Rethinking Risk Management

This paper presents a theory of corporate risk management that goes beyond the “variance‐minimization” model that long dominated academic discussions of the subject. It argues that the primary goal of risk management is not to dampen swings in corporate earnings, cash flows, or value, but rather to provide protection against the possibility of costly lower‐tail outcomes—situations that would cause financial distress or make a company unable to carry out its investment strategy. In the jargon of finance specialists, risk management can be viewed as the purchase of “well‐out‐of‐the‐money put options” designed to limit downside risk. By eliminating downside risk and reducing the expected costs of financial trouble, risk management can also help a company to achieve both its value‐maximizing capital structure and its optimal ownership structure. For besides increasing corporate debt capacity, the reduction of downside risk also encourages larger equity stakes for managers by shielding their investments from “uncontrollables.” The paper also departs from standard finance theory in suggesting that some companies may have a comparative advantage in bearing certain financial market risks—an advantage that derives from information acquired through their normal business activities. Although such specialized information may lead some companies to take speculative positions in commodities or currencies, it is more likely to encourage “selective” hedging, a practice in which the risk manager's “view” of future price movements influences the percentage of the exposure that is hedged. But to the extent that such view‐taking becomes an accepted part of a company's risk management program, it is important to evaluate managers’ bets on a risk‐adjusted basis and relative to the market. If risk managers want to behave like money managers, they should be evaluated like money managers.