Risk Management and Value Creation in ... - Arabictrader.com

86 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
whereas options provide a nonlinear payoff. Hence, managers who hold
substantial option positions in their company will have an incentive to
increase the riskiness of the firm by not managing risks (or even by
outright speculation), 170 because higher risk increases the volatility and
consequently the value of the expected utility of an option contract for
a risk-averse manager. 171 Equity options for less capable managers, hence,
increase the incentive to speculate, whereas for capable managers, equity
options can even create an incentive to manage risk. 172
Therefore, due to the risk preference problem, we should find firms
with a high investment of human capital and substantial stock holdings
(but not equity option holdings) of their managers to have more risk
management than vice versa and that is necessary from the shareholders’
point of view. This creates agency costs because:
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The firm might diversify beyond its core capabilities, that is,
engage in unnecessary diversification (especially when at a cost)
Managers overinvest
The leverage of the firm is too low with regard to what would
be optimal from a tax shield point of view
The firm might have to spend additional money to ensure that
managers perform appropriately if they have risk management at
their discretion, that is, they do not speculate (especially if they
hold equity options) 173
These agency costs reduce the value of the firm’s equity. On the one
hand, increasing the firm’s leverage can reduce them, which can be
achieved with the help of risk management even without increasing the
probability of default. On the other hand, they can be reduced by using
risk management as a device to change the distribution of payoffs from
managerial compensation, 174 which will allow the firm to save money
because it will then be able to enforce cheaper incentive compensation
contracts. 175
Signaling higher management quality: The delegation of decision/con-
170 See Smithson (1998), p. 13.
171 See Tufano (1996), p. 1110.
172 As we will see below, capable managers can signal their quality. See Raposo (1999),
p. 47.
173 Allen and Santomero (1996), p. 17, refer to Metallgesellschaft and Barings as
recent and extreme examples of these agency costs.
174 See Raposo (1999), p. 45.
175 If manager’s compensation depends on the distribution of the firm’s payoffs, so
does the manager’s utility.