When Is Risk Management Recommended

1/27/15

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.

1

1/27/15

•  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.

2

1/27/15

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.

3

1/27/15

Capital Markets Theory

•  Risk-Free Asset

–  Zero variance –  Certain return

•  Covariance

–  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...