Where Corporate Risk Management Matters
The commonly accepted idea in the financial world is that any financing action that a company undertakes by itself cannot really add value because an investor can undertake the same action by himself and if the risk management practices are expensive they might just damage the firm’s economic value. This however does not hold in cases where there are financial distress costs, taxes and access to capital markets and there is no asymmetry of information between financial market participants. If any of these things exist then risk management can add value.
Risk management by hedging should increase value in cases where large losses due to events like bankruptcy cause a huge decrease in firm value. In cases such as bankruptcy companies often experience a large drop in value due to forced sales or legal costs of the process.
There are situations where external financing is required when the years are not that good. In normal years this financing happens internally and in bad years if the company decides not to hedge its financial risk it leads to more variability in earnings. Also the fact is that if the external borrowing costs are too high some worthy projects will not be funded in bad years and hedging helps this situation where there is a lack of financing and investment.
Another factor is that of bad management affecting the performance of the company. They are hired from outside the company and have the discretion to run the company as they wish. If they turn out to be good then the damage is not so much, but bad managers have an effect and without risk mitigation there can be side-effects which can make it difficult to identify the quality of management. With hedging bad managers can be identified and action taken against them.
The final situation in which risk management could be useful is when a large shareholder has access to expertise in the firm’s business and this may increase the firm’s value because of the ability to monitor the management more effectively than others. Such people who have a large fraction of their wealth invested in the company would be willing to invest a large amount in the company if the firms risks are managed more effectively.