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Rationales for Risk Management in Banks 65
While keeping in mind that we defined firm value in Equation (2.1) as
a function of the present value of the (expected) cash flow and the appropriate
discount rate, which reflects both the riskiness and the financing
mix of the firm, 66 we need to establish the answer to the question of whether
or not to manage risk at the corporate level along three dimensions (see
Table 3.1).
■
■
■
Is the firm trying to manage risks on behalf of well-diversified investors
or not well-diversified investors (dimension A. versus B. in Table
3.1)?
Is the intended risk management done through financial instruments
or by changes in operations (dimension I. versus II. in Table 3.1)?
Is the corporate risk management aimed at specific or systematic risks
[dimension (1) versus (2) in Table 3.1]?
Let us first turn to a world where firms try to manage risks on behalf
of well-diversified investors (A. in Table 3.1). In this world, for risk management
through financial instruments (I. in Table 3.1) in capital markets
to affect firm value, there are the following four potential scenarios (as
indicated in the first row of Table 3.1 and as depicted in more detail in
Table 3.2).
Let us consider what happens if a firm tries to eliminate specific risks
on behalf of their investors [dimension (1) in Tables 3.1 and 3.2]. Since we
assume in this section that typical investors in the firm are well-diversified,
they will not be concerned with (firm-) specific risks. They can always
eliminate specific risk by diversification on their own (at no cost) and will
therefore not appreciate diversification provided by the firm. Because the
discount rate in Equation (2.1) only depends on systematic risk, the overall
firm value is also not dependent on specific risk. There are two scenarios in
this setting:
TABLE 3.1
Overview of Corporate Risk-Management Scenarios
Investors Risk (1) Specific (2) Systematic
Management Risk Risk
A. Well-diversified I. Financial ❶,❷ ❸,❹
II. Operational ➎ ➏
B. Not well-diversified I. Financial ❼ ❽
II. Operational ➒ ❿
66 See Damodaran (1997), p. 784.