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MIT OpenCourseWarehttp://ocw.mit.edu 15.997 Practice of Finance: Advanced Corporate Risk Management Spring 2009 For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.Lecture Notes on Advanced Corporate Financial Risk Management John E. Parsons and Antonio S. Mello Chapter 1: Introduction 1.1 The Revolution in Risk Management Risk management as it is currently taught is a relatively new field in the domain of finance. Why? What makes it new? Risk has always been at the center of business. Any company that makes an investment, builds a factory, pours dollars into developing a new technology or commits resources to branding a new product is taking on risk. That is how profit is made. And the management of risk isn’t exactly a new line of business. Insurance companies have been around for ages. But risk management in the way it is now practiced in corporations and in how it is taught in business schools is a new field. Something changed; something is different; something is new. The latter half of the twentieth century ushered in a revolution in our understanding of risk. And this understanding wasn’t suddenly pulled out of Zeus’ head fully formed, but was built upon and developed in tandem with new markets in specific risks. From their origins in agricultural commodities and metals in the mid-nineteenth century, the use of futures, options and other derivatives grew and multiplied, first gradually, then exploding in the latter part of the twentieth century. This development provided fertile terrain for the intellectual mastery of new concepts and tools for measuring, pricing and managing risk. And the effort to understand these new markets for risk also benefited from advances in mathematics and economics that made it possible to grapple with the complications presented by the problem. During the first half of the twentieth century corporate finance theory struggled mightily to cope with just two types of financing: debt and equity. Debt was low risk. Equity was high risk. The company’s choice was largely limited to how much debt, how much equity. Then things changed. By the end of the century the risk could be carved up and packaged into more cuts than a side of beef. Highly leveraged transactions created debt that seemed, in terms of risk, to more nearly resemble stock. Warrants and stock options presented us with risk distilled in more and more concentrated forms. Creditors could make their loans repayable in gold or copper or oil.Chapter 1: Introduction Investors could participate in various tranches of mortgages, the level of interest rate risk portioned out in ever higher concentrations as the number of the tranches grew. Participants in the financing of this or that major investment project could assign the various risks to different stakeholders: construction completion risk to one lender, oil price risk to the bondholder, foreign exchange risk to the currency market, operating risk to the equity investor. Modern financial managers have many choices about risk beyond how much debt and how much equity. Even practices that had always been present—such as making the ultimate funding of a credit or investment contingent upon key events or hurdles—suddenly became more subject to careful engineering and management. The contingent events could, in some cases, be precisely specified, their likelihood measured, and the value of the contingency measured in an active marketplace. This is the revolution in risk management. Certain risks now have a market. These risks are subject to careful measurement, valuation and management. Therefore corporations and other economic agents can shape their business decisions, their capital investments, their operating decisions, their product offerings and marketing campaigns to reflect this more precise understanding of risk, its measure and its value. Corporations have more flexibility in shaping their financing plans and their business strategy. And competitive pressures will demand that they exploit this possibility or fail. 1.2 What is Corporate Risk Management? Risk management as a discipline has been developed primarily by and for financial institutions, whether commercial banks, investment banks or other financial intermediaries. A key principle of this course is that the tools and principles developed for banks and other financial intermediaries are useful, indeed, essential tools for non-financial corporations that are the customers of the banks.1 The perspective of non-financial corporations is essentially different than the perspective of financial corporations. Because of the historical development of the field, most courses in risk management are taught from the perspective of the financial corporation, even when they claim to 1 In the field of derivatives a distinct term came to be applied to these non-financial corporations who found themselves deeply involved in these markets for risk: they were called “end-users”. Following some of the early derivatives debacles in the mid-1990s they had even formed their own advocacy and lobbying arm, the End-Users of Derivatives Association. page 2Chapter 1: Introduction be addressing risk management issues generally. This course is different. It is organized specifically for non-financial corporations. How does this different perspective shape the course? First and foremost is the question of “where is value created?” In many courses targeted to investment bankers, the focus is on spotting mispriced securities and profiting from them: so-called arbitrage trading. Value is captured through trading – buying low and selling high. Value isn’t really created. The game is zero-sum. Value is captured by one party at the expense of the other. While the zero-sum game needn’t, indeed oughtn’t, be the end-point of a course for non-financial corporations, it often is. And the value of risk management is often taught to originate from getting the pricing right when others are getting it wrong. The objective is to execute the right arbitrage transaction and end up on the right side of the zero-sum game. Where value is actually created by financial corporations is a complicated subject that we won’t grapple with here. Our concern is with non-financial corporations where the source of value is, generally, easier to comprehend. Non-financial corporations are essentially in the business of taking a bundle of assets— whether plant


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MIT 15 997 - The Revolution in Risk Management

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