VALUE OF RISK MANAGEMENT
The two pillars of modern risk management are the concepts of market efficiency and diversification.
The former postulates that asset prices contain all information, making it impossible to generate a profit by claiming to possess informational advantages. Although this concept is widespread, many managers continue to believe that they possess comparative advantages in certain markets. Consequently, firms use their resources to develop investment strategies that are very risky because a high return is generally accompanied by high risk. However, these practices have been abandoned by many firms that realize they did not actually possess comparative advantages within their sector or because they had bad experiences resulting from the inappropriate use of hedging instruments.
In fact, firms do not necessarily need to hedge against all the financial risks they may face, particularly when they are already well diversified internally. In order to maximize firm value, hedging should focus on the risks that are most difficult to diversify and that incur real costs for firms. Researchers have identified four of these costs:
- Expected default costs (Smith and Stulz, 1985)
- Supplementary payments or risk premiums to stakeholders (Stulz, 1996)
- Expected tax payments (Graham and Smith, 1999; Graham and Rogers, 2002)
- Investment financing (This last cost will be studied in parallel with the paper by Froot, Sharfstein, and Stein, 1993)
More recently, risk management has been associated with:
- Greater firm efficiency (Cummins et al., 2009)
- The payment of dividends (Dionne and Ouederni, 2011)
- Corporate governance (Dionne and Triki, 2013);
- Industrial organization (Dionne and Santugini, 2014; Léautier and Rochet, 2014)
- Mergers and acquisitions (Savor, 2002)
- Market regulation (Basel II and III and Solvency II) An efficient risk management strategy reduces the costs associated with the outcome of the risks to which a firm is exposed.
Expected Default Costs
Default costs refer to the costs associated with default, not bankruptcy. Default costs can be divided into two categories: direct costs such as lawyer fees, consultant fees, and court-related expenses; and indirect costs incurred when a firm is under bankruptcy protection laws, such as reorganizational costs. Both these categories of costs are directly reflected in a firm’s valuation. The goal of an efficient risk management strategy is to maintain these costs at an optimal level, while taking into consideration the cost of hedging instruments.
Risk Premium to Stakeholders
Similar arguments can be made regarding stakeholders who may request higher salaries or risk premiums when a firm is less diversified because they face a higher risk of losing their job or their investment. Suppliers may also be less lenient with respect to credit terms and may also request a premium for this risk. These costs can be represented in the same manner as default costs
- Dionne, Georges, 2019, Corporate Risk Management: theories and applications, Wiley, ISBN 9781119583172 (Epdf)
- Stulz, R.M., 1996. “Rethinking Risk Management.” Journal of Applied Corporate Finance 9, 8–24.
- Stulz, R.M., 2003. Risk Management and Derivatives. Thomson/South-Western.
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