Risk Management

1. Risk Management By RichardMacMinn

2. Outline • Corporate Risks • Categories • Risk Management • Financial Markets • Risk Management and Value

3. Risks • Notion • Random variable • Function of a random variable • P = P q – C(q) • See Sandmo, A. (1971). "On the Theory of the Competitive Firm Under Price Uncertainty." American Economic Review61: 65-73. • Type • Speculative • risk characterized by a random gain or loss • Pure • risk characterized by only a random loss • P = P q – C(q) – L • The loss may be property or liability • Property losses are generated by hazards such as fire, flood, etc. • Liability losses are generated by hazards such as product defects, environmental damage, directors’ malfeasance, etc.

4. Risk Categories • Operational • Financial • Legal • Political rethinking risk financing.pdf See page 10 in the link to Rethinking Risk Finance

5. Risk Management • Pure risks • Mehr, R. I. and B. A. Hedges (1963). Risk Management in the Business Enterprise. Homewood, Illinois, R. D. Irwin. • Mehr and Hedges used the notion of enterprise risk management and included derivatives • Risks can be: • Avoided by not assuming the risk or otherwise eliminating the hazard associated with the activity • Reduced by taking preventative action, e.g., sprinklers to reduce fire damages or other action to reduce the probability of loss • Retained • Transferred using insurance or derivatives • Cummins, J. D. (1976). "Risk Management and the Theory of the Firm." Journal of Risk and Insurance: 587-609. • Cummins considered risk management in the context of the Capital Asset Pricing Model (CAPM) • MacMinn, Richard D. (1987) “Insurance and Corporate Risk Management” Journal of Risk and Insurance: 658-677

6. Link this to my page on capital structure theorems. Note that risk management and capital structure are substitutes. If the firm is highly levered then it may have a positive probability of bankruptcy. If this risk is too costly then the firm can reduce the bankruptcy risk by changing its capital structure but the same reduction in bankruptcy risk can be accomplished by risk management. Risk Management • Speculative risks • Stulz, R. M. (1996). "Rethinking Risk Management." Journal of Applied Corporate Finance9(3): 8-24. • risk management is viewed as variance minimization in most academic circles • risk management may be viewed as the “elimination of costly lower-tail outcomes” or equivalently risk management is the purchase of out of the money put options • Note that this approach does suggest that only those firms with bankruptcy risk need to actively manage risk. • This approach also provides an intuitive connection with capital structure theory. • Metallgesellschaft, I.e., p.10 • Daimler-Benz Consider the value of the firm stated in terms of options. Daimler-Benz had exchange rate losses in 1995 due to a weakening dollar. One of its subsidiaries had an order book of DM20 billion and 80% of it was fixed in dollars. Hence, this subsidiary had revenue promised in dollars that had to be converted to marks. Its cost was apparently already in marks. The firm could have hedged the transactions by purchasing forward contracts.

7. Financial Markets • The lessons of modern finance theory • Market efficiency • Diversification • CAPM • Arbitrage Pricing • Theorems • Smith and Stulz 1985 • Tufano 1996 See page 12 in Stulz and discuss the two noted paragraphs on finance theory.

8. Risk Management Process • Risk assessment • Identification of global and organizational risks • Frequency and severity • Risk control • Avoid • Reduce • Transfer • Risk finance • Self-finance • (Re)insurance • Alternative Risk Transfer • Administration

9. Risk Management and Value • False sources of value • Diversification • Takeovers • LBO, Spin-off, etc. • Real sources of value • Reduces the costs of financial distress • Reduces payments to stakeholders • The under-investment problem • The risk-shifting problem • Reduces taxes • Convexity • Stochastic dominance

10. Concluding Remarks • What is risk? • Should it be managed? • To what purpose? • How does risk management affect the corporation? • How does risk management affect the market?