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

130 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
market values from risk. 1 Although there are only very narrow empirical
studies that offer some valuable information on what the prevailing (best)
practice is in firms, full hedging is not what we observe in reality. 2
As an example of how unspecific some academic recommendations can
be with regard to risk management, we refer to the following two propositions:
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If risk can be managed at no or at a very low cost 4 it should be. At
worst, risk management will have no effect on value, and at best it
will provide positive feedback effects that will increase value.
If risk can be managed at a cost, it makes sense to hedge the risk
only if the benefits 5 that arise from hedging exceed the costs.
One could also extend these propositions and infer the following (also
from our previous discussion): 6
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Closely held or private firms typically gain more from risk management
than widely held firms with well-diversified investors.
Firms that experience significant agency problems between managers
and shareholders, and between shareholders and bond holders,
are likely to gain more from risk management than firms that do
not.
Firms that are exposed to large indirect bankruptcy costs will gain
the most from risk management. This would imply that banks should
conduct more risk management than industrial corporations, because
they have higher costs associated with financial distress situations. 7
Risk management can help to increase the leverage of corporations
to their optimal debt ratio to minimize the costs of capital. 8
1 See Froot et al. (1993), p. 1630.
2 See also the “Empirical Evidence” section of Chapter 2 for a discussion of this
behavior, which is called selective hedging.
3 See Damodaran (1997), p. 788.
4 Possible instruments are, for example, changes in operations, financial decisions, or
the usage of derivatives.
5 Examples are reduced taxes, increased debt capacity, or better investment decisions.
6 See Damodaran (1997), pp. 788–789.
7 This is implied by both the results of various studies mentioned in “The Costs of
Financial Distress” section of Chapter 3 (see e.g., James (1991)) and the reductions
in market values during the Russian crisis in 1998 that exceeded the credit exposure
of various banks by a multiple.
8 There are two open questions with respect to banks: (1) Why do banks all have
capital ratios around 8%? and (2) Would banks be able to use risk-management
techniques to adjust to the “optimal” capital structure because of regulatory constraints?