Lecture 10 - Risk Management Flashcards
What is Risk Management. What is the theoretical and practical implications of risk management.
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
How do companies manage risk
- ) Hedging
2. ) Derivatives (Options, forwards, futures, swaps)
What are the 4/5 reasons for risk management
FACE T
Risk Management REASON 1
Financial Distress
Elaborate Risk Management REASON 1
Reduces direct & indirect costs of financial distress.
Risk Management REASON 2
Agency Cost
Risk Management REASON 3
Cost of raising external finance
Elaborate Risk Management REASON 2
Reduces agency cost associated with high debt levels that may result from unhedged outcomes
Elaborate Risk Management REASON 3
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
Risk Management REASON 4
Employee and Management Remuneration
Elaborate Risk Management REASON 4
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
Risk Management REASON 5
Taxes. Only for progressive tax rates.
Why does Steve disagree with Risk Management REASON 5
- ) Company tax is constant and aren’t progressive.
2. ) Companies get accumulated tax losses.
Out of all the 5 reasons for Risk Management, which is major, which is minor and which is debatable
FAC - Obvious
E - Minor
T - Debatable
Type 1 of Risk Mars of management: Natural Hedge
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.
Type 2 of Risk Management: Derivatives. One Example.
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.
What is VaR
Value-at-Risk.
It quantifies risk by estimating the worst loss under normal market conditions
What is the colloquial intuition of VaR
“What is the dollar amount VaR such that the probability of an outcome worse than VaR is no more than p”
What does a p = 5% with a VaR of 1 million mean
A loss of more than 1 million would be expected to occur on 5% of days
What are the pros of VaR
- ) Short-term risk measurement
2. ) Can be used in conjunction with simulation analysis
What are the cons of VaR
- ) VaR is Subjective
- ) Inputs are subjective (5%)
- ) “NORMAL” market conditions is subjective and ambiguous
