No Marshmallows, Just Term Papers
When should Managers consider using Risk Management Strategies?
• Berle and Gardiner (1932)* argued that the modern corporation was developed to enable entrepreneurs to disperse risk among many small investors. • But for some, it’s hard to see why corporations need to reduce risk if investors can manage risk on their own!
* See: A. Berle Jr. and C. Gardiner (1932), “The Modern Corporation and Private Property”, Transaction Publishers, NY.
• Rationale: if an investor does not want to be exposed to a certain type of risk, she can hedge herself by holding a balanced combination of assets that have positive and negative sensitivities to that particular risk factor (diversification).
Systematic vs. unsystematic risk • The Theory of Capital Assets Valuation (CAPM) is the stepping stone of Modern Corporate Finance. • Its main tenants are that “normal” investors are “risk averse” and for that reason need to be compensated for holding risk with additional returns.
Systematic vs. unsystematic risk
• But markets don’t compensate an investor for the full amount of risk contained in a given asset…that is because a good part of total risk may be “diversified”.
Capital Markets Theory • Financial markets are efficient. • Borrowing rate = lending rate, and both are equal to the risk-free rate. • All investors have the same information (expectations, analysis capacity). • Investors only have a one period investment horizon. • No taxes nor transaction costs. • No restrictions on investments.
Capital Markets Theory
• Risk-Free Asset
– Zero variance – Certain return
– The covariance of the risk-free asset with any risky investment is equal to zero.
The investments opportunity set • It is the set of all possible risk-return combinations. • When moving in a northwest direction one can get more return and less risk (standard deviation). • The objective is to...