Risk Management Theory : Equity Value

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Risk management theory can be divided in two competing approaches: equity value maximising strategies and strategies determined by managerial risk aversion. The first category suggests that hedging can increase the market value of equity and that companies should be concerned with total risk rather than systematic risk. There is, however, no comprehensive framework for explaining risk management within the imperfect financial environment in which firms operate. Therefore, it is not possible to draw undisputed conclusions on the value maximising risk management policy. Assuming imperfect capital markets, hedging theory suggests the following policies to maximise the market value of equity: Assuming no transaction costs, a constant volume of…show more content…
If the firm’s primary concern is to reduce the costs of financial distress and it can faithfully communicate its true probability of default, the firm should minimise the likelihood of the firm value falling below the market value of debt and/or avoid cash flow shortfall. If hedging is prompted to reduce the demand for costly external finance and the investment volume is independent of the risk factor(s), the firm should perfectly hedge all hedge able risks to minimise cash flow variability. If the firm wants to minimise the demand for external finance and the optimal investment volume is perfectly correlated with the risk factor(s), the firm has a natural hedge and, therefore, does not need to manage risk actively. If external debt has to be raised, the company should minimise contracting costs. To achieve this goal, the firm can faithfully define a conservative risk management policy by bond covenants or reputation building, it can choose preferred stock or convertible debt instead of straight debt and it can constrain its dividend payments. Once the hedging policy is identified, the firm has to trade-off hedging costs and the benefits of hedging (Fok, 1997). The competing approach to value enhancing risk management techniques claims that managers will maximise their expected utility rather than the market value of equity. This approach may have other implications for risk management,
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