximize firm value, thus making risk management a central function of firms. Yet, in perfect financial markets, hedging risk cannot increase firm value by an irrelevance proposition discussed in Smith and Stulz (1985), which is a natural extension of the leverage irrelevance theorem of Modigliani and Miller (1958).
The current state of research generally agrees that financial risk management can only add value if it lowers the firm’s expected taxes, costs of financial distress or bankruptcy, and/or agency costs. In the case of taxes, risk management activities allow a corporation to shift earnings from a state where marginal taxable earnings are high to a state where marginal taxable earnings are low. Thus a firm facing a convex tax schedule increases its value by reducing the variability of its taxable earnings. As for the costs of financial distress or bankruptcy, risk management allows a reduction in the return that investors require so that the cost of external financing is reduced, the availability of debt is increased, and the firm may benefit even more from the tax shield associated with debt financing. As a result, the cash flows’ discount rate is reduced so that the firm’s value increases. Risk management can also facilitate optimal investment and add value to the firm if the cost of external financing is higher than the cost of funding projects internally.
Although the theoretical justification for corporate risk management is strong, the empirical evidence is rather weak. The reason for such a week support may be that empirical researchers have dismissed the coordination value that financial risk management provides. We show in this paper that financial risk management contributes to firm value by facilitating cooperation and coordination between the different management functions in the firm.
We separate the “real” component of risk management from its “financial” component. Real risk management refers to the management of risk through the selection of activities related to production and capacity investment; these “real activities” are an integral part of all business operations decisions. Financial risk management refers to risk mitigation actions taken on or through the financial markets. As we will show, financial risk management plays a role of facilitator for value maximizing operations decisions. The management of financial risks brings flexibility to the value generating process, and it is through this flexibility that financial risk management contributes, albeit in an indirect but important way, to the value of the firm.
Our representation of the different firm functions within allows us to find value in financial risk management even in a Modigliani-Miller framework with no taxes, no information asymmetry between the different stakeholders (creditors versus stockholders, stockholders versus managers) and no financial distress costs. Our representation of risk management, in both its financial version and its real or operational version, and of traditional production and operations management allows a better-integrated vision of the respective roles of those functions within the firm. We focus on the fundamental interactions between the traditional operations management function of the firm and the real and financial risk management functions to maximize the value of the firm.
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