Risk Management
Summer 2005, Volume 17.3
A Proposal for Expensing Employee Compensatory Stock Options for Financial Reporting Purposes
This approach to stock option accounting views the employee as owning a 90-day option (no matter the stated maturity) and earning a 90-day extension to that option for each quarter of continued employment. It enables the use of publicly traded options to determine fair value, makes Black-Scholes pricing more reliable, and eliminates adjustments for early exercise and employee attrition.
Capital Allocation in Financial Firms
A line of business's cost of capital includes a deadweight cost that reflects its marginal contribution to firm-wide risk. By diversifying across businesses with similar deadweight costs, financial firms can reduce the cost of risk capital for the individual businesses, making investment opportunities more profitable at the margin and enabling the businesses to operate on a larger scale.
Does Risk Management Add Value? A Survey of the Evidence
The use of derivatives is associated with lower sensitivity of stock returns to interest rate and FX movements. But does reduced price sensitivity increase shareholder value? This survey of almost 30 years of academic research finds a link between lower cash flow volatility and higher corporate investment and market values—and in industries where hedging is common, hedgers outperform non-hedgers.
Exchange Rate Exposure of Exporting and Importing Firms
While a strong dollar hurts exports, it often reflects a strong local market and higher domestic sales. The net effect for an exporter could be close to zero. For importers, however, a weak dollar can have a “doubly” negative effect because of higher import prices and a weaker local economy. As a result, importers—in contrast with exporters—are likely to have significant currency exposure.
Exposure-Based Cash-Flow-at-Risk: An Alternative to VaR for Industrial Companies
Like VaR in financial institutions, Cash-Flow-at-Risk sums up a company’s risk exposures in a single number that can help guide corporate risk management decisions. CFaR measures cash flow variability as a function of various macroeconomic and market risks to determine the elements of a company’s risk profile. The technique is illustrated using the case of Norsk Hydro.
FAS 133: What Is Accounting Truth?
Besides being expensive to implement and difficult to follow, FAS 133 causes accounting treatment to diverge markedly from economic reality, introducing artificial volatility into earnings and discouraging companies from hedging. Companies should make sensible hedging decisions and then provide supplemental earnings disclosure to explain how they conceptualize, measure, and manage risk.
Market Efficiency versus Behavioral Finance: A Discussion
Two prominent economists—one the author of "A Random Walk Down Wall Street" and the other a behavioral finance scholar from Harvard—debate the efficient markets hypothesis in light of recent evidence on investor and market behavior. Their seemingly disparate views lead to important areas of common ground, including the recommendation that individual investors should stick to broad-based index funds.
Morgan Stanley Roundtable on Enterprise Risk Management and Corporate Strategy
For many companies, risk management has become a matter of strategic scope and importance. This discussion among a group of corporate risk officers, consultants, and bankers addresses the goals of enterprise risk management; the extent to which ERM adds shareholder value; which risks a company is in business to bear and which risks it should transfer; and effective disclosure under FAS 133.
Risk Management, Risk Capital, and the Cost of Capital
An earlier Journal article suggested that hedging “releases” equity, but underestimated the cost of capital by including the released equity in the capital base. This article shows how conventional cost of capital calculations can be modified to integrate risk capital, thereby accurately representing the cost of capital for a company with a policy of active risk management.
Statement 133: Not Perfect, but a Step in the Right Direction
While FAS 133 results in balance sheets that offer a clearer picture of corporate derivatives positions, it has come under fire for increasing earnings volatility. Until the FASB adopts fair value accounting for all assets and liabilities—eliminating hedge accounting and its related complexity—it will remain the job of analysts to undo FAS 133’s murky disclosure and determine “normalized” earnings.
The Rise and Evolution of the Chief Risk Officer: Enterprise Risk Management at Hydro One
This article describes the five-year implementation of enterprise risk management at Hydro One, a Canadian electric utility in a newly deregulated market. Among the most tangible benefits were a better-coordinated and more effective capital allocation process and a favorable response from the rating agencies. Hydro One is now better positioned to respond to new business developments.
The Uses and Abuses of Finite Risk Reinsurance
Finite risk products are designed to help companies manage exotic or “tail” risks, such as environmental claims, clean-up costs, or old liabilities in a merger or acquisition. Although finite risk solutions have recently prompted investigations and litigation, they can provide a credible and transparent method of capping liabilities and eliminating the possibility of reserve manipulation.
The views and opinions expressed in the Journal do not necessarily represent those of Morgan Stanley or its affiliates.
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For close to 20 years, the Journal of Applied Corporate Finance has distinguished itself as a unique forum for addressing the topics that drive corporate value. Featuring articles by top academic thinkers and financial practitioners, this quarterly publication presents the practical application of the best current research in finance.
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