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60 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
cant financial stakes are involved 25 —that is, they prefer a certain stream of
income to an uncertain stream of income with the same expected value.
Therefore risk-averse investors care about the trade-off between risk and
return—but, since they are assumed to be well-diversified, only with regard
to systematic risks. 26 Hence, they only request a risk premium for taking
these systematic risks, 27 meaning that they are only willing to bear additional
(systematic financial) risk if they are adequately compensated with
higher expected returns.
Risk-averse people, thus, have an incentive to manage (systematic) risk
because doing so—as we have just seen—lowers the expected rate of return
they require to engage in a risky activity. Individual risk aversion 28 can thus
explain the purchase of insurance, but also explains the hedging by small
companies in which a substantial fraction of the owner’s personal wealth
is invested. Risk management at the level of individuals is therefore well
established, and investors have two effective instruments for managing their
risks: asset allocation and diversification. 29 The usage of these two riskmanagement
tools is sufficient for individual investors to achieve their optimal
risk-return trade-off.
However, this logic fails for widely held corporations. 30 Unlike individuals,
it is not clear why a corporation would want to manage its risks. The
organizational form of the modern corporation was developed precisely
to enable entrepreneurs to disperse risk among a large number of small,
but well-diversified shareholders, each of whom bears only a small part of
the risk. Therefore, it is hard to see why corporations themselves also need
to manage the volatility of their income streams. Investors can manage
risks on their own, and there is no reason for the corporation to, for example,
hedge on behalf of the investor. The above assumptions of the
neoclassical world imply that, for firms, investor risk-aversion is a poor reason
for risk management. 31 Because companies cannot systematically make
25 See, for example, Bernstein (1996), pp. 113–114, referring to Bernoulli, who provided
the basis for this analysis in 1738; see Bamberg and Coenenberg (1992), pp.
73+.
26 Given these assumptions, investors can diversify specific risks at no extra cost.
27 See, for example, Bamberg and Coenenberg (1992), pp. 83–84.
28 Methods for determining risk aversion are discussed, for example, by Krahnen et
al. (1997).
29 See Stulz (2000), pp. 2-2–2-3. Asset allocation defines in which assets investors
want to invest their wealth, whereas diversification specifies how their funds are
distributed among these assets to achieve this optimum.
30 See Smith (1995), p. 20.
31 See Fenn et al. (1997), p. 15.