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Rationales for Risk Management in Banks 103 -100% 0% 100% Hedge ratio Negative Hedging Underhedging Overhedging Amplifying Partially exposure offsetting exposure Figure 3.6 Over- and underhedging. Source: Adapted from Fenn et al. (1997), p. 24. Reversing exposure that is less exposed should hedge more than a firm whose investment opportunities are more exposed to the price of a specific risk factor. Changing financing opportunities: Negative shocks to a firm’s current cash flow might also make it more costly for the firm to raise money from outside investors. 268 Hence the supply schedule for external finance is not exogenously fixed and insensitive to the risks affecting the firm’s cash flows from its existing assets. If that is the case, then it may make sense for the firm to hedge more than it otherwise would. This will allow the firm to fund its investments while making less use of external financing in bad times than in good times. 269 The effect of changing financing opportunities on the hedge ratio is as follows: The optimal hedge ratio is greater than one, being greater the more sensitive assets are in place to the risk variable. Hedging must now allow the firm to fund its investments and yet avoid borrowing at those times when external finance is most expensive. If both investment opportunities and financing opportunities are fluctuating, obviously there are wide-ranging implications for the design of riskmanagement strategies. Linear hedging—as described previously by asset allocation and diversification 270 —may no longer be optimal. If nonlinear instruments such as options are available, the firm will indeed wish to con- 268 This is especially true for banks. 269 See Froot et al. (1993), p. 1641. 270 Stulz (2000) and the line of reasoning above assume that the investment program is fixed.
104 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS struct a hedging strategy that leads to nonstochastic investment. Linear hedges can add value, but they will not generally maximize value if nonlinear instruments are available. 271 Risk management can be beneficial for firms through the coordination of investment and financing. 272 By being able to reduce the variability of internally generated cash flows, risk management can ensure that a company has enough internal funds available to pursue attractive investment opportunities. This avoids the cost of underinvestment and hence increases net cash flows and, therefore, firm value. Risk management can thus make external financing redundant and can lower the direct and indirect costs associated with visiting capital markets. It can further increase the value of the firm by avoiding unnecessary fluctuations in either investment spending or funds raised from outside investors. If the firm’s cash flows are low, obtaining additional funding is even more costly and the probability increases that the firm will postpone positive NPV projects. Risk-management programs that break this dependency of investment on internally generated cash flows can increase the firm’s value by doing so 273 and can give firms access to a wider range of lucrative investment projects. 274 However, the coordination of investment and financing insulates the company from the scrutiny of external markets 275 and can increase agency conflicts between managers and shareholders and, hence, the associated costs. 276 All of these theoretical arguments derived above for industrial companies generally also apply to banks. However, the protection of the optimal investment program takes on another aspect for banks: The avoidance of a change in the default probability is the main rationale for conducting risk management in banks and not securing the availability of internal funds. The funds necessary for a bank’s investments are almost exclusively obtained from the outside (mostly in the form of deposits). However, only as long as there is no concern with financial distress are banks actually able to (easily) obtain these external funds (both debt and equity) in the capital markets for positive NPV projects. 277 As soon as there is a change in the 271 See Froot et al. (1993), pp. 1645–1648. Note that hedging cannot change the expected level of wealth. 272 The probability of risk management increases with the demand for funds (which is typically determined by the firm’s growth opportunities as indicated by the firm’s market-to-book ratio or its Tobin’s q) and the unavailability of internal funds. 273 See Tufano (1996), pp. 1107–1108. 274 See Smithson et al. (1990), p. 375. 275 As described by Jensen (1986) and (1993). 276 See Tufano (1998). 277 See Smith (1993), p. 21.
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isk management and value creation i
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Copyright © 2002 by John Wiley & S
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preface From an empirical as well a
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acknowledgments No book is solely t
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x CONTENTS Goals of Risk Management
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xii CONTENTS Definition of RAROC 24
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xiv FIGURES Figure 5.5 Figure 5.6 F
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symbols ↑ ↓ α β i xvi Increas
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xviii SYMBOLS ln Natural logarithm
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abbreviations APT BIS bn bps CAPM C
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2 RISK MANAGEMENT AND VALUE CREATIO
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CHAPTER 2 Foundations for Determini
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Foundations for Determining the Lin
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Page 76: Foundations for Determining the Lin
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eferences Aguais, Scott D., and Ant
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References 295 Blanden, Michael (19
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References 297 and Abuses,” Journ
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References 299 Froot, Kenneth A., a
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References 301 risiken aus Handelsg
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References 303 Investments in Stock
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References 305 Institute of Technol
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References 307 Sharpe, William F. (
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References 309 Wall, L.D., and John
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312 INDEX Approach (continued) top-
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314 INDEX Capital: Tier-1, 139, 146
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316 INDEX Credit: derivatives, 178,
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318 INDEX Expectations: homogeneous
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320 INDEX Incentive(s), 22, 33, 45,
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322 INDEX Managers, poorly diversif
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324 INDEX Overinvestment, 75, 79, 8
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326 INDEX Reserve(s) (continued) lo
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328 INDEX Risk, liquidity, 3, 165 R
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330 INDEX Sharpe ratio, 244, 252 Sh
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332 INDEX Value at risk (VaR) (cont
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