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Implications of the Previous Theoretical Discussion for This Book 131 In contrast, finance theory based on the neoclassical paradigm offers sophisticated answers as to what “risk-management mechanics” 9 can be used (e.g., calculating the hedge ratio by using Black-Scholes-type models). However, it has less specific answers to the questions that must logically be asked first in order to design a coherent risk-management strategy: 10 ■ Which risks should be hedged and which risks should be left unhedged? ■ To what degree (partially or fully)? 11 ■ What kind of instruments and trading strategies are appropriate? Rather than simply demonstrating that there is a role for risk management, a well-designed strategy—both in terms of the amount of risk management and the instruments used 12 —can enable a firm to maximize its value. 13 We will return to this issue in Chapter 6 when we analyze a metric that is used in banks (Risk-Adjusted Performance Measures = RAPM) to answer the question of whether a risk-management activity creates value. Such a metric is important because managers should be able to identify what is worth hedging. Worrying about stock-price volatility in itself is not worthwhile, because individual investors can better manage this volatility through their portfolio strategies. 14 Also, there is an intertemporal trade-off as to whether the firm should manage the risks of the present value of all cash flows or whether it should insulate the level of cash at each point in time. 15 It is especially interesting how sensitive these cash flows, and hence firm value, are to various risk variables and the changes in the economic environment. Understanding this connection between a company’s investment/growth opportunities and the key economic variables is critical in developing a coherent risk-management strategy because it defines how much hedging is necessary: If there is no correlation between the two, a firm should fully 9 See Froot et al. (1993), p. 1629. 10 See Froot et al. (1993), p. 1629, and Chapter 2. 11 However, even if the above framework comes to the conclusion that it is best to fully hedge, the framework does not address the fact that not all of the risks affecting a firm’s cash flows are marketable and thus can be hedged. 12 Even the best risk-management programs will incur losses in some trades. However, more severe is the opportunity cost for using the wrong instrument and taking positions in derivatives that do not fit well with the corporate strategy, meaning that a (coherent) risk-management strategy needs to be integrated with the overall corporate strategy. 13 See Froot et al. (1993), p. 1631. 14 See Froot et al. (1994), pp. 98–102. 15 See Froot et al. (1993), p. 1655.
132 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS hedge. However, if they are correlated, it might not be necessary for the firm to hedge at all, because the company has a natural hedge already built into its business. 16 Likewise, it is important to understand the impact of fundamental economic/risk factors on the firm value rather than only on the cash flows of specific projects to ensure the long-term survival of the company, to retain its competitiveness, and to meet its strategic objectives. 17 Fourth, the likelihood of default is the central component and forms the foundation for practically all of the potential rationales for conducting risk management in the neoinstitutional world. Its most obvious manifestations are the (expected) costs of financial distress that are the key argument for managing risks at the corporate level, particularly when viewed from a costbenefit perspective, but also because this factor influences almost all of the other components. Therefore, value gains seem to be most profound when a firm tries to avoid the costs of financial distress via risk management. This is especially true for banks for which unexpected external financing needs and financial distress are associated with higher costs (because of the central role of creditworthiness in the provision of financial services 18 and the potential loss of their franchise value) than for industrial corporations. Fifth, therefore, firms, and especially banks, are trying to avoid lowertail outcomes or are trying to decrease the likelihood of their occurrence by using risk management, which results in a (quasi 19 ) risk-averse behavior. Increases in total risk (and not only in the systematic part of it) make it more likely that a firm will end up in a situation where it cannot take advantage of valuable projects. In the neoclassical world with costless and perfect contracting, a firm can always recapitalize at fair market prices. However, 16 Banks can have extremely large “hidden hedge funds” in their portfolios that they might be completely unaware of, because it is an unavoidable consequence of a wider business strategy. Due to the multidimensionality and the complexity of the counterbalancing effects in such large portfolios of risky assets, firm behavior is not always value enhancing, and the practical solutions to risk management do not always increase firm value. See, for example, Drzik et al. (1997), p. 1, and Pritsch and Hommel (1997), p. 685. 17 See Froot et al. (1994), pp. 98–102. Also, risk-management strategies should depend on both (1) the nature of the product market competition and (2) the competitors’ risk-management strategies. For instance, when investment is a “strategic substitute” a firm will want to hedge more when its rival hedges less (as in the product market). However, the overall industry equilibrium will involve some risk management by both firms. When investment is a “strategic complement” (as in the case of research and development, where firms want to invest more when their rivals invest more), firms will want to hedge more when their rivals hedge more. See Froot et al. (1993), pp. 1650–1652. 18 See Mason (1995), p. 28. 19 Firms/banks are not risk-averse themselves.
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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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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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