creating firm value with risk management

[sleepybird]

Hi David,
Looking over my notes I found the following 3 sentences in my notes, which seem to contradict each other. Can you why they are correct or incorrect? Thanks. Sleepybird.

1. In a friction-less market, financial transactions to reduce a firm's systematic risk will not increase firm value.
2. Operational changes to reduce a firm's systematic risk may increase firm value.
3. Risk management can create value by reducing diversifiable/idiosyncratic/firm specific risk (i.e., non-systematic risk).

 

[David Harper CFA FRM]

Hi sleepybird,

Your sentences nicely summary, in my opinion, the logical thicket found in Stulz Chapters 2 & 3. You are not the first to wonder about the contradictions. My interpretation of Stulz, not necessarily comprehensive:

• His "straw man" is the theoretical, frictionless world (not unlike M&M, http://en.wikipedia.org/wiki/Modigliani–Miller_theorem). In the frictionless world, value is determined by discounting cash flows with the CAPM, and CAPM only discounts systematic risk (beta), it discounts nothing for idiosyncratic (firm specific). So the theoretical baseline is: CAPM in a frictionless world. In this theoretical state, basically risk management never adds value. Can't add value reducing idiosyncratic risk b/c nobody pays for it; can't add value reducing systemic risk because the cost to do so = benefit (specifically: the cost to reduce beta exactly equals its benefit). So, your statement (1) refers to the frictionless baseline
• Then possible opportunities to add value reduce basically to exceptions and instances where frictions actually exist (e.g., tax is a friction). Your case (2) is possible because reducing beta DOES increase value, by reducing the discount rate per CAPM, and the "exception" is: unlike a short forward contract, an operational improvement may have lower cost than benefit.
• Your case (3) is not something I'd expect the exam to use (per CAPM, right?). More common is: RM reducing diversifiable risk does not create value. But Stulz has some exceptions, namely: a large undiversified shareholder (e.g., private equity firm). They would benefit. They are an "exception" to the theoretical frictionless world (where shareholders are all diversified).

I hope that helps, thanks,

 

[sleepybird]

Hi David,
I have more seemingly contradicting notes. Sorry I didn't know if I should create a new thread since it pertains to different topic but...

1. Consistent (estimator) means the "accuracy of the estimator increases as n increases, i.e., the standard error of the sample mean decreases (I agree). The rate of sampling error has no relation to the sample size; all things being equal, the likelihood of sampling error will be the same regardless of sample size (this seems to contradict?)

2. The sum of two normals is normal (summation stability) and the sum of two lognormal is lognormal, but the product of 2 normals or 2 lognormals are not! (I agree). The product of 2 random lognormal variables is also a random lognormal variable (this seems to contradict?)

Thanks.
Sleepybird