Creating Value with Risk Management

    1           Basic Viewpoint

Hedging Irrelevance Proposition says that, in a perfect market, the firm cannot create value by hedging a risk when the price of bearing that risk within the firm is the same as the price of bearing it outside of the firm. However, financial markets are not likely to be perfect markets in practice which suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management.

    2           Creating Value in Different Ways

2.1          Handling Bankruptcy Costs and Financial Distress Costs

When a firm has risky debt in its capital structure, there is some probability that the firm’s operating income will be insufficient to pay the debt holders. In this case the firm may file for bankruptcy. In the real world, it is costly for firms to file for bankruptcy. Firms have to hire lawyers, incur court costs, and need to pay for all sorts of financial advice. Costs incurred as a result of a bankruptcy filing are called bankruptcy costs. The present value of future bankruptcy costs reduces the value of a firm. However, hedging can reduce cash flow volatility so that the present value of bankruptcy costs decreases because bankruptcy becomes less likely.

Moreover, even if bankruptcy is avoided, a firm in financial trouble may experience added costs from debt renegotiation, forgone value-creating projects, etc. The costs firm incur because of a poor financial situation are called costs of financial distress. Costs of financial distress can occur even if the firm never files for the bankruptcy or never defaults. The analysis of the benefits of risk management in reducing bankruptcy costs holds for all costs of financial distress also. Therefore, hedging can increase firm value if it helps avoid a large cost of financial distress.

In addition, the risk of bankruptcy and financial distress intuitionally cannot be hedged by the shareholders, thus, it may be value increasing for the firm to undertake risk management to reduce or eliminate these costs.

2.2          Moving Income Across Time and by Reducing Taxes

Assuming no carry-over provisions, the income tax in a very good year is high and is not offset by a tax refund in a year with losses. If we can rearrange the risks we take so that we have less income when the tax rate is high and more income when the tax rate is low, the present value of taxes paid is reduced. Therefore, by stabilizing earnings, corporations reduce the average tax payment over time, which should increase their value.

2.3          Reducing Diversifiable Risk of Large Shareholders

Generally, for investors who have a large position in a firm, unsystematic risks do not balance out. As a result, they might want the firm to reduce risk as homemade hedging may not be possible for this large investor. If the firm gains from having the large shareholder, then it can make sense to hedge to make it possible for the large shareholder to keep her investment in the firm.

There are two reasons why shareholder monitoring can increase firm value.

First, an investor might become a large shareholder because he has some ability in evaluating the actions of management in a particular firm. Such an investor has knowledge and skills that are valuable to the firm which helps the firm’s manager increase the value.

Second, managers do not necessarily maximize firm value but rather maximize their welfare like all economic agents. Therefore, monitoring can make it more likely that managers maximize firm value. In practice, investors hire managers to serve as their agents and give them discretion to run the company. However, good and bad managers are not always easy to identify. Without hedging, earnings fluctuate due to outside forces. This makes it difficult to identify the performance of management. With hedging, there is less room for excuses. Bad managers can be identified more easily and fired, which should increase firm value. In addition, shareholders can ensure that managers are motivated to maximize the value of the company’s shares through a managerial compensation contract that gives managers a stake in how well the firm does. If managers earn more when the firm does better, this induces them to work harder.

2.4          Reducing Probability of Debt Overhang

Consider a firm that has experienced poor operating results to the point where there is significant probability that there will not be enough firm value to satisfy the debt obligations and to where the equity is worthless. One implication of this situation is that managers may accept high-risk projects that will decrease expected firm value but will also increase the probability of positive equity value at the end of the period. Another implication is that management may also negatively impact firm value by not accepting positive net present value projects. The reason may probably lie in the fact that financing a profitable project by issuing new equity will increase firm value, but most of the increase in value will accrue to the debt holders. In conclusion, firms are said to have decreased value due to debt overhang. In another word, risk management that reduces the probability of getting into a situation of debt overhang can increase firm value.

2.5          Reducing Information Asymmetries

When one party to a deal knows more than the other, we call this an information asymmetry. The costs associated with management’s opportunity to undertake projects that have a negative net present value when it is advantageous from them to do so are called agency costs of managerial discretion which make it harder for a firm to raise funds and increase the cost of funds. However, risk management can help to increase the confidence of outside investors that firm results reflect management quality, reducing funding costs and increasing firm value.

    3           Example

3.1          FRM EXAM 2009-QUESTION 1-2

By reducing the risk of financial distress and bankruptcy, a firm’s use of derivatives contracts to hedge its cash flow uncertainty will

a.       Lower its value due to the transaction costs of derivatives trading

b.       Enhance its value since investors cannot hedge such risks by themselves

c.       Have no impact on its value as investors can costlessly diversify this risk

d.       Have no impact as only systematic risks can be hedged with derivatives

Answer: b

The cost of financial distress is a market imperfection, or deadweight cost. By hedging, firms will lower this cost, which should increase the economic value of the firm.

3.2          FRM EXAM 2009-QUESTION 1-8

In perfect markets, risk management expenditures aimed at reducing a firm’s   diversifiable risk serve to

a.       Make the firm more attractive to shareholders as long as costs of risk management are reasonable

b.       Increase the firm’s value by lowering its cost of equity

c.       Decrease the firm’s value whenever the costs of such risk management are positive

d.       Has no impact on firm value

Answer: c

In perfect markets, risk management actions that lower the firm’s diversifiable risk should not affect its cost of capital, and hence will not increase value. Further, if these activities are costly, the firm value should decrease.

Reference:

1)        Handbook, P20-22

2)        Schweser Study Notes, Part I, Book 1, P94-98

3)        Rene Stulz, Risk Management & Derivatives, Chapter3 P1-54

4)        http://en.wikipedia.org/wiki/Financial_risk_management