Lecture 10 - Risk Management

Question 1

What is Risk Management. What is the theoretical and practical implications of risk management.

Answer 1

To reduce uncertainty

Theoretically: Uncertainty does not matter. In perfect capital markets, cost of insurance does not affect NPV in the long run.

Practically: Uncertainty matters. Some costs (e.g. countries) must be avoided

Question 2

How do companies manage risk

Answer 2

1. ) Hedging

2. ) Derivatives (Options, forwards, futures, swaps)

Question 3

What are the 4/5 reasons for risk management

Answer 3

FACE T

Question 4

Risk Management REASON 1

Answer 4

Financial Distress

Question 5

Elaborate Risk Management REASON 1

Answer 5

Reduces direct & indirect costs of financial distress.

Question 6

Risk Management REASON 2

Answer 6

Agency Cost

Question 7

Risk Management REASON 3

Answer 7

Cost of raising external finance

Question 8

Elaborate Risk Management REASON 2

Answer 8

Reduces agency cost associated with high debt levels that may result from unhedged outcomes

Question 9

Elaborate Risk Management REASON 3

Answer 9

Raising external finance costly due to direct transaction cost and information asymmetry

High debt levels as a result from unhedged outcomes lead to these costs being incurred

Question 10

Risk Management REASON 4

Answer 10

Employee and Management Remuneration

Question 11

Elaborate Risk Management REASON 4

Answer 11

Employees and Managers face cost in event of bankruptcy.

Reduce PV (Bankruptcy) > Reduce wages & salary to them as employment is assured

Akin to how debtholders demand higher interest if debt is riskier

Question 12

Risk Management REASON 5

Answer 12

Taxes. Only for progressive tax rates.

Question 13

Why does Steve disagree with Risk Management REASON 5

Answer 13

1. ) Company tax is constant and aren’t progressive.

2. ) Companies get accumulated tax losses.

Question 14

Out of all the 5 reasons for Risk Management, which is major, which is minor and which is debatable

Answer 14

FAC - Obvious

E - Minor

T - Debatable

Question 15

Type 1 of Risk Mars of management: Natural Hedge

Answer 15

Reduction in risk from company’s normal operations

E.g. Less risk for Australian-based company with operations in Germany to borrow in Europe compared to Australia.

• If borrow in Australia and Australia interest rates goes up, need to use German income to pay Australian Debt
• If borrow in Germany and Germany interest rates up go up, at least it is constant.

Question 16

Type 2 of Risk Management: Derivatives. One Example.

Answer 16

Forwards and Options.

E.g. Mexico’s put options on oil. While in long-term perfect capital markets NPV is constant, government cannot afford risks. Risk managed but government had years of premium without exercise.

Question 17

What is VaR

Answer 17

Value-at-Risk.

It quantifies risk by estimating the worst loss under normal market conditions

Question 18

What is the colloquial intuition of VaR

Answer 18

“What is the dollar amount VaR such that the probability of an outcome worse than VaR is no more than p”

Question 19

What does a p = 5% with a VaR of 1 million mean

Answer 19

A loss of more than 1 million would be expected to occur on 5% of days

Question 20

What are the pros of VaR

Answer 20

1. ) Short-term risk measurement

2. ) Can be used in conjunction with simulation analysis

Question 21

What are the cons of VaR

Answer 21

1. ) VaR is Subjective
2. ) Inputs are subjective (5%)
3. ) “NORMAL” market conditions is subjective and ambiguous