Please define irrelevance theorem?

[williamhsu]

Please define irrelevance theorem.

 

[David Harper CFA FRM]

Hi William, if you refer to Stulz's "risk management irrelevance proposition," it is the theme of his (unassigned) chapter 2. Importantly, it requires the unrealistic CAPM assumptions.

If CAPM is assumed, he says that risk management (i.e., risk reduction at the firm level) cannot add value because:

• reductions in non-systematic (specific) risk are not priced by investors (no credit in CAPM: investors can diversify on their own), and
• while reductions in systematic risk (i.e., reductions in firm beta) do lower the firm's discount rate, this is EFFICIENTLY offset by a reduction in firm's expected cash flow (no free lunch). So, the lower beta changes firm's risk profile but does not create net present value as cost = benefit.

The theme of assigned chapter 3 is then to show where risk management can create value due to the realistic violations of the efficient market/CAPM (the "frictions") assumptions. Thanks,

 

[muppirisetty]

Dear David Sir,

I am a commerce graduate and working in a bank as Branch Head. Now i am planning to do FRM. i am facing difficulty in understanding the basics...I would request you to please tell me which books to refer to strengthen my basics before starting FRM.

 

[williamhsu]

Hi William, if you refer to Stulz's "risk management irrelevance proposition," it is the theme of his (unassigned) chapter 2. Importantly, it requires the unrealistic CAPM assumptions.

If CAPM is assumed, he says that risk management (i.e., risk reduction at the firm level) cannot add value because:

• reductions in non-systematic (specific) risk are not priced by investors (no credit in CAPM: investors can diversify on their own), and
• while reductions in systematic risk (i.e., reductions in firm beta) do lower the firm's discount rate, this is EFFICIENTLY offset by a reduction in firm's expected cash flow (no free lunch). So, the lower beta changes firm's risk profile but does not create net present value as cost = benefit.

The theme of assigned chapter 3 is then to show where risk management can create value due to the realistic violations of the efficient market/CAPM (the "frictions") assumptions. Thanks,

Hi William, if you refer to Stulz's "risk management irrelevance proposition," it is the theme of his (unassigned) chapter 2. Importantly, it requires the unrealistic CAPM assumptions.

If CAPM is assumed, he says that risk management (i.e., risk reduction at the firm level) cannot add value because:

• reductions in non-systematic (specific) risk are not priced by investors (no credit in CAPM: investors can diversify on their own), and
• while reductions in systematic risk (i.e., reductions in firm beta) do lower the firm's discount rate, this is EFFICIENTLY offset by a reduction in firm's expected cash flow (no free lunch). So, the lower beta changes firm's risk profile but does not create net present value as cost = benefit.

The theme of assigned chapter 3 is then to show where risk management can create value due to the realistic violations of the efficient market/CAPM (the "frictions") assumptions. Thanks,

Hi William, if you refer to Stulz's "risk management irrelevance proposition," it is the theme of his (unassigned) chapter 2. Importantly, it requires the unrealistic CAPM assumptions.

If CAPM is assumed, he says that risk management (i.e., risk reduction at the firm level) cannot add value because:

• reductions in non-systematic (specific) risk are not priced by investors (no credit in CAPM: investors can diversify on their own), and
• while reductions in systematic risk (i.e., reductions in firm beta) do lower the firm's discount rate, this is EFFICIENTLY offset by a reduction in firm's expected cash flow (no free lunch). So, the lower beta changes firm's risk profile but does not create net present value as cost = benefit.

The theme of assigned chapter 3 is then to show where risk management can create value due to the realistic violations of the efficient market/CAPM (the "frictions") assumptions. Thanks,

Hi William, if you refer to Stulz's "risk management irrelevance proposition," it is the theme of his (unassigned) chapter 2. Importantly, it requires the unrealistic CAPM assumptions.

If CAPM is assumed, he says that risk management (i.e., risk reduction at the firm level) cannot add value because:

• reductions in non-systematic (specific) risk are not priced by investors (no credit in CAPM: investors can diversify on their own), and
• while reductions in systematic risk (i.e., reductions in firm beta) do lower the firm's discount rate, this is EFFICIENTLY offset by a reduction in firm's expected cash flow (no free lunch). So, the lower beta changes firm's risk profile but does not create net present value as cost = benefit.

The theme of assigned chapter 3 is then to show where risk management can create value due to the realistic violations of the efficient market/CAPM (the "frictions") assumptions. Thanks,

 

[williamhsu]

Hi David
I cant find the chapter 2 "risk management irrelevance proposition" in the books assigned by GARP. Can you please advise where I can find that chapter reading? Is the chapter in the book "Foundation of Risk Management" or else where. Thanks

William.

 

[David Harper CFA FRM]

Hi William,

Stulz Chapter 2 is here in GARP's digital library (it was assigned in 2011 but dropped in 2012): http://www.garpdigitallibrary.org/display/product.asp?pid=1097
Here are our notes from last year on Stulz Chapter 2: https://www.dropbox.com/s/9j5yc06y4b8lwdr/0921_StulzChapter2Notes.pdf
(which frankly in my opinion is enough, the chapter basically established CAPM (in Stulz characteristically awful and confusing prose), which is covered by Elton now, and the irrelevance theory above (as the key risk implication of CAPM set of assumptions). I hope that helps, thanks,