Topic: Risk management 1. What is risk?

Risk is the standard deviation of returns (): Can be positive or negative Types of risk: Systematic risk - Market and credit risk Idiosyncratic/Non-systematic risk Risk to corporate reputation Operational risks Business risks, Human capital risks, Product liability risks, Environmental liability risks, Third party risks, Business interruption risks, Political risks 2. What is risk management? Goal: Eliminate lower tail outcomes (If shareholders had wanted a riskless investment, they would have/should have simply invested in risk-free government securities) 3. Why manage risk? Managerial self-interest

Non-linearity of taxes

Managers are risk averse and underdiversified wrt their firm-specific wealth and compensation - Require extra compensation to bear this risk - If firm hedges, firm risk is reduced hence lower risk premium is required by managers A reduction in the volatility of taxable income can lower expected taxes for firms with convex effective tax functions Assuming (Constant CFs over x years) = (Volatile CFs over x years)

Costs of financial distress

Smith & Stulz: Hedging narrows the distribution of possible firm-value outcomes Hedging reduces the probability of financial distress and the likelihood that shareholders will find it beneficial to pass up +NPV projects (Myers Underinvestment problem) Froot, Sharfstein and Stein: External financial is more costly than internal financing Hedging can reduce the need for a company to access funds from capital markets Markets are imperfect and have frictions

Existence of financial market imperfections

Maximise market value of shareholders wealth

4. How is risk measured? Value-at-risk Used by Banks Define: Uses a statistical approach to quantify the level of risk that a portfolio of assets may be exposed to unexpected movements in the market When is this measure of risk useful? When the focus is on market prices in the short term (ie. Debt, FX, Derivative markets) VaR is readily applicable to a banks trading book, which is highly liquid and marked-tomarket daily Less useful for firms because: Firms focus on earnings (not on market prices) in a longer term How is this measure used? To set trading limits for individual trading desks (and the sum of exposures of each trading desk = banks exposure as a whole) Problem: NAB options currency desk To set capital adequacy requirements (Used by regulators) To check whether banks have been reporting appropriate VaR Units: VaR of $1million over the next day at a probability of 0.05 => Implies that once every 20days (1/0.05), the firm will lose at least $1million

Capital-at-risk Companies incorporate risk to capital in investment decisions by requiring projects to achieve certain risk-adjusted hurdle rates (WACC) using the traditional NPV method maximizing shareholders wealth Option to manage risk/hedge can be thought of as a Real option. Such options are valuable due to the uncertainty surrounding the investment

5. What is the firms risk exposure? Exposure Clock 6. How to manage/reduce risk? Natural hedging Hedging Only hedge net exposure that have not been hedged by companys natural hedges, since there is a cost to hedging Examine internal and external environment that could put the company at risk

Even if a company has all its revenues and costs in the same currency, it may be essential to manage foreign currency exposure. Why? Consider if competitors are hedging! If a foreign competitor is hedging but our company does not, when the forex turns favourably, foreign competitor can enter market at large discounts that we will not be able to match.