FRM Powerpoints 2011 Unit ID The Value of Risk Management

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

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I. Concepts of Risk Management D. The Value of Risk Management
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Version: January 3, 2011 Unit I.D The Most Important Question Does risk management create shareholder value? p. 2 of 32
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Version: January 3, 2011 Unit I.D Financial Decisions and Shareholder Value o The 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. p. 3 of 32
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Version: January 3, 2011 Unit I.D Financial Decisions and Shareholder Value (cont.) o The Modigliani-Miller Propositions (cont.) n Value is created only by investing in assets, not by how those assets are financed n Managing risk is often thought of as a financing decision, although this is not completely correct n Can companies create value by hedging, say a floating-rate loan to a fixed-rate loan o Shareholders could possibly do the same hedge o Perhaps companies can do it more effectively p. 4 of 32
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Version: January 3, 2011 Unit I.D Financial Decisions and Shareholder Value (cont.) o The Modigliani-Miller Propositions (cont.) n Some examples of hedging by corporations o Airlines hedging the cost of jet fuel o Mining companies hedging their output n Just shedding risk for no reason is not a good reason to hedge p. 5 of 32
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Version: January 3, 2011 Unit I.D Market Imperfections as Justification for Managing Risk o Taxes n Tax Convexity Example: Consider a firm that produces one product that it sells in a liquid market. The firm lives for one period, generates value from that product, pays its taxes, and liquidates, giving whatever is left over to shareholders. Let the firm’s (progressive) tax schedule be as follows: Income Tax rate $0- 400 25% > $400 30% Note that the tax rate is 25% on the first $400 and 30% on any excess, not 30% on all income if income is over $400. p. 6 of 32
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Version: January 3, 2011 Unit I.D Market Imperfections as Justification for Managing Risk (cont.) o Taxes (cont.) n Tax Convexity (cont.) Let there be the following possible outcomes for a firm. We assume that it generates income in the form of cash, which becomes the value of the firm. It then distributes that cash to its stockholders. Pre-tax Value Prob Tax RateAfter-tax Value $100 0.5 0.25 $100 - $100(0.25) = $75 $500 0.5 0.30 $500 - $400(0.25) - $100(0.30)= $370 The analysis above is on a per share basis. Thus, $100 or $500 is the value per share. We see that the company’s value in one period will be either $75 or $370 with equal probability. p. 7 of 32
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Version: January 3, 2011 Unit I.D Market Imperfections as Justification for Managing Risk (cont.) o Taxes (cont.) n Tax Convexity (cont.) Suppose the risk-free rate is 5%, and investors require an after-tax return of 8%. The value of the firm today is
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FRM Powerpoints 2011 Unit ID The Value of Risk Management -...

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