This study extends the work of liebenberg and hoyt

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This study extends the work of Liebenberg and Hoyt (2003) by examining the equity market response to the firm’s announcement of the hiring of a senior execu- tive overseeing risk management. To our knowledge, previous research has not investigated explanations for the observed cross-sectional differences in the magni- tude of the stock price response to the CRO hiring announcement. Because corpo- rations disclose only minimal details of their risk management programs (Tufano [1996]), our focus on hiring announcements of senior risk officers attempts to measure the valuation impact of the firm’s signaling of an ERM process. The basic premise that ERM is a value-creating activity actually runs coun- ter to modern portfolio theory. Portfolio theory shows that, under certain assump- tions, investors can fully diversify away all firm (or idiosyncratic) risk (Markowitz [1952]). 2 This diversification can be achieved costlessly by randomly adding stocks to an investment portfolio. Because investors can diversify away firm-specific risk, they should not be compensated for bearing such risk (e.g., risks associated with holding an undiversified portfolio). As a result, investors should not value costly attempts by firms to reduce firm-specific risk, particu- larly given an investor’s costless ability to eliminate this type of risk. Thus, under modern portfolio theory, any expenditure on risk management is value destroying and should be negatively perceived by investors. While portfolio theory might suggest a lack of value associated with ERM implementation, markets do not always operate in the manner presented by Mar- kowitz (1952). Stulz (1996, 2003) presents arguments under which risk manage- ment activities could be value increasing for shareholders in the presence of agency costs and market imperfections. The motivation behind Stulz’s work is to reconcile the apparent conflict between current widespread corporate embrace of risk management practices and modern portfolio theory. Stulz (1996, 2003) argues that any potential value-creating role for risk man- agement is in the reduction or elimination of ‘‘costly lower-tail outcomes.’’ Lower-tail outcomes are those events in which a decline in earnings or a large loss would result in severe negative consequences for the firm. Thus, when a firm is faced with the likelihood of lower-tail outcomes, engaging in risk 2. See Markowitz (1952) although the number of papers that have extended this early seminal work is extensive. 315 INFORMATION CONVEYED IN HIRING ANNOUNCEMENTS
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management that reduces the likelihood of real costs associated with such out- comes could represent a positive NPV project. Only firms facing an increased likelihood of these actual negative consequences associated with lower-tail events will benefit from risk management, whereas firms not facing such events will see no benefit at all (Stulz [1996, 2003]) and, indeed, could be destroying value by engaging in costly risk management.
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