Published On:Monday 19 December 2011
Posted by Muhammad Atif Saeed
Interest rate risk management
The management of risk is a key area within a number of ACCA papers, and exam questions related to this area arecommon. It is vital that students are able to apply risk management techniques, such as using derivative instruments to hedge against risk, and offer advice and recommendations as required by the
scenario in the question. It is also equally important that students understand why corporations manage risk in theory and in practice, because risk management costs money but does it actually add more value to a corporation? This article explores the circumstances where the management of risk may lead to an increase in the value of a corporation.
Risk, in this context, refers to the volatility of returns (both positive and negative) that can be quantified through statistical measures such as probabilities, standard deviations and correlations between different returns. Its management is about decisions made to change the volatility of returns a corporation is exposed to, for example changing a company’s exposure to floating interest rates by swapping them to fixed rates for a fee. Since business is about generating higher returns by undertaking risky projects, important management decisions revolve around which projects to undertake, how they should be financed and whether the volatility of a project’s returns (its risk) should be managed.
scenario in the question. It is also equally important that students understand why corporations manage risk in theory and in practice, because risk management costs money but does it actually add more value to a corporation? This article explores the circumstances where the management of risk may lead to an increase in the value of a corporation.
Risk, in this context, refers to the volatility of returns (both positive and negative) that can be quantified through statistical measures such as probabilities, standard deviations and correlations between different returns. Its management is about decisions made to change the volatility of returns a corporation is exposed to, for example changing a company’s exposure to floating interest rates by swapping them to fixed rates for a fee. Since business is about generating higher returns by undertaking risky projects, important management decisions revolve around which projects to undertake, how they should be financed and whether the volatility of a project’s returns (its risk) should be managed.
The volatility of returns of a project should be managed if it results in increasing the value to a corporation. Given that the market value of a corporation is the net present value (NPV) of its future cash flows discounted by the return required by its investors, then higher market value can either be generated by increasing the
future cash flows or by reducing investors’ required rate of return (or both). A risk management strategy that increases the NPV at a lower comparative cost would benefit the corporation. The return required by investors is the sum of the risk free rate and a premium for the risk they undertake. If investors hold well-diversified portfolios of investments then they are only exposed to systematic risk as their exposure to firm-specific risk has been diversified away. Therefore, the risk premium of their required return is based
on the capital asset pricing model (CAPM).
future cash flows or by reducing investors’ required rate of return (or both). A risk management strategy that increases the NPV at a lower comparative cost would benefit the corporation. The return required by investors is the sum of the risk free rate and a premium for the risk they undertake. If investors hold well-diversified portfolios of investments then they are only exposed to systematic risk as their exposure to firm-specific risk has been diversified away. Therefore, the risk premium of their required return is based
on the capital asset pricing model (CAPM).
Research suggests companies with diverse equity holdings do not increase value by diversifying company specific risk, as their equity holders have already achieved this level of risk diversification. Moreover, risk
management activity designed to transfer systematic risk would not provide additional benefits to a corporation because, in perfect markets, the benefits achieved from risk management activity would at least equal the costs of undertaking such activity. Therefore, in a situation of perfect markets, it may be argued that risk management activity is at best neutral or at worst detrimental because costs would either equal or be more than the benefits accrued. Such an argument would not apply to smaller companies which have
concentrated, non-diversified equity holdings. In this case the equity holders, because they are exposed to both specific and systematic risk, would benefit from risk diversification by the company.
management activity designed to transfer systematic risk would not provide additional benefits to a corporation because, in perfect markets, the benefits achieved from risk management activity would at least equal the costs of undertaking such activity. Therefore, in a situation of perfect markets, it may be argued that risk management activity is at best neutral or at worst detrimental because costs would either equal or be more than the benefits accrued. Such an argument would not apply to smaller companies which have
concentrated, non-diversified equity holdings. In this case the equity holders, because they are exposed to both specific and systematic risk, would benefit from risk diversification by the company.
Therefore, whereas larger companies may not create value from risk management activity, smaller companies can and should undertake risk management. However, empirical research studies have found that risk management is undertaken mostly by larger companies with diverse equity holdings and not by the smaller companies. The accepted reason for this is that the costs related to risk management are large and mostly fixed. Small companies simply can not afford these costs nor can they benefit from the economies of scale that
large companies can. In addition to the ability of larger companies to undertake risk management, market imperfections may provide the motivation for them to do so. Market imperfections that exist in the real world,
as opposed to the perfect world conditions assumed by finance or economic theory, may provide opportunities to reduce volatility in cash flows and thereby reduce the costs imposed on a corporation. The following discussion considers the circumstances which may result in providing such opportunities.
Taxation Risk management may help in reducing the amount of tax that a corporation pays by reducing the volatility of the corporation’s earnings. Where a corporation faces taxation schedules that are progressive (that is the corporation pays proportionally higher amounts of tax as its profits increase), by reducing the variability of that corporation’s earnings and thereby staying in the same low tax bracket will reduce the tax payable. According to academics, corporations could often find themselves in situations where they face progressive tax functions, for example, when they have previous losses which are not written off or, in the case of multinational corporations, due to the taxation treaties which exist between different countries. The amount of taxation that can be saved depends upon the corporation’s individual circumstances. Insolvency and financial distress A corporation may find itself in a situation of being insolvent when it cannot meet
its financial obligations as they fall due. Financial distress is a situation that is less severe than insolvency in that a corporation can operate on a day-to-day basis, but it finds that these operations are difficult to conduct because the parties dealing with it are concerned that it may become insolvent in the future. When facing financial distress a corporation will incur additional costs, both direct and indirect, due to the situation
it is facing. The main indirect costs of financial distress relate to the higher costs of contracting with the corporation’s stakeholders, such as customers, employees and suppliers. For example, customers may demand better warranty schemes or may be reluctant to buy a product due to concerns about the corporation’s ability to fulfil its warranty; employees may demand higher salaries; senior management may ask for golden hellos before agreeing to work for the corporation; and suppliers may be unwilling to offer favourable credit terms.
large companies can. In addition to the ability of larger companies to undertake risk management, market imperfections may provide the motivation for them to do so. Market imperfections that exist in the real world,
as opposed to the perfect world conditions assumed by finance or economic theory, may provide opportunities to reduce volatility in cash flows and thereby reduce the costs imposed on a corporation. The following discussion considers the circumstances which may result in providing such opportunities.
Taxation Risk management may help in reducing the amount of tax that a corporation pays by reducing the volatility of the corporation’s earnings. Where a corporation faces taxation schedules that are progressive (that is the corporation pays proportionally higher amounts of tax as its profits increase), by reducing the variability of that corporation’s earnings and thereby staying in the same low tax bracket will reduce the tax payable. According to academics, corporations could often find themselves in situations where they face progressive tax functions, for example, when they have previous losses which are not written off or, in the case of multinational corporations, due to the taxation treaties which exist between different countries. The amount of taxation that can be saved depends upon the corporation’s individual circumstances. Insolvency and financial distress A corporation may find itself in a situation of being insolvent when it cannot meet
its financial obligations as they fall due. Financial distress is a situation that is less severe than insolvency in that a corporation can operate on a day-to-day basis, but it finds that these operations are difficult to conduct because the parties dealing with it are concerned that it may become insolvent in the future. When facing financial distress a corporation will incur additional costs, both direct and indirect, due to the situation
it is facing. The main indirect costs of financial distress relate to the higher costs of contracting with the corporation’s stakeholders, such as customers, employees and suppliers. For example, customers may demand better warranty schemes or may be reluctant to buy a product due to concerns about the corporation’s ability to fulfil its warranty; employees may demand higher salaries; senior management may ask for golden hellos before agreeing to work for the corporation; and suppliers may be unwilling to offer favourable credit terms.
