Value-Based Motives for Corporate Risk Management

This article provides the theoretical underpinning for why risk should be managed at all and why it should sensibly be managed on the level of the firm rather than by investors themselves. The analysis uses the perfect world of Modigliani-Miller as a starting point of the analysis and establishes in this context that risk management is equivalent to any other change in the firm’s financial structure in its neutral effect on shareholder value. Corporate risk management is subsequently motivated by market imperfections such as asymmetric information, transaction costs, non-neutral taxes and limited access to external financing. A discussion of the empirical literature on derivative usage highlights the practical relevance of the various risk management motives. Hedging as a means of providing sufficient internal funding for vital investments has overall the most intuitive appeal and is also compatible with the widely used Cash-Flow-at-Risk methodology.