What is financial risk?
The exposure of a company’s earnings, cashflow, or market value to external factors (interest rates, credit, market prices, liquidity, FX).
What are the three main ways to mitigate risk?
Hedging (removes upside and downside), Insurance (removes downside, keeps upside), Diversification (averages out firm-specific exposures).
What does M&M’s irrelevance theorem say about risk management?
In perfect capital markets, corporate risk management is a zero-NPV transaction and does not create or destroy shareholder value.
What are the five conditions for M&M irrelevance to apply to risk management?
No financial distress costs, no tax effects, fixed investment policy, investors can manage risk as cheaply as the firm, no information asymmetry.
What is the CAPM argument against corporate risk management?
Shareholders can diversify away idiosyncratic (firm-specific) risk themselves, so firms reducing earnings volatility won’t be rewarded with lower required returns.
What is the difference between systematic and idiosyncratic risk?
Systematic risk (β × R_M) is non-diversifiable market-wide risk. Idiosyncratic risk (ε) is firm-specific and can be diversified away.
What is the underinvestment (debt overhang) problem?
When a firm is in financial distress, equity holders refuse to fund positive-NPV projects because all gains flow to debtholders, not themselves.
How does hedging solve the underinvestment problem?
By stabilising income, hedging ensures the firm avoids financial distress, so equity holders always capture the returns from new investments.
How does risk management reduce tax liabilities?
By stabilising income, firms can fully utilise tax credits. With volatile income, high-income years are fully taxed while low-income years waste credits — increasing expected tax overall.
What did Tufano (1996) find about who manages risk?
Managers with higher share ownership hedged more. Managers with options-heavy compensation hedged significantly less.
What did Bodnar et al. (2019) find?
More risk-averse managers hedge more, especially when compensated with stocks/options (making their personal wealth less diversified).
What did Bartram et al. (2011) find about derivatives use?
Across 6,888 firms in 47 countries, derivative use reduced risk and cash flow volatility, and positively affected firm value — suggesting derivatives are used for risk management, not speculation.
