Risk Management: Foundations for a Changing Financial World

CHAPTER 34

DOES RISK MANAGEMENT ADD VALUE?^ah

Charles W. Smithson

Press reports on disastrous outcomes from derivatives use have created anxiety about risk-management products. Risk management via derivatives can increase the value of a company, however, by reducing taxes, reducing transaction costs, and facilitating value-maximizing investments. Moreover, preliminary empirical evidence suggests that the market reacts positively when companies use derivatives to reduce their exposure to financial price risk.

The year 1994 was a watershed in risk management. Prior to 1994, many corporate treasurers and chief financial officers hesitated to use risk-management products because they feared that this approach was too subtle and complex for their shareholders to understand. After the first quarter of 1994, some CFOs and treasurers still hesitated to use risk management, now because they feared that if the market found out they were using derivatives, their companies would be penalized; their share prices would fall.

This presentation discusses why and how nonfinancial companies apply risk management and previews some new empirical evidence on how the market reacts to a company’s use of risk management.¹

COMPANY USES OF RISK MANAGEMENT

Companies use risk-management products for a variety of reasons: to reduce their funding costs, to increase their debt capacity, and to increase net cash flows by reducing costs associated with financial distress and bondholder-shareholder conflict. ...