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Questions and Answers
What is the primary goal of risk management?
What type of risk arises from external events such as natural catastrophes or changes in tax or regulatory policies?
What is the measure of risk in finance?
What type of risk is inherent in the operations of the firm and can be managed to a certain extent?
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What is the definition of risk in the context of finance?
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What type of risk can be managed using financial derivatives or other financial contracts?
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What is the primary objective of risk management?
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According to M-M's 'Irrelevance' Theorem, why does risk management not affect firm value?
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How can risk management add value through cash flow effects?
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What is one of the benefits of avoiding underinvestment problem through risk management?
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What is one of the reasons why risk management can increase firm value?
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What is an example of how managerial self-interest can affect risk management?
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Study Notes
Sources of Corporate Risk
- Corporate risk refers to the exposure of a company's earnings, cash flows, or market value to uncertain external factors or events.
- Risk is the uncertainty of outcomes, often measured by standard deviation.
Types of Corporate Risks
- Market risks: price movements in financial markets, including interest rate, exchange rate, and commodity price risks.
- Commercial (or operational) risks: inherent in the operations of the firm, subject to management's control or influence.
- External event risks: not firm-specific, stemming from non-market events such as natural catastrophes or changes in tax or regulatory policies.
Risk Management
- Risk management aims to reduce uncertainty associated with future outcomes, ideally removing bad outcomes without affecting good outcomes.
- The risk management process involves risk identification, risk assessment, selection of appropriate risk management techniques, and implementation and monitoring.
Why Do Firms Manage Risks?
- According to M-M's "Irrelevance" Theorem, in perfect markets, risk management does not affect firm value.
- However, risk management can add value through cash flow effects, WACC effects, non-linearity of taxes, bankruptcy costs, avoiding underinvestment, and managerial concerns.
Does Risk Management Add Value?
- Risk management can increase firm value by:
- Reducing volatility of taxable income, leading to lower expected taxes.
- Lowering the probability of going bankrupt.
- Avoiding underinvestment by reducing the need for costly outside financing.
- Allowing firms to continue investing in value-enhancing projects.
- Addressing managerial self-interest and better monitoring.
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Description
Learn about corporate risk, its definition, and how it affects a company's earnings, cash flows, and market value. Understand the concept of risk in finance and its measurement through standard deviation.
