1 Chapter 23 Risk Management

2 Topics in Chapter Risk management and stock value maximization. Fundamentals of risk management.

3 How can risk management increase the value of a corporation? Risk management allows firms to: Have greater debt capacity, which has a larger tax shield of interest payments. Implement the optimal capital budget without having to raise external equity in years that would have had low cash flow due to volatility. (More... )

4 Risk management allows firms to: Avoid costs of financial distress. Weakened relationships with suppliers. Loss of potential customers. Distractions to managers. Utilize comparative advantage in hedging relative to hedging ability of investors. (More... )

5 What is corporate risk management? Corporate risk management is the management of unpredictable events that would have adverse consequences for the firm.

6 Different Types of Risk Speculative risks: Those that offer the chance of a gain as well as a loss. Pure risks: Those that offer only the prospect of a loss. Demand risks: Those associated with the demand for a firm’s products or services. Input risks: Those associated with a firm’s input costs. (More... )

7 Financial risks: Those that result from financial transactions. Property risks: Those associated with loss of a firm’s productive assets. Personnel risk: Risks that result from human actions. Environmental risk: Risk associated with polluting the environment. Liability risks: Connected with product, service, or employee liability. Insurable risks: Those which typically can be covered by insurance.

8 What are the three steps of corporate risk management? Step 1.Identify the risks faced by the firm. Step 2.Measure the potential impact of the identified risks. Step 3.Decide how each relevant risk should be dealt with.

9 What are some actions that companies can take to minimize or reduce risk exposures? Transfer risk to an insurance company by paying periodic premiums. Transfer functions which produce risk to third parties. Purchase derivatives contracts to reduce input and financial risks. (More... )

10 Take actions to reduce the probability of occurrence of adverse events. Take actions to reduce the magnitude of the loss associated with adverse events. Avoid the activities that give rise to risk.

11 What is financial risk exposure? Financial risk exposure refers to the risk inherent in the financial markets due to price fluctuations. Example: A firm holds a portfolio of bonds, interest rates rise, and the value of the bonds falls.

12 What actions can companies take to reduce property and liability exposures? Both property and liability exposures can be accommodated by either self- insurance or passing the risk on to an insurance company. The more risk passed on to an insurer, the higher the cost of the policy. Insurers like high deductibles, both to lower their losses and to reduce moral hazard.

13 How can diversification reduce business risk? By appropriately spreading business risk over several activities or operations, the firm can significantly reduce the impact of a single random event on corporate performance. Examples: Geographic and product diversification.

14 What is financial risk exposure? Financial risk exposure refers to the risk inherent in the financial markets due to price fluctuations. Example: A firm holds a portfolio of bonds, interest rates rise, and the value of the bonds falls.

15 Financial risk management concepts Duration: Average time to bondholders' receipt of cash flows, including interest and principal repayment. Duration is used to help assess interest rate and reinvestment rate risks. Immunization: Process of selecting durations for bonds in a portfolio such that gains or losses from reinvestment exactly match gains or losses from price changes.