Economics Update (April-June 1998)

Risk Management Activity on the Rise

R isk management is nothing new. For well over a hundred years farmers have engaged in risk management, hedging against the risks of price fluctuations in agricultural commodity markets.

Unlike a family farmer, however, a corporation is owned by shareholders, who can reduce or eliminate the risk of low prices simply by holding a diversified portfolio. Why, then, do managers find it worthwhile to engage in risk-management activities, doing for shareholders what shareholders apparently can do for themselves?

An article in the Atlanta Fed's Economic Review (First Quarter 1998) looks at various rationales concerning why corporations might engage in risk-management practices. According to authors J. David Cummins, Richard D. Phillips and Stephen D. Smith, the answer must, roughly speaking, lie in one of two areas: either there are some risks that shareholders cannot manage for themselves as inexpensively, or managers are acting in their own interests rather than those of the firms' stockholders.

Some empirical evidence, the authors report, is consistent with the idea that managers use derivative securities, a particular form of risk management, to reduce the volatility of their own income stream. But a growing body of literature suggests that at least some derivatives contracting is related to activities that increase firms' value — for example, avoiding costly external finance and lowering expected tax bills.

Further research on this question is needed, the authors conclude, to get to the heart of whether or not derivatives in particular, and risk-management techniques in general, are being used to enhance firms' value in underlying securities markets or to provide benefits to parties other than the shareholders.

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