What this chapter is about

Why do companies manage risk? Many people think that the objective is to hedge, i.e. to reduce risk. Clearly that’s not always the case. Companies are in the business of taking risks! Every time a company builds a new factory, embarks on a new product line, invests in new human capital and new lines of R&D, the company is taking a risk, making a bet. Risk management is about these decisions, too. Risk management is about evaluating risks and deciding which are profitable?

We introduce a balance sheet metaphor, with “real” investment and asset management decisions on the left-hand-side of the balance sheet, and financing decisions on the right-hand-side. The interplay between risk and value is fundamentally different between the two sides of the balance sheet.

On the left-hand-side, risk management is all about taking risks. The hard part is evaluating the risks properly. Then, the task is to exploit the evaluation to optimize the management of assets and increase the generation of value.

On the right-hand-side, risk management is all about reducing risk. But not about reducing all risks. It’s about identifying the right risks to hedge. The manager need to develop a dynamic financing strategy, one that is custom tailored so that the risk profile of the financing strategy fits the risk profile of the real asset strategy.

It’s a common mistake to imaging that risk management can directly add to a company’s value. This view supposes that a company can find the right “deal” that gives them the right package of risk and return. But hedging and trading risk seldom adds value to the firm directly. There is an unpublished corollary to the Modigliani-Miller Theorems that says that hedging doesn’t add value to the firm so long as the firm’s investment and operating decisions remain the same. Of course, like the two main MM Theorems, the key to this corollary is in that proviso, "so long as the firm's investment and operating decisions remain the same". If risk management shapes the firm’s investment and operating decisions, then indirectly risk management can add value. The key is identifying these indirect channels correctly.

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