Capm Categorizes Two Types Of Risk

Published Date: 02 Nov 2017

Abstract

This essay will start by defining the key terms; hedging and corporate value in the introduction part. In the main body it will focus on arguments for and against concerning hedging and value of the firm. Finally the conclusion of the literature and empirical evidence drawn by different scholars.

Introduction

According to business dictionary, Hedging can be defined as a risk management strategy used in limiting or offsetting probability of loss from fluctuations in prices of commodities, currencies, or securities. In effect, hedging is a transfer of risk without buying insurance policies. Hedging employs various techniques but, basically involves taking equal and opposite positions in two different markets (such as cash and futures markets). Hedging is used also in protecting one’s capital against effects of inflation through investing in high-yield financial instruments (bonds, notes, and shares), real estate or precious metals.

Literature Review

This essay will look at the literature and empirical evidence presented by different scholars concerning the arguments for and against of corporate risk management relevance and its influence on the company’s value. Modigliani and Miller (1958) show that if markets are perfect and complete the value of the firm is independent of its hedging policy.

Danijela Milos Sprcic et al (2007) revealed that there are two chief classes of rationales for corporate decision to hedge, maximization of shareholders value or maximization of manager’s private utility. Financial theories explain that value of the firm is the net present value (NPV) of its future cash flows discounted by the return required by its investors.

V= ∑ E (NCFt) / (1+k) t.

Where (V) stand for net present value of a firm, (t) is period, (k) investors required rate of return. The higher market value of a firm can either be generated by increasing the future cash flows or by reducing investors’ required rate of return or both. A risk management strategy that increases the NPV at a lower comparative cost would benefit the corporation. The return required by investor is the sum of the risk free rate and a premium for the risk they undertake. If investors hold well-diversified portfolios of investments then they are only exposed to systematic risks as their exposure to firm-specific risk has been diversified away. Therefore, the risk premium of their required return is based on the capital asset pricing model (CAPM).

Return= Rf + (Rm – Rf) ẞ. Where (Rf) stand for risk free rate, (Rm) is return on market portfolio and (ẞ) is beta (measure of share volatility).

CAPM categorizes two types of risk that a firm might face i.e. unsystematic risk and systematic risk. Unsystematic risk is that risk associated with an individual asset and it can be reduced/eliminated through portfolio diversification.Systematic risk is that risk that cannot be diversified away through portfolio diversification rather than hedging.

Since the introduction of the Modigliani and Miller model, many studies have been published that argue that the existence of imperfections in the form of financial distress, tax shields and underinvestment costs lead risk management to increase firm value. They also judge that if corporate hedging decisions are capable of increasing firm values, they can do so by reducing the volatility of cash flows. Also they revealed that, by hedging financial risks firms can decrease cash flows volatility, which leads to a lower variance of firm value. Reduced volatility of cash flows results the following benefits which are considered to be supporting arguments for corporate hedging.

Taxation Costs, (Smith and Stulz, 1985).Hedge may help in reducing the amount of tax that a corporation pays by reducing the volatility of the corporation’s earnings. Where a corporation faces taxation schedules that are progressive (that is the corporation pays proportionally higher amounts of tax as its profits increase), by reducing the volatility of that corporation’s earning and thereby staying in the same law tax bracket will reduce the tax payable. Corporations could often find themselves in situations where they face progressive tax functions, for example, when they have previous losses which are not written off. Or, in the case of multinational corporations, due to the taxation treaties which exist between different countries. The amount of taxation that can be saved depends upon the corporation’s individual circumstances. (Nance et al, 1993).

Insolvency and Financial distress costs, Costs associated with bankruptcy or with breaching debt covenants create a reason for firms to hedge variable revenue and expenditure streams (Smith and Stulz, 1985; Nance, 1993). Leverage (the debt-to-equity ratio) is one common measure of exposure to financial distress costs (Berkman & Bradbury. 1996).When corporation have critical cash flows problem it may find itself in a situation of being insolvency when it cannot meet its financial obligations as they fall due. Evidence for hedging to protect against financial distress costs is found across a range of studies including Smith and Stulz (1985), Geczy et al (1997), and Allayanis and Ofek (2001). Nguyen and Faff (2002) find that distress costs (leverage and liquidity, as well as firm size) are important factors associated with the decisions of large Australian companies to use financial derivatives. Furthermore, once the decision to use derivatives has been made, derivative-based hedging increases as leverage increases. These results extend to the specific use of currency hedging instruments (Nguyen and Faff, 2003). When organization actively manages its risk and prevent or reduce the probability of situations of financial distress, it will find it easier to contract with its shareholders and at a lower cost. Hence, the more volatile the cash flows of a firm, the more likely the need to manage its risk in order to reduce the costs related to financial distress.

Underinvestment costs, Differences in costs of internally generated funds and external funds may lead to under investment. Bessimbinder (1991) finds that shareholders may under-invest in circumstances where gains go mainly to debt holders. Froot, Scharfstein & Stein (1993) demonstrate that hedging can help overcome the underinvestment problem by ensuring a greater, and more dependable, supply of internal funds. Thus, in cases where firms wish to reduce dependence on external funding, hedging should be a positive function of the firm’s investment opportunities. The latter may be proxied by the market-to-book ratio or by the ratio of investment to total expenses. Another common proxy underpinned by an hypothesis that high R&D companies are likely to be fast growth firms, is the ratio of firm R&D expenses to the firm’s total expenses.

Support is forthcoming for the Froot et al (1993) hypothesis from the studies of Adam (2002), which finds that firms hedge to reduce their dependence on external capital markets, and Mello and Parson (2000) who demonstrate that hedging is used as a means to increase financial flexibility by improving liquidity. Evidence for greater hedging by firms heavily involved in R&D is obtained by Allayannis and Ofek (2001).However this variable is not significant in several other studies.

Managerial risk aversion, information asymmetry and governance, Managerial risk aversion provides a reason for managers to hedge and so reduce variance in earnings. For instance, CEO tenure may be affected by a single adverse result, promoting hedging against downside possibilities. Managerial incentives can promote adoption of unhedged, and even of speculative, positions. The latter may occur where remuneration is a convex function of firm value (e.g. via stock options).Where datasets are used that do not include managerial compensation variables,other measures, such as the ownership structure of the firm, may be used to proxy managerial risk aversion effects. For instance, owner-managers may face less risk of dismissal than managers of listed firms. Further, there may be a difference in managerial risk aversion and behaviour according to whether the firm is predominantly foreign or domestically owned.The more volatile that cash flows are, the more difficult it may be for shareholders to monitor manager performance.

Breedan & Viswanath (1998) argue that adoption of risk management practices that reduce the noise in earnings also reduces the noise in the learning process concerning the manager’s capacities. Corporate hedging may therefore be adopted by highly qualified managers to signal their superior abilities.The percentage of shares held by institutions, or by other large shareholders, is one potential measure of information asymmetry. Governance approaches may differ between listed and non-listed firms; hence distinguishing between listing status (and possibly also domestic versus foreign) firms may be a useful proxy for information and/or governance differences. A number of studies find that corporate hedging activity does not increase stock return volatility and so is not considered speculative (Hentschel and Kothari, 2001; Nguyen and Faff, 2002). However, other evidence suggests that management frequently engage in selective hedging (which can be interpreted as tactical or speculative management) of currency and other exposures (De Ceuster et al, 2000).

External Funding and Agency theory, Agency theory extends the analysis of the firm to include separation of ownership and control, and managerial motivation. In the field of corporate risk management agency issues have been shown to influence managerial attitudes toward risk taking and hedging (Smith and Stulz, 1985). Theory also explains a possible mismatch of interest between shareholders, management and debt holders due to asymmetries in earning distribution, which can result in the firm taking too much risk or not engaging in positive net value projects (Mayers and Smith, 1987). Consequently, agency theory implies that defined hedging policies can have important influence on firm value (Fite and Pfleiderer, 1995).

(Myers. S et al 1984) .External financing is generally more costly than internal financing. This is due to transaction costs and information asymmetries associated with those borrowings. Financial distress may make the cost of external debt and equity finding so expensive that a corporation at its management may be forced to reject profitable projects. Therefore, when raising debt capital, a corporation that is subject to low levels of financial distress would face higher agency costs, with lenders imposing higher borrowing costs, and more restrictive covenants. A corporation that faces high levels of financial distress would find it difficult to raise equity capital in order to undertake new investments. Therefore, risk management in reducing financial distress by reducing the volatility of the corporation’s cash inflows may help the management to obtain an optimal mix of debt and equity, and to undertake profitable project.

Size, Judge (2006) found that the size of the firm is positively related to the foreign currency hedging decision, indicating that larger firms are more likely to hedge as compared with smaller firms. This finding is consistent with significant information and transaction cost scale economies of hedging that discourages smaller companies from hedging.

Arguments against hedging in a perfect world market such as that of Modigliani and Miller (1958), suggest that there would almost be no justification for corporations to engage in hedging, including those strategies that use derivatives. However, financial economics offers several hypotheses to explain why corporate hedging can be rational or value-enhancing, each of which relies on some form of market imperfection.

Although there are arguments in favor of hedging, there are both theoretical and practical reasons that organizations do not hedge. First of all, in regards to financial distress, although the shareholders are reluctant to provide additional equity for funding value-adding projects, being in financial distress increases the volatility of the assets. This means that shareholders benefit from the upside variation while lenders undertake the downside risk. These circumstances might deter shareholders from hedging.

Secondly, shareholders are better able than organizations to diversify portfolio risk. An investor's well-diversified portfolio may be unaffected by the financial risks faced by an organization. If investors are better equipped with the skills and expertise to hedge on their own, they should do so. Moreover, if organizations are acting in the best interest of their well-diversified shareholders, hedging is, most of the times, unnecessary.

Thirdly, there is an issue with diversifiable risks in the financial markets. The standard model used to explain the relationship between risk and return, Capital Asset Pricing Model (CAPM), considers the risk free rate (r) plus a risk premium to determine the required rate of return and the beta (b) of each asset to determine the systematic risk, which, however, cannot be removed by diversification. Therefore, hedging changes neither the expected future cash flows nor the required rate of return if the risks being hedged are diversifiable.

Conclusion

As we have seen above the most cited arguments justifying corporate hedging with associated benefits such as the reduction of the financial distress costs, the tax liability, the underinvestment costs as well as the satisfaction of managerial risk aversion. Recently, explanations based on corporate governance and macro-economic characteristics were introduced. Corporate Finance theory models in the real world attempts to determine the added value of hedging in a definite way. Although it makes sense to reduce the volatility of value or the variance of the expected future cash flows by hedging risks in the derivatives markets, theories are not conclusive. Hedging does add value provided financial market risks are not diversifiable. Hedging does add value to an organization that has more debt than equity. These principles should be taken into consideration when evaluating the added value of hedging. Therefore, finance managers and CFOs should not only understand theory, but also its limitations.

Also we have seen some other cited arguments against hedging which are basically derived from perfect world market as per Modigliani and Miller (1958), which are trying to say hedging is of no important due to some factors. (The Modigliani-Miller Theorem) says that mangers cannot increase the value of a firm by undertaking financial transactions that the shareholders can make themselves, Hedging cannot add value, it only uses resources. The reduction in risk might not be sufficiently large to compensate for the reduced cash flow, Agency theory: Management act in their own self-interest. All of these arguments were derived from Markowitz (1952) portfolio selection theory which demonstrated that diversification is the best tool to reduce the unsystematic risk of the entire portfolio.

In general we can sum up the conclusion by saying that hedging is of more important for both financial and non-financial firms since these firms are exposed to risks, unsystematic and systematic risks and not all of these risks are reduced through portfolio diversifications. Therefore, hedging is the best tool which can insure maximum firm value through stabilization of cash flows.