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The Actuary The magazine of the Institute & Faculty of Actuaries
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Risk: Show me the money

Why do companies manage risk? By taking steps such as buying hedges or insurance, they may well reduce their profits. The logical explanation for companies’ actions is that managing risk ought to increase shareholder value. We know that hedging, insurance and similar risk management tools can lead to higher shareholder value for a number of reasons; in particular they reduce the likelihood of financial distress and the costs that this brings.

However, decisions about managing risk are made by managers whose objectives may differ from those of shareholders. This article summarises three papers that look at whether risk decisions depend on the incentives and characteristics of managers. In each case, they suggest they do. So, can boards of directors implement governance mechanisms to promote shareholders’ interests above those of managers?

Reviewing the evidence
Peter Tufano (1996) investigated the US and Canadian gold mining industry in 1990-93. He found that 15% of firms sold all their gold at spot prices, with the remaining 85% using financial risk management, in particular hedging, to reduce the impact of future gold prices. He also found 17% of firms shed 40% or more of their gold price risk. Why the differences between firms? Theory suggests that hedging adds more to the shareholder value of firms that are financially weak (and hence susceptible to financial distress), planning large investments (hedging protects internal resources that can fund such plans), or where their tax position is such that higher profits lead to an increased tax rate (meaning that volatile profits increase the tax bill).

However, none of these factors was statistically significant in explaining differences between firms in their management of gold price risk. What was significant, however, was managerial remuneration. If managers had large shareholdings, the firms’ risk reduction tended to be greater — this conserves managers’ wealth. If they had large share options, risk reduction was less — upside risk is of value to options. We should be careful about attributing cause and effect here, as it could be that managers do not seek option-based compensation if they know the firm reduces gold price risk.

Tufano also found that firms with chief financial officers who had longer tenure tended to reduce risk rather less. There was no clear explanation of this, but it supports the idea that managerial characteristics can influence corporate risk management policy.

A possible counterbalance to managerial influence was the existence of external investors, such as institutions, with large blocks of shares. These investors were looking for the profits expected from taking risks, leading firms to hedge less.

A second opinion
Don May (1995) examined whether the risk preferences of managers affected acquisitions, in particular, were the acquisitions diversifying in nature? In deciding if an acquisition was diversifying, May used a number of indicators, such as the covariance of equity returns between bidder and target firms.

Using multivariate analysis of US acquisitions, he found strong evidence suggesting that if the CEO’s equity stake in the firm was a high proportion of his wealth, the firm’s acquisitions tended to be diversifying. This is consistent with the CEO wishing to avoid undue risk to his wealth. However, if the CEO is a specialist in the firm’s existing technology, the acquisitions tended to be non-diversifying, which is logical if there are gains to be made from concentrating in his area of expertise. Moving into a new line of business was associated with poor performance.

Third time’s the charm
Lastly, J.D. Knopf et al (2002) investigated the impact managers’ holdings of shares and share options had on companies’ hedging activities. They found that if the sensitivity of the value of share option portfolios to share price increases was relatively high, firms tended to hedge more. However, if share option portfolios were highly sensitive to share return volatility, firms tended to hedge less — the greater upside risk benefited the value of the managers’ options. It should be noted that the statistical significance of this latter finding was rather weak.

The evidence which these studies use is from US firms. The findings may or may not apply in the UK. However, in light of the issue of bankers’ bonuses, they should make us think about managers’ characteristics and remuneration structures when we consider firms’ risk management strategies, while non-executive directors and regulators should also be alert to the role of managers’ incentives.

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Further reading

>> Knopf, J.D. et al (2002) ‘The volatility and price sensitivities of managerial stock option portfolios and corporate hedging’, Journal of Finance, 57, 2, 801-813.
>> May, D.O. (1995) ‘Do managerial motives influence firm risk reduction strategies?’ Journal of Finance, 50, 4, 1291-1308.
>> Tufano, P. (1996) ‘Who manages risk? An empirical examination of risk management practices in the gold mining industry’, Journal of Finance, 51, 4, 1097-1137

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Christopher O’Brien is a director of the Centre for Risk and Insurance Studies at Nottingham University Business School