Why Manage

Risk?

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Erdiyan Angga
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Genta Chreyza
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1
Nissan Internal
 Should a company attempt to
manage its exposure to
financial risk?

Finance theory generally judges policies

whether they increase firm or
shareholder values. If we apply this
yardstick to corporate risk management
activities, we must be able to identify
how these activities create value.

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 Why Manage Risk?

Financial Risk
The exposure of a companys earnings, Cash-flow, or
market value to external factors (interest rates,
exchange rates or commodity prices).
Various Types Of Ways To Mitigate Risk
Hedging (completely eliminates an exposure),
Insurance (provides protection against the financial
effects of unfavorable events but leaves the exposed
party with the potential to benefit from favorable
events), and
Diversification (by holding a large collection of
imperfectly-correlated assets, all exposures except
those common to the pool can be averaged-out)
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 Risk Management Without Imperfection

The most individuals are risk-averse, prefer to hold the

asset with less variable returns.
Risk-averse willing to pay premium (excess of the
fair value of the risk) in advance in order to be
compensated for possible events that would otherwise
destroy they wealth.
Companies would acting in similar manner with risk-
averse.
Individuals hold shares in firms, individuals want to
minimize variability, firms manage their risk higher
shareholder value.

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 Example

Risk Management Without Imperfection

When firms that manage their risk should have a

higher shareholder value, all other factors being equal,
unfortunately, this appealing argument is inconsistent
with finance theory.

Sell 100 metric

tons worth of
Purchase Sell short
aluminum
500,000 BMC 500,000 AMC
forward at
shares at Pb shares at Pa
$1,200 per
metric ton

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 Franco Modigliani and Merton Miller Theory

In 1958 & 1961, Franco Modigliani & Merton Miller (M&M),

establish more general propositions regarding the financial
policies of firms.

M&M proposed that the financial policies of a firm (i.e., debt level
and dividend policy) are irrelevant given the following conditions:

There are no increased costs associated with

a higher likelihood of financial distress,

The policy has no tax effects

The firm has fixed and maintainable

investment policy

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Imperfection that Make Risk
Management Relevant

Financial Distress

Investment Policy

Tax Effects

Transaction Costs

Asymmetric Information

Managerial Concern

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 Financial Distress

A firm can use risk management activities to decrease

the likelihood of financial distress. This policy can create
value if the value that the firm protects in the product
markets is greater than the cost it will pay in the
financial markets for risk protection.

The asymmetry between the impact of the investors

actions and the firms actions with regard to the costs
of financial distress can justify risk management
activities at the corporate level.

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 Investment Policy

In a
difficult
Year

Access capital
Cut back on some
markets for
or all of R&D
external source of
Expenditures
funding

The company may be able to avoid both

alternatives altogether if it reduces the variability
of its cash flows by managing its risks

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 Tax Effect
Thanks to convex tax schedule, the tax on the
average earnings is less than the average tax on the
actual earnings.
Hence, firms facing strongly convex or progressive
tax schedules prefer to use risk management to lock
in their earnings and tax bill.

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 Transaction Costs

If a shareholder cannot get cheap and efficient risk

management transactions as a firm, then the investor
may prefer to have the corporation manage risk.
Individual investors usually pay higher commissions and
fees, and may face significant barriers to entry in some
derivative markets.

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Asymmetric Information

Being transparent of risk management

to the shareholder, shareholder can
set the companys goal.

If the total exposure of the firm to

financial risk is not transparent to
shareholders, they will not be able to
optimally or efficiently manage the
risk themselves.

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 Managerial Concerns

Risk-averse manager tends to do the risk management

intensively.
Risk management can create value for the firm only if;
a) there was no secure contract for the risk-averse
manager; and
b) risk management create more value rather than the
cost it required.

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Corporations may be
able to reduce the Enjoy tax benefits from
likelihood of costly hedging
financial distress

Avoid costly untimely Preempt concerns about

external financing of asset substitution which
necessary strategic lead to costly debt
projects financing

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 LESSON LEARNED
1. The company do not need risk management, if
condition in M&M theory achieved. Why
Manage
2. Company need risk management because of Risk?
uncertainty and imperfections.

3. Before do the risk management, company have to Dealing

calculate the cost they will spend. Compare the with
cost with the profit and make decision whether uncertainty
they will do the risk management or not.

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