Question:

According to Rene Stulz (Chapter 2 & 3), identify whether the following risk management tactics increase value, and if so, why.

(i) Reduce idiosyncratic (firm-specific) risk
(ii) Reduce systemic risk
(iii) Hedge price risk
(iv) Reduce the costs of financial distress
(v) Shift income to other tax years
(vi) Alter capital structure

Answer:
(i) The general rule is the HEDGING IRRELEVANCE PROPOSITION, which includes the idea that reducing (or eliminating, via hedging) diversifiable (idiosyncratic) risk does not create value. However, the hedging irrelevance proposition holds only when financial markets are pefect. Since financial markets are imperfect, reducing idiosyncratic risk can create value.
(ii) The hedging irrelevance proposition holds that, under perfect markets, investors can achieve their own “homemade” risk management. As such reductions in systematic risk do not create value UNLESS the cost to bear them are less within the firm than in capital markets.
(iii) The default perspective is that hedging price risk does not create value: while it lowers the volatility of future cash flows, it also lowers the firm’s beta. But again, per the central theme of Stulz Chapters 2 and 3, this is the rule that proves the exception. If the firm has financial distress costs (or more specifically, bankruptcy costs), the firm can create value by hedging price risks because this effectively offloads the costs of financial distress to the capital markets which bear the cost at a price of zero.
(iv) In the presence of bankruptcy costs, the risk management irrelevance theorem no longer holds and the firm can increase value.
(v) Per 3.2., risk management can create value by shifting taxable income to lower tax regime (effectively by paying less taxes and increases after-tax profits)
(vi) Yes, per 3.3., increasing the firm’s leverage CAN INDEED CREATE VALUE. That’s because increasing leverage shifts more of the capital structure to a lower cost source of financing. But, normally, that is offset by a higher cost of financial distress; risk management may decrease that cost and allow for greater leverage. (i.e., and lower WACC, such that firm value is higher).

David, I’m confused! For ii) the answer is that reduction in systematic risk does not create value unless the cost is cheaper within the firm than in the market. However, slide 27 diagram shows that reduction in systematic risk increases firm value. Could u pls clarify...Thank you!

FRM_wannabe,

Yes this is confusing, but in my defense, hopefully you will agree: no less confusing than Stulz Chapters 2 & 3, surely two of the most confusing chapters (poorly written, poorly edited) in the history of risk literature ?!

My slide 27 is weak as standalone. Without the speaking, I see how it creates confusion (apologies). I hope you agree when I spoke to it I echoed the same point from Stulz:

“Reducing systematic risk only creates value if benefit exceeds costs”

This is the Stulz logic:

Chapter 2 is about hedging irrelevance proposition; i.e., hedging either systematic or unsystematic (idiosyncratic) risk does not create value under the set of assumptions that includes perfect markets

Chapter 3 is about the exceptions that arise, as the assumptions aren’t true in practice. So, the exceptions include: if the firm can bear systemic costs more cheaply (less expensively) than the capital markets, then hedging systemic risk can create value.

BTW, this “it’s true in theory but not in practice” conundrum parallels the M and M capital structure irrelevance: there the core insight is that capital structure does not matter based on unrealistic assumptions. Then the real-life exceptions to the assumptions give rise to the reasons why in fact capital structure does matter.

David