Chapter 23
Risk Management
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Topics in Chapter
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Risk management and stock value
maximization.
Fundamentals of risk management.
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How can risk management increase
the value of a corporation?
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Risk management allows firms to:
Have greater debt capacity, which has a
larger tax shield of interest payments.
Implement the optimal capital budget
without having to raise external equity
in years that would have had low cash
flow due to volatility.
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Risk management allows firms
to:
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Avoid costs of financial distress.
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Weakened relationships with suppliers.
Loss of potential customers.
Distractions to managers.
Utilize comparative advantage in
hedging relative to hedging ability of
investors.
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What is corporate risk
management?

Corporate risk management is the
management of unpredictable events
that would have adverse consequences
for the firm.
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Different Types of Risk
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Speculative risks: Those that offer the
chance of a gain as well as a loss.
Pure risks: Those that offer only the
prospect of a loss.
Demand risks: Those associated with
the demand for a firm’s products or
services.
Input risks: Those associated with a
firm’s input costs.
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Financial risks: Those that result from financial
transactions.
Property risks: Those associated with loss of a firm’s
productive assets.
Personnel risk: Risks that result from human actions.
Environmental risk: Risk associated with polluting
the environment.
Liability risks: Connected with product, service, or
employee liability.
Insurable risks: Those which typically can be
covered by insurance.
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What are the three steps of
corporate risk management?
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Step 1. Identify the risks faced by the
firm.
Step 2. Measure the potential impact of
the identified risks.
Step 3. Decide how each relevant risk
should be dealt with.
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What are some actions that companies
can take to minimize or reduce risk
exposures?
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Transfer risk to an insurance company
by paying periodic premiums.
Transfer functions which produce risk to
third parties.
Purchase derivatives contracts to reduce
input and financial risks.
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Take actions to reduce the probability of
occurrence of adverse events.
Take actions to reduce the magnitude of
the loss associated with adverse events.
Avoid the activities that give rise to risk.
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What is financial risk
exposure?
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Financial risk exposure refers to the risk
inherent in the financial markets due to
price fluctuations.
Example: A firm holds a portfolio of
bonds, interest rates rise, and the value
of the bonds falls.
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What actions can companies take
to reduce property and liability
exposures?
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Both property and liability exposures
can be accommodated by either selfinsurance or passing the risk on to an
insurance company.
The more risk passed on to an insurer,
the higher the cost of the policy.
Insurers like high deductibles, both to
lower their losses and to reduce moral
hazard.
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How can diversification reduce
business risk?
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By appropriately spreading business risk
over several activities or operations, the
firm can significantly reduce the impact
of a single random event on corporate
performance.
Examples: Geographic and product
diversification.
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What is financial risk
exposure?


Financial risk exposure refers to the risk
inherent in the financial markets due to
price fluctuations.
Example: A firm holds a portfolio of
bonds, interest rates rise, and the value
of the bonds falls.
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Financial risk management
concepts
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Duration: Average time to bondholders'
receipt of cash flows, including interest and
principal repayment. Duration is used to help
assess interest rate and reinvestment rate
risks.
Immunization: Process of selecting durations
for bonds in a portfolio such that gains or
losses from reinvestment exactly match gains
or losses from price changes.
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