1. Synopsis-Rethinking Risk Management
In this Article the author has suggested another model for corporate risk management other than
variance minimization model i.e. Elimination of costly lower tail outcomes that is designed to
reduce the costs of financial troubles however it preserves a company’s ability to exploit any
comparative advantage in risk bearing. Under this approach some companies may need to hedge all
financial risks while the other need not hedge at all. Risk management changes both capital
structure as well as ownership structure. Also it increases the debt capacity and facilitates larger
equity stakes for management. As per the author, the common measures of risk, Value Added Risk
(VAR) are not useful for risk management in non-financial companies. For Nonfinancial companies,
normally CAR (Cash Flow at Risk) is used. Firms with low debt and high debt rating have zero
probability of default , thus it does not require hedging.
According to various surveys conducted, the extent of hedging would depend on the corporation’s
view on future price movements, and use of derivatives is greater for larger firms than smaller firms.
Though Market efficiency and diversification, hedging financial exposures through normal business
operations can be discouraged. However as per author, A risk management program eliminates the
risk of bankruptcy reduces these costs to zero and thus increase the value of firm. Risk Management
can increase share holder’s wealth in five ways:
1) As discussed above , Risk management can reduce the present value of bankruptcy and
financial distress costs.
2) It can make it more likely that the firm will be able to take advantage of valuable investment
opportunities.
3) It can reduce the present value of taxes paid by corporation.
4) It can increase the firm’s debt capacity.
5) It reduces the cost to stakeholders, large shareholders and managers of bearing firm specific
risk.
Reduces bankruptcy Costs:-
By eliminating the possibility of bankruptcy, it increases the value of firm’s equity by an
amount roughly equal to bankruptcy costs multiplied by the probability of bankruptcy if the
firm remains un hedged .
Reduces Payment to stock Holders:
Hedging makes it easier for the firm to honour its bargain with stakeholders. It can hedge at
lower cost than the monetary compensation it would have to give to stakeholders to offset
the impact on their welfare of the firm’s risk.
Risk Management can Reduce Taxes and increases the debt capacity:

2. Risk Management enables a firm to increase its tax benefits from debt without increasing its
probability of financial distress. A firm can issue more risk free debt and therefore reduce its
present value of tax payments. By having more debt, firms can increase their tax shield from
debt but increase the present value of costs of financial distress. The optimal capital
structure of a firm balances the tax benefits of debt against the cost of financial distress.
Risk Management and comparative Advantage in Risk Taking:
A firm may take decisions regarding selective hedging based on the informational advantages it may
enjoy over the market. Banks in an efficient market can make more money if they have access to
such information before hand. The best approach to adopt in case of deciding whether to take risks
or not is “Risk Taking Audit”.
Risk Management and Capital Structure:
Risk management can be effectively viewed as a technique that allows management to substitute
debt for equity, since risk management enables firms to have a higher debt level and hence a greater
tax shield from debt for any likelihood of financial distress. The firms with higher credit rating and
lower debt ratios are better off using debt financing than equity financing which will help to increase
their leverage and improve efficiency and add value. .
Corporate Risk Taking and Management Incentives:
One way shareholders can ensure that managers are motivated to maximize the value of company’s
shares is through a managerial compensation contract that gives managers a stake in how well a firm
does. If the firm can reduce its risk through hedging , firm values depends on variables that
management controls ; in this case relating compensation to firm value does not force managers to
bear too much risk and dies not induce them to make decisions that are not in the interests of
shareholders to eliminate risks. When managers work hard to increase their compensation, they also
work hard to increase shareholder wealth. A risk management program eliminates sources of
fluctuation in market value due to forces that re not under management control. Saving
compensation enhances value.Managers compensation related to the stock price also can have
adverse implications for managers. Making managerial compensation depend strongly on any part of
stock return that is not under control of management could be counterproductive. Concentrated
ownership, performance measures produced by hedging and possibility of higher leverage add
significant value.
Improving on VAR:
The quantification of probability of lower tail outcomes is done by using VAR(Value at risk). VAR
compresses the expected distribution of bad outcomes into a single number. However VAR has
certain drawbacks:
1) VAR cannot be used to eliminate the lower tail of outcomes.
2) VAR relies on normal distribution thus the probability of lower tail events are not reported
correctly.
Thus one can make use of Monte Carlo simulation to calculate VAR over one year horizon. Si
mulations also incorporate any special properties of cash flows .