FRM Notes 2011 Unit ID The Value of Risk Management

FRM Notes 2011 Unit ID The Value of Risk Management -...

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Version: January 3, 2011 FIN 7400: Financial Risk Management Unit ID Notes Page 1 of 16 D. M. Chance, LSU I. CONCEPTS OF RISK MANAGEMENT D. The Value of Risk Management Recall that the objective of any firm would be the maximization of shareholder wealth. With that in mind, we must first ask the question of whether risk management can contribute to the maximization of shareholder wealth. In other words, Does risk management add value for shareholders? If the answer is no , then risk management would not be worth doing. Financial Decisions and Shareholder Value First let us recall from the study of corporate finance, the celebrated Modigliani-Miller Propositions: In a world of no taxes or transaction costs, financial decisions are of no value to shareholders. Financial decisions consist of the decision of how much debt to use, called the capital structure decision, and how much to pay in dividends. The reason for this irrelevance of the capital structure and dividend decisions is that the firm can presumably do nothing for the shareholders that they can not do for themselves. If the firm uses less debt than a shareholder wants, the shareholder can borrow to finance the shares he holds, thereby creating personal leverage. If the firm uses more debt than the shareholder wants, the shareholder can hold some of the company’s debt to undo the corporate leverage. If a company pays lower dividends than the shareholder wants, the shareholder can sell some shares and generate cash. If the company pays higher dividends than the shareholder wants, the shareholder can use the funds to buy additional shares. The M&M Propositions in general argue that financial decisions, meaning decisions on the acquisition of funds (or the right-hand side of the balance sheet) are irrelevant . What matters is allocation of funds (the left-hand side of the balance sheet). Companies can add value by investing funds in the markets for products and services in which they have a competitive advantage, thereby generating positive net present values, which increase shareholder wealth. Think of the assets as a pie and the liabilities and capital as the claims on the pie: slicing the pie differently will not make the pie bigger. The goal of the firm is to make the pie bigger. Risk management is generally thought to be a form of financial decision making. Hence, the M&M Propositions would argue that risk management adds no value for shareholders. In some cases, this is true; in others, it is not.
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Version: January 3, 2011 FIN 7400: Financial Risk Management Unit ID Notes Page 2 of 16 D. M. Chance, LSU First consider a pure financial decision: a firm decides to hedge interest rate risk on some of its floating-rate loans. Does this add value? Shareholders could theoretically hedge that risk themselves. But implementing hedges in practice is easier for firms than individuals.
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This note was uploaded on 02/28/2012 for the course FIN 7400 taught by Professor Donchance during the Fall '11 term at LSU.

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FRM Notes 2011 Unit ID The Value of Risk Management -...

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