Risk Management

By Richard MacMinn

Outline

     Corporate Risks Categories Risk Management Financial Markets Risk Management and Value 5/1/2020 2

Risks

  Notion  Random variable  Function of a random  P = P q – C(q)  variable See Sandmo, A. (1971). " On the Theory of the Competitive Firm Under Price Uncertainty ." American Economic Review

61

: 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.

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Risk Categories

    Operational Financial Legal Political rethinking risk financing.pdf

See page 10 in the link to Rethinking Risk Finance 5/1/2020 4

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 5/1/2020 5

Link this to my page on capital structure theorems.

Risk Management

 Speculative risks  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.

Stulz, R. M. (1996). "Rethinking Risk Management." Journal of Applied Corporate Finance

9

(3): 8-24.

Consider the value of the firm stated in terms of options.

    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 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.

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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.

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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 5/1/2020 8

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 5/1/2020 9

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?

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