Adding value with Risk Management

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Hi David,

I have a question regarding the reduction of systematic (i.e. nondiversifiable risk) and its impact on firms:

I've read two separate points which confuse me:

(1) from a previous FRM practice q: "reducing firm systematic risk by strategies that REDUCE costs will INCREASE firm value if costs are LOW enough."

(2) from Kaplan: Financial transactions to decrease fimr's systematic risk will NOT increase firm value --

which is it? Is it to say that there's no value-added to decreasing systematic risk (i.e. beta), because it is not diversifiable?

Thanks!!

 

[David Harper CFA FRM]

Hi shi,

That is an astute comparison. I blame Stulz, who is the assigned source of this confusion (Ch 2 & Ch 3). Both of these are correct, in their own way.

Kaplan's (2) is correct per the hedging irrelevance theorem (beta reduction has no free lunch).
GARP (1) is true as an EXCEPTION to the rule; if the firm can reduce beta more cheaply than the market
… this is the general SOP of Stulz Ch 2 & Ch 3: a general rule (risk management cannot add value) followed by exceptions (except for …)

Re: "Is it to say that there’s no value-added to decreasing systematic risk (i.e. beta), because it is not diversifiable? "
… I would restate, paraphrasing Stulz thusly:

"There is no value-added to decreasing systematic risk because the cost to do so, in theory, should equal the benefit. Unless a firm can find a way (technology, operations; non market) to do it more cheaply than the market would charge"

David