Risk management and firm value: recent theory and evidence

• Pages: 56-81
• Date: 07 March 2016
• Published date: 07 March 2016
• DOI: https://doi.org/10.1108/IJAIM-05-2015-0027
• Author: Timothy A Krause,Yiuman Tse
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Risk management and rm

value: recent theory

and evidence

Timothy A. Krause

Black School of Business, Penn State University, Erie,

Pennsylvania, USA, and

Yiuman Tse

Department of Finance, University of Missouri, St. Louis, Missouri, USA

Abstract

Purpose – This paper aims to provide an update to the risk management literature, as it compiles a

survey of 65 recent theoretical and empirical studies on the topic.

Design/methodology/approach – This is a survey paper that summarizes recent theoretical and

empirical research regarding the relationship between risk management and rm value.

Findings – Recent empirical evidence provides support for theoretical propositions in the literature

that risk management increases rm value and returns, while reducing return and cash ow volatility.

The results are largely consistent with early ndings, and there have been signicant empirical

advances that address concerns regarding the endogeneity of risk management practices relative to

corporate nancial decisions. The literature has become broader and deeper, as there are now studies

with larger sample sizes across more industries and geographic areas.

Practical implications – Firms that use sound risk management practices obtain higher valuations,

achieve better nancial performance and experience diminished costs of nancial distress. Recent

research has emerged regarding enterprise risk management and its potential for value creation and

risk reduction.

Originality/value – The paper provides a new compilation and synthesis of recent theoretical and

empirical research in risk management that addresses many of the limitations of prior research.

Keywords Risk management, Derivatives, Firm value, Enterprise risk management

Paper type Literature review

1. Introduction

The relationship between risk management (RM) and rm value has been explored to a

signicant extent in the nance, accounting and information management literature.

Several inuential articles (Stulz, 1984;Smith and Stulz, 1985;Froot et al., 1993) explore

the potential implications of this relationship and provide suggestions for further

research, garnering over 6,000 citations in the process. The purpose of the current study

is to review and synthesize the research conducted since the latest survey of empirical

The authors would like to thank the Editor, Chunhui (Maggie) Liu, and an anonymous referee for

their insightful comments and suggestions that improved the paper substantially. Krause

received support for this research from the Black School of Business at Penn State Erie – The

Behrend College.

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

IJAIM

24,1

56

Received 21 May 2015

Revised 31 May 2015

Accepted 1 June 2015

InternationalJournal of

Accountingand Information

Management

Vol.24 No. 1, 2016

pp.56-81

©Emerald Group Publishing Limited

1834-7649

DOI 10.1108/IJAIM-05-2015-0027

RM studies (Smithson and Simkins, 2005) to summarize the empirical and theoretical

advances that have been made in this area over the past decade.

To provide context for the recent empirical and theoretical studies that we

survey, a brief recap of the early RM theory literature is appropriate. Stulz (1984)

provides the rst attempt to explain optimal rm hedging problems in a

continuous-time theoretical setting. His model posits that rms should implement

active hedging strategies to maximize rm value, not necessarily hedging 100 per

cent of every rm exposure. Smith and Stulz (1985) construct a model to demonstrate

that rms’ hedging decisions should be made in concert with other nancing

decisions. They nd that rms hedge for three reasons: to reduce taxes; to reduce the

costs of nancial distress; and managerial risk aversion. Stulz (1996) summarizes

the results of these papers in a practitioner-friendly, accessible way, providing an

examination of the broad theory of RM that is based on comparative advantage in

risk-bearing. He argues that RM benets three aspects of rm value: by reducing the

variability of cash ows and the potential costs of bankruptcy, by reducing the cost

of capital and by reducing taxes. While academics focus on the variance reduction

aspects of RM, he notes that practitioners seem to focus on the avoidance of

“lower-tail outcomes”. Additionally, managerial compensation structures should be

congured such that companies only take advantage of RM opportunities that

increase shareholder value. Finally, if executives are going to place bets due to their

comparative advantage in RM, managerial performance should be evaluated on a

risk-adjusted basis. As a further follow-up, Stulz (2013) sets out the “rst principles”

of RM that emphasize rms’ comparative advantages in risk-bearing, the use of RM

in an integrated fashion to avoid crippling outcomes, its role as a substitute for

equity and the importance of communication in the implementation of RM systems.

Stulz (2015) applies these prescriptions specically to nancial institutions, given

their importance to the health of the nancial system. He notes that better RM

should lead to better risk-taking, and not simply a reduction in risk.

Froot et al. (1993), in their seminal theoretical study, bring an additional perspective

to the discussion, as they consider the benets of hedging relative to external sources of

nance. One of the implications of their paper is that an optimal hedging strategy does

not completely insulate the rm from marketable price risks, consistent with Stulz (1984

and 1996). Another implication is that rms should hedge less when their cash ows are

highly correlated with future investment opportunities. They also note the importance

of non-linear hedging instruments such as options as more precise instruments to

coordinate investment and nancing plans. They also nd that optimal hedging

strategies should also consider the hedging strategies of a rm’s competitors and the

nature of product market competition. Finally, in a fashion similar to Stulz (1996);Froot

et al. (1994) provides a practitioner-oriented discussion of the main implications of Froot

et al. (1993).

Given the normative theoretical prescriptions of early RM theory, Smithson and

Simkins (2005) survey the empirical work that seeks to answer the question of

whether or not RM contributes to rm value. They nd that company share prices

do reect the value of interest rate RM in nancial institutions, but the results are

less clear when examining industrial companies. With regard to variance

minimization, the evidence is strong that rms using RM tools do experience lower

return and cash ow volatility. Finally, the survey examines a group of papers that

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Risk

management

and rm value