finance: risk management - institut für …. should the firm hedge in order to please the larger...

Institute for Risk Management and Insurance

Winter 2010/2011

Finance: Risk Management

Module III: Risk Management Motives

Petra [email protected]

mailto:[email protected]


Perfect financial markets

• Assumptions:

no taxes

no transaction costs

no costs of writing and enforcing contracts

no restrictions on investments in securities

symmetric information

investors take prices as given (because they are too small to affect prices)

( real-world financial markets are imperfect)

51Petra Steinorth Finance: Risk Management


Risk management and shareholder wealth

• Would shareholders want a firm to spend cash on reducing the volatility of its cash flow?

• Assumptions:

The only benefit of risk management is to decrease share return volatility.

Shareholders are investors who care only about

• expected return,

• volatility.

Shareholders hold a well-diversified portfolio of risky assets (market portfolio or a portfolio not too

different from it).

Shareholders allocate their wealth between the risk-free asset and a diversified portfolio of risky

assets.

(recall what you know from the CAPM)

• Reduction of volatility by reduction of

diversifiable risk (unsystematic risk)

systematic risk



Reduction of diversifiable risk

• The only benefit of the payment is a reduction / elimination of diversifiable risk of the shares

If reduction is costly: expected cash flows are reduced.

But: firm value does not depend on diversifiable risk

• Shareholders are diversified

They have no reason to care about diversifiable risks.

Shareholders do not want the management to decrease the firm„s diversifiable risk at a cost.

They can eliminate the firm„s diversifiable risk by diversification at zero cost.

Reduction of diversifiable risk does not increase shareholder wealth.



Reduction of systematic risk through financial transactions

• Reduction of systematic risk reduces the firm„s ß, (but increases the risk buyer„s ß) in

financial markets, every investor charges the same for systematic risk (this price is

determined by the CAPM)

The buyer wants to be paid to take additional systematic risk.

• The firm cannot create value by selling market risk to other investors at the market price of

that risk:

• ß is reduced

• expected return is reduced

share price remains unchanged

Reduction of systematic risk does not increase shareholder wealth.

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µ SML



• In a perfect capital market, a firm cannot create value by hedging risks, if the

cost of bearing the risk equals the cost of passing it to the capital market.

• A firm can not contribute to the shareholders„ welfare through risk

management.

• This holds for diversifiable and for systematic risk:

Hedging irrelevance proposition:

Hedging a risk does not increase firm value when the cost of bearing the risk is the

same, regardless of whether the risk is borne within the firm or outside the firm by

capital markets.

The risk management irrelevance proposition



Risk management in imperfect capital markets

Capital market imperfections

• Situations can arise where

• investors cannot mimic risk management of the firm or

• the cost of bearing the risk inside the firm differs from the cost of bearing it outside the firm.

• For risk management to increase firm value, it must be more expensive to take risk within

the firm than paying the capital markets to take it.



Bankruptcy costs and the cost of financial distress (I) – motivation

• A study of bankruptcy for 31 firms over the period from 1980 to 1986 finds an average ratio of direct bankruptcy costs to total assets of 2.8 %, with a high of 7 % (Weiss 1990).

• Direct costs of bankruptcy are the costs incurred as a result of bankruptcy filing, e.g. hiring lawyers, court costs, payment of financial advice

• Costs firms incur because of a poor financial situation are called costs of financial distress. They can occur even if the firm never files for bankruptcy or never defaults, e.g. cuts in investments leading to losses in future profits.

• Reducing the costs of financial distress is one of the most important benefits of risk management.

• Present value of future bankruptcy costs reduces the present value of a firm that has debt relative to one that does not.



• A strategy that reduces the probability of bankruptcy reduces the expected costs of

bankruptcy as well.

• Creditors charge a spread as compensation for the costs coming up in the case of

bankruptcy.

• Thus, shareholders can improve the conditions of debt financing by reducing the

bankruptcy risk.

• Bankruptcy costs create a „wedge“ between cash flow to the firm and cash flow to

the firm„s claimholders.

• By hedging, the firm increases its value:

It does not have to pay bankruptcy costs.

Claimholders (shareholders, debitors) get the firm„s entire cash flow.

In this situation, claimholders‟ individual risk management cannot substitute risk

management within the firm.

Bankruptcy costs and the cost of financial distress (II)



Stakeholders (I)

• There are individuals and companies whose utility depends on how well a firm is doing but

who cannot diversify the impact of firm risks on their individual situation („stakeholders“)

workers

suppliers

customers

• Should a firm care about stakeholders?



Stakeholders (II)

• Owners (shareholders) of a firm want the firm to be managed in a way that maximizes

their welfare.

• Sometimes it is advantageous for shareholders to reduce other stakeholders„ risks:

- Shareholders may want other stakeholders to make long-term firm-specific investments, e.g.

advanced firm-specific vocational training of employees or R&D-expenses of suppliers.

• Stakeholders might be reluctant to make firm-specific investments if they question the

firm„s financial health.

- The firm has to pay the stakeholders directly to make firm-specific investment, e.g. higher

compensation for workers, ...

- Such economic incentives can be more expensive than hedging.



• Recall: Risk management can only create value if it is more expensive to

assume risk within the firm rather than to pay the capital markets to bear it.

• Corporate taxes can increase the cost of taking risks within a firm.

• Risk management can reduce the (expected) present value of taxes.

Reduction of tax burden when taxation is convex (I)



Reduction of tax burden when taxation is convex (II)

• Convex (progressive) taxation:

• higher levels of earnings are taxed at higher tax rates

• convexity can arise from tax exemptions, deductions for certain expenditures, ...

The residual income after tax is concave.

• Assume risk-neutral owners/management

• Insurance against a „fair“ premium is worthwhile (same argument as for a risk-averse

insured with a concave utility function)

• Formally: If the tax function T(·) is strictly convex and the income w is random,

Jensen„s inequality yields: T[E(w)] < E[T(w))]

Taxes based on the expected value of income are lower than the expected value of taxes

on random income.

Full insurance at the “fair” premium increases the mean of the income after taxes.



w

)(wT The company„s income is two-point distributed (w1; 0,5; w2), where

w1= w2-L

w0Tax deduction

T(w0)

“Convex” taxation – An exampleLinear taxation with a tax deduction



T(w2)

w1 w2 w

The company„s income is two-point distributed (w1; 0,5; w2), where

w1= w2-L

T(w1)E[w]

E[T(w)] =0.5T(w1) +0.5T(w2)

Consider the effect an insurance contract against a

premium of 0.5·L has on expected taxes

Tax deduction

T(E[w])

“Convex” taxation – An exampleLinear taxation with a tax deduction

)(wT



“Convex“ taxation – Carry forwardsLinear taxation with a tax deduction

• Carry forward of losses

- Negative income of this year can be used as a deduction against future earnings.

- Assumptions:

• Firm can carry forward every € of losses with interest.

• As before: Linear taxation with tax deduction.

- The expected present value of every € carried forward is a tax relief of -1 €.

- In our example with linear taxation all (even negative) income is taxed at the marginal rate.

no “convexity”



w1 w2E[w]

T(w2)

w

)(wT

T(w1)

E[T(w)] = T(E[w])

“Convex“ taxation – Carry forwardsLinear taxation with a tax deduction



Agency costs and dysfunctional investment (I)

• Facing the threat of insolvency, shareholders hold the so called „Default Put Option“, as

the value of their share cannot be negative.

• Shareholders have some control over management decisions agency relationship

between shareholders and bondholders.

• In the case of insolvency (firm value < nominal value of liabilities) further negative

consequences are borne by the creditors, e.g. a huge loss.

• Potential problem: Investment in projects with negative net present value, but with a high

return if they are successful: If the project fails and significant losses occur, a major share

is borne by the other bondholders (asset substitution).

• Similar: Shareholders have an incentive to pass up certain positive NPV projects if they

pay for the full cost but benefit only if the firm does not go bankrupt (underinvestment).

• Creditors anticipate these problems higher cost of debt that can be reduced by risk

management.



Z-D

Value of claims

Total company value

45°

D

D

A

A-D

ZY

From the perspective of share-

holders: “Heads I win, tails you lose“

Agency costs and dysfunctional investment (II) - Asset substitution

A: starting situation, risk-free

Consider a risky project, that either

increases the firm„s value by Z-A or

decreases the firm„s value by A-Y

(each with a probability of ½)



45°

D

D

A ZY Z*

N

Y*

N

C Total company value

Value of claims

Similar situation as before (initial

firm value is A, risky project from

the last slide has been chosen;

random final wealth is Y or Z)

Now consider an additional

investment opportunity that

certainly increase the firm„s value

by N – at a cost of C.

Agency costs and dysfunctional investment (III) - Underinvestment



Large undiversified shareholders (I)

Investors holding a large position in a firm's diversifiable risks may not have a balanced

private portfolio:

• These investors care about firm-specific risks.

• The firm may have a competitive advantage in hedging these risks relative to the large

shareholder.

Should the firm hedge in order to please the larger shareholder?

Large shareholders have high incentives for monitoring and may be able to increase firm

value because …

• they may have some ability in evaluating the actions of management and provide value through

their skills and knowledge.

• managers do not necessarily maximize firm value; monitoring can make it more likely that they do.



Large undiversified shareholders (II)

• A firm„s risk generally makes it unattractive for a shareholder to have stakes large enough

to make monitoring worthwhile.

• A firm that manages the risk may make ownership more attractive to shareholders with a

competitive advantage in monitoring.

• If this shareholder gets involved, other shareholders benefit.



Manager incentives

• Performance-related compensation gives managers incentives to maximize firm value.

Manager compensation is risky and depends strongly on parameters that the management can

influence / control.

• Managers are risk-averse. If their compensation depends on company performance, their

decisions on behalf of the company will reflect their risk-aversion. They may refuse risky

projects with a positive NPV although these projects increase the welfare of (risk-neutral)

shareholders.

• Also, risk management can reduce value volatility that is not under the management„s

control.

Managers accept lower compensation to attain the same utility; saving compensation enhances

firm value.

Risk management improves the owners‟ ability to observe the impact of management performance

on share prices ( compensation can be related more closely to effort).



The cost of external post-loss financing

• If a firm suffers a loss and lacks sufficient internal funds to finance the loss (post-loss

financing), external sources must be used.

• External post-loss financing tends to be expensive.

• Hence, it can be advantageous for a firm to assure financing terms ex ante (pre-loss

financing), e.g. through insurance.



Optimal capital structure and risk management

• Interest paid is deductible from income.

• A levered firm that pays interests pays less in taxes than one without interest payments

for the same operating cash flow.

Debt comes with a tax benefit.

It increases the value of the firm relative to the value of the unlevered firm.

• An increase of the firm„s debt increases the likelihood of financial distress.

• By having more debt, firms increase their tax shield from debt, but increase the present

value of costs of financial distress.

• The optimal capital structure balances the tax benefits of debt against the costs of

financial distress.

• A firm can reduce the present value of the costs of financial distress through risk

management by making financial distress less likely.

The firm can take more debt.



Core risk and incidental risk

• Investment opportunities are risky by nature.

• All firms take risks. This is how they earn profit.

• A firm can have a comparative advantage or disadvantage in taking certain risks.

• A firm faces core risks and incidental / noncore risks:

• Core risks concern the firm„s areas of competence the firm has a comparative advantage in

taking these risks.

• A firm has no special advantage in handling incidental risks.

• Idea: A firm can transfer incidental risks to outsiders in order to free up capacity to

assume more core risk („coordinated risk management“).



Selected empirical evidence

Cummins, Phillips & Smith (2001) Expected costs of financial distress and tax considerations

as motives (among others) for insurers„ use of financial

derivatives.

Grace, Klein & Phillips (2005) Insolvency costs for insurers are higher than for other

firms.

Hoyt & Liebenberg (2006) The use of ERM significantly increases firm value

(measured by Tobin„s Q).

Graham & Rogers (2002) Firms hedge to increase debt capacity and because of

expected financial distress costs.

Minton & Schrand (1999) Higher cash flow volatility is associated with lower average

levels of investment in capital expenditures, R&D, and

advertising.

Smithson & Simkins (2005) Literature review regarding the value of RM.


finance: risk management - institut für …. should the firm hedge in order to please the larger...

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