Stulz - Rethinking Risk Management Flashcards
What is the lesson of market efficiency for corporate risk managers?
Attempt to earn higher returns in most financial markets generally means bearing large risks. In highly liquid markets such as those for interest rate and FX futures - and in the case of heavily traded commodities like oil and gold as well - industrial companies are unlikely to have a comparative advantage in bearing those risks.
Why the concept of diversification should discourage some companies from hedging financial exposures?
A company’s rate of return depends on the strength of the firm’s tendency to move with the broad market. i.e. only on its non-diversifiable (or systematic) risk.
In general, most of a company’s interest rate, currency, and commodity price exposure will not increase the risk of a well-diversified portfolio.
The shareholder can likely diversify its portfolio/hedge its overall risks much more efficiently than the firm.
For this reason, , it makes sense to devote resource to manage it commodity/FX risks only if the cash variability has the potential to impose real cost on the corporation.
What are the three major costs associated with higher variability?
- higher expected bankruptcy costs 2. higher expected payments to corporate “stakeholders” 3. higher expected tax payments
Risk management can reduce bankruptcy costs
-What are the costs of bankruptcy?
What are the costs of bankruptcy?
- payments to lawyers and court costs -
- larger indirect costs:
- interference from the court => potential to cause significant reduction in the ongoing operating value of the firm
- If shareholders view bankruptcy as a real possibility, the expected PV of these costs will be reflected in a company’s current market value.
- cost of outside funding may become so great that management chooses to pass up profitable investments (underinvestment)
Risk management can reduce payments to stakeholders
- shareholders are likely able to diversify their risks more efficiently than the firm can. But other stakeholders, including managers, employees, suppliers, etc. have much more non-diversifiable firm specific risk and they will require larger payments as risk increases. e.g.s
- employees will demand higher wages where the probability of layoff is greater
- mangers with alternative opportunity will demand higher salaries
- suppliers will be reluctant to enter into LT contracts
Risk management can reduce taxes
Potential tax benefits of risk management:
- Increasing marginal tax rates, limits on the use of tax loss carry forwards and the alternative minimum tax all serve to make extreme levels of profit (too high or too low) less desirable than a more stable income level.
Primary Objective of Risk Management
to eliminate costly lower tail outcomes=> minimizing the likelihood of financial distress and preserving the financial flexibility to carry out their investment objectives.
What is the right corporate risk management decision for a company? (seperate into 3 cards)
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Firms that have a lot of equity capital can make bets without worrying about whether doing so will bring about financial distress.
- One would not expect these firms to hedge aggressively, particularly if risk management is costly and shareholders are better off without it.
- Major issue that such companies must address, it whether they have too much capital. => hedging could help to increase shareholder value by enabling them to raise leverage
- A firm with significant probability to face distress, it should eliminate the probability of encountering financial distress through risk management. The cost of having a bet turn sour can be substantial, since this would almost certainly imply default. => one would not expect the management of such firm to let its view affect the hedge ratio.
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A firm that is in distress: Companies in distress have no need for risk management. Any benefits from
activities such as hedging would go to debt holders. If they take risks, there is a chance that there would be enough of a gain to escape financial distress. Any
downside risk would affect bondholders.
Why VaR cannot be used to execute the risk management goal to eliminate the lower-tail outcomes to avoid financial distress?
VaR is not useful information when management’s concern is whether firm value will fall below some critical value over an extended period of time.
Management’s concern is:
- if we define financial distress as a situation where we cannot raise funds with a rating of BBB, or the value of equity fall below some target, what is the probability of distress over the next three years?
VaR by itself cannot answer this question, nor can traditional measures of volatility.
What are the two major difficulties in extending the VaR over longer time horizons?
- 99% VaR over one year horizon means a 1 in 100 year event. It’s difficult to calculate the model or subject it to empirical testing.
- when one is especially concerned with tail probabilities, the assumption about the statistical distribution is important. Research suggest that the tail probabilities are generally larger than implied by normal distribution
What is the alternative for VaR for risk management
Cash flow simulations to estimate default probabilities. VaR computed at the one-year horizon at the 99th percentile answers the question: What is the maximum loss in firm value that I can expect in 99 years out of 100?
But when a company hedges an exposure, its primary concern is the likelihood of distress during the year, which depends on the value of the cumulative loss throughout the year. Thus, it must be concerned about the path of firm value during a period of time rather than the distribution of firm value at the end of period.
What is the most practical approach to assessing a company’s probability of financial distress give the focus on cumulative changes in firm value during a period of time?
Conduct sensitivity analysis on the expected distribution of cash flows. One could simulate the company’s cash flows over a ten-year horizon in a way that is designed to reflect the combined effect of all the firm’s major risk exposures on its default probability. The probability of distress over that period would be measured by the fraction of simulated distributions that falls below a certain threshold.
What are the advantages of using simulation techniques?
Their ability to incorporate any special properties of the cash flows.
The VaR approach assumes the gains and losses are “serially independent”, which means that if your firm experience a loss today, the chance of experience another loss tomorrow is unaffected. But this assumption is likely to be wrong.
Simulation has the ability to build this “serial dependence” of cash flows. If cash flow is poor today, it is more likely to be poor tomorrow.
How does management evaluate the outcome of a bet?
For the case of AAA firm, it is not concerned about lower-tail outcomes and thus has no reason to hedge. When evaluating outcome of a bet, the appropriate benchmark is the expected gain adjusted for risk. It is not enough to earn more than risk-free rate or even more then the firm’s cost of capital. The bet must earn a return that is higher than other investments of comparable risk to add value. So, the abnormal or excess return should be the measure for company AAA.
For the case of BBB firm, management should hedge to reduce the prob. of distress to acceptable levels. At the same time, management should also consider subjecting its bets to an even higher standard of profitability to compensate share holders for any associated increase in expected financial distress costs. How much higher? - One method: assume that instead of hedging the firm raise additional equity capital to support the expected increase in volatility associate with the bet. in this case, the bet would be expected to produce the same risk-adjusted return on capital as the bet taken by AAA company.
How should a compensation scheme be devised?
Traditional compensation schemes: a risk-taker simply receives a bonus for making gains, he has incentives to take random bets because he gets a fraction of his gains while the firm bears the losses.
To structure the incentive payments so that they are encouraged to take only those bets that are expected to increase shareholder wealth. Managers should no be compensated for earning average returns when taking risks. They should be compensated only for earning more than what their shareholders could earn on their own when bearing the same amount of risk.
Evaluating manager’s performance against a risk-adjusted benchmark can help discourage risk-taking that is not justified by comparative advantage.