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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

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

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

13. 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

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