Topics 24. Rethinking risk management R. M. Stulz 2019/2/23 Hu - Risk Management

Risk Management Practice Wharton-Chase survey 530 responded 1/3 used futures, forwards, options, or swaps Large companies used more 65% for firm market value > $250 million 13% for firm market value < $50 million Puzzle Large firms has lower probability of default 2019/2/23 Hu - Risk Management

Risk Management Practice Wharton-Chase survey Usage Only usage over ½ firms: Hedge contractual commitments or transaction anticipated within 12 months. 2/3 never used derivatives to reduce funding costs, to hedge B/S or economic exposures Over 1/3 take positions that reflect their market view of interest rates and FX Metallgesellschaft Daimler-Benz 2019/2/23 Hu - Risk Management

Risk Management Theory - Reasons not to use derivatives Efficient market Do executives have predicting ability? Do they have comparative advantage? FX dealers profits come from market-making, not position making (Article 4) Understanding the source of comparative advantages helps to allocate resources and design incentives. High return – high risk 2019/2/23 Hu - Risk Management

Risk Management Theory - Reasons not to use derivatives Efficient market Should firms hedge financial exposures through normal business operations? Can hedge reduce the cost of capital? Are risks of interest rate, currency, and commodity ‘diversifiable’ or ‘non-systematic’? 2019/2/23 Hu - Risk Management

Bankruptcy costs (cost of financial distress) Risk Management Theory - Reasons to use derivatives Reduce bankruptcy costs Bankruptcy costs (cost of financial distress) Direct cost Indirect cost Lower revenue, higher cost Agency cost Asset substitution Underinvestment 2019/2/23 Hu - Risk Management

Risk Management Reduce bankruptcy costs Implications Risk management link with risk-taking and capital structure Low debt ratio firms don’t need hedge Risk management is a substitute for equity Risk management is useful when the cost of equity is higher than the cost of debt 2019/2/23 Hu - Risk Management

Risk Management Reduce bankruptcy costs AAA firm Least likely to default, can afford to bet BBB firm It is likely to default, should hedge S&L firm Almost surely to default, should bet Risk Management Reduce bankruptcy costs 2019/2/23 Hu - Risk Management

Risk Management Theory - Reasons to use derivatives Reduce required returns to undiversified stakeholders Reduce required returns to undiversified stakeholders Owners of closely held firms Holders of firm-specific investments Employees Customers Suppliers 2019/2/23 Hu - Risk Management

Risk Management Reduce required returns to undiversified stakeholders Link with management incentives Evidence 48 gold mining companies High ownership, more hedging Serves to remove noise (gold price movement) More options features, less hedging 2019/2/23 Hu - Risk Management

Risk Management Theory - Reasons to use derivatives Reduce expected tax Example 2019/2/23 Hu - Risk Management

Risk Management Theory - Reasons to use derivatives Reduce expected tax Reduce tax Income after tax Income before tax 2019/2/23 Hu - Risk Management

Risk Management Measuring risk Variance We only care about lower-tail outcomes VAR Maximum extent of the loss within 95% level on a given period Default probabilities Using cash flow simulations to estimate 2019/2/23 Hu - Risk Management

Risk Management Measuring risk 2019/2/23 Hu - Risk Management