Abstract
Purpose In the presence of capital market imperfections, risk management at the enterprise level is apt to increase the firm's value to shareholders by reducing costs associated with agency conflicts, external financing, financial distress, and taxes. The purpose of this paper is to provide an accessible and comprehensive account of these rationales for corporate risk management and to give a short overview of the empirical support found in the literature.
Design/methodology/approach The paper outlines the main theories suggesting that corporate risk management can enhance shareholder value and briefly reviews the empirical evidence on these theories.
Findings When there are imperfections in capital markets, corporate hedging can enhance shareholder value through its impact on agency costs, costly external financing, direct and indirect costs of bankruptcy, as well as taxes. More specifically, corporate hedging can alleviate underinvestment and asset substitution problems by reducing the volatility of cash flows, and it can accommodate the risk aversion of undiversified managers and increase the effectiveness of managerial incentive structures through eliminating unsystematic risk. Lower volatility of cash flows also leads to lower bankruptcy costs. Moreover, corporate hedging can also align the availability of internal resources with the need for investment funds, helping firms to avoid costly external financing. Finally, corporate risk management can reduce the corporate tax burden in the presence of convex tax schedules. While there is empirical support for these rationales of hedging at the firm level, the evidence is only modestly supportive, suggesting alternative explanations.
Originality/value The discussed theories and the empirical evidence are described in an accessible way, in part by using numerical examples.
1. Introduction
Nonfinancial firms increasingly employ risk management to shield their performance against financial risks, such as foreign exchange and interest rate risk, as several surveys indicate (e.g. Berkman et al., 1997; Bodnar et al., 1998). Corporate risk management can be implemented in many ways, such as derivatives, foreign currency debt, operative hedging, etc. (Levi, 1996). While risk management at the firm level appears to lower the exposure of firms to exchange rate risk (Allayannis and Ofek, 2001), neo-classical finance theory seems to purport that corporate hedging cannot increase firm value, as explained below. Recent research, however, shows that in the presence of realistic capital market imperfections, i.e. agency costs, costs of external financing, direct and indirect bankruptcy costs, as well as taxes, corporate hedging will enhance shareholder value.
5. Summary and conclusion
In the presence of capital market imperfections, which consist of agency costs, transaction costs, such as bankruptcy and financial distress costs, and taxes, corporate risk management constitutes a means to enhance shareholder value. In particular, hedging at the firm level may reduce agency conflicts between shareholders and bondholders, such as the incentive to invest below optimal levels or the incentive to increase the riskiness of the assets. Also, agency conflicts between shareholders and managers due to different risk preferences can be alleviated via corporate risk management.
