Corporate Risk Management: A Theoretical Appraisal

Abstract

This paper shows that under perfect market assumptions hedging is not value maximising. However, the theories of hedging question the validity of the perfect market assumptions and show how their refutation leads to arguments in support of hedging. The theories of hedging argue that an equivalent statement of the Modigliani and Miller proposition is that if financial policy in general - or hedging specifically - is to affect firm value, then it must do so through changes in tax liabilities, through changes in stakeholder contracting costs, or through important interdependencies between the choice of financial policy and future real investment decisions. The paper then makes a distinction between cost reducing and risk reducing risk management activities. Cost reducing strategies are defined as those that make inconsequential the effects of cash flow volatility on firm value and risk reducing strategies are defined as those that lower the volatility of cash flows. It is suggested that cost reducing strategies are not explanations for hedging, but rather controls for substitute forms of hedging. Finally, the circumstances where speculative activity will be value maximising for shareholders are identified. It is argued that in some instances firms have potentially motives for both hedging and speculating and therefore it might not be possible to distinguish between these two activities.

Keywords: Risk Management, Corporate Hedging, Derivatives, Taxes, Financial Distress, Agency Costs

JEL Classification: F3, G3, G30, G32