[Solution]Why Manage Risk?

Corporate interest in risk management should seem curious, after all: • Classic Portfolio Theory: • investors may eliminate firm-specific risk by diversifying their holdings •…

Corporate interest in risk management should seem curious, after all: • Classic Portfolio Theory: • investors may eliminate firm-specific risk by diversifying their holdings • since firm-specific risk may be eliminated exposure to it is not rewarded by the market • investors should hold a combination of the risk-free asset and the market-portfolio ) firms should not waste resources on risk management as investors do not care about firm-specific risk

• Modigliani-Miller Theorem: • firms should simply maximize expected profits regardless of the risk entailed • holders of securities may achieve risk transfers via appropriate portfolio allocations ) the value of a firm is independent of its risk structure However, the strict conditions required by the Modigliani-Miller theorem are routinely violated in practice: Capital market imperfections, such as taxes and costs of financial distress cause the theorem to fail and create a role for risk management

Bankruptcy costs: if investors see future bankruptcy as a
nontrivial possibility then the cost of bankruptcy will reduce the
current value of the firm. Risk management can increase the
value of the a firm by reducing the probability of default.
• Taxes: Risk management can help reduce taxes by reducing
the volatility of earnings. Lowering the volatility of future
pre-tax income ! lower net present value of future tax
payments ! increase value of the firm.
• Capital Structure and the cost of capital: Risk management
may allow the firm to have a higher debt-to-equity ratio
(riskiness of the firm) which is beneficial if debt financing is
inexpensive. Similarly, proper risk management may allow the
firm to expand more aggressively through debt financing.

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