The Role of Theory in Explaining Corporate Risk Management Practice - Coursework Example

Evaluate the role of theory in explaining corporate risk management practice A risk is some future happening that results in a change in the environment. It has associated with it a loss that can be estimated, a probability that the event will occur, which can be estimated, and a choice on the management’s part as to what to do, if anything, to mitigate the risk and reduce the loss that will occur. The business decision is to assess how the expected loss compares to the cost of defraying all or some of the loss and then taking the appropriate action. Corporate Risk management is a broad and deep topic in economics, and we are only able to brush the surface in this essay by discussing the different theories related to risk management. There has been a vivid changes occur in the functions of risk management in corporations. In the past risk management was known as the activities connected with the purchase of insurance. Treasurers also carried out the duty of risk management, but their focus was on prevarication interest rate and foreign exchange risks. With the passage of time, corporations have taken into account other types of risk. On the other hand, corporations started to pay more attention to operational risk and reputation risk. Presently, strategic risks have been added to the categories of risks. The duties of the board in examining risk measures and setting restrictions for these measures are greater than before at many corporations. By risk management, a firm can decrease the chances of large unfavorable cash flow deficits. With the help of hedging, organizations can get rid of their experience to many risks at low cost. For example, a foreign exchange hedging program that makes use of forward contracts has usually very low transaction costs. If the hedging is inexpensive, then there is no good economic explanation for an organization not to hedge economic risks if it faces the risk of cash flow deficits that could force it to give up important projects. Many corporations face risks that they cannot beneficially arrange in the capital markets or other urbanized risk transfer markets. We can better explain it with the help of an example, an organization that discovers a mode to develop its business beneficially cannot hedge economically many of the risks from doing so. The organization recognizes the risks from the development superior than anybody else. If it finds a technique to hedge these risks, its hedging costs will be increased because possible counterparties will want to be compensated for trading with an improved knowledgeable party and for building models to judge the risks they would hedge. Agency Theory: Agency theory is one of the most instructive, practical, and attractive theories, that are the part of the economics. It is definitely also one of the most dominant econ theories in the corporate risk management. According to the (Eisenhardt, 1985), Agency theory clarifies how to best put in order contacts in which one party (that is called Principal) decides the work, which another party (that is known as agent) assumes. The theory says that under circumstances of imperfect information and ambiguity, which distinguish most business settings, two agency problems happen, one is adverse selection and other is moral hazard. Adverse selection is the circumstance under which the principal cannot determine if an agent correctly characterizes its capability to do the work for which he is being paid. On the other hand, Moral hazard is the circumstance under which the principal may not be confident if the agent has put forth maximal attempt. Agents are likely to have different purposes to principals. Some factors such as financial rewards, labor market opportunities, and relationships with other parties can be influenced to these agents. For example, result in a propensity for agents to be more hopeful about the economic routines and progress of an entity or their performance under an agreement than the reality would propose. Agents may also be more risk reluctant than principals. As a result of these conflicting interests, agents may have an inducement to bias information flows. Principals may also state concerns about information asymmetries where agents are in possession of information to which principals do not have right to use. According to Agency theory, in defective labor and capital markets, managers will look for making the most of their own utility at the expenditure of corporate shareholders. Agents have the capability to perform a functions in their own self-interest instead of the best interests of the organization because of asymmetric information for example, managers be familiar with superior than shareholders whether they are accomplished of meeting the shareholders objectives and doubt. Support of self-interested managerial behavior consists of the utilization of some corporate capital in the form of perquisites and the prevention of best possible risk positions, whereby risk-averse managers’ go around money-making opportunities in which the firms shareholders would favor they invest. Outside investors are familiar with that the firm will make decisions different to their best interests. For that reason, investors will markdown the prices they are agreeable to pay for the firms securities. Advantage of Agency Theory: When supply improbability becomes an important factor, the application of agency theory proposes that the purchasing organization hold management efforts that decrease the probability and force of a unfavorable event on the firm. The proper risk reduction strategies can be classified as behavior-based management efforts or buffer-oriented methods to protect the organization from damaging events. Signaling Theory: Signaling is the suggestion that agent pass on some meaningful information about itself to the Principal. For instance, in Michael Spences job-market signaling representation, staff signals the rank of their skills to employers by obtaining a definite degree of education. Signaling used an idea of asymmetric information (Symmetric information are deviate from the actual information), which suggests that in some financial transactions, dissimilarities in access to information distress the normal market for the trade of goods and services. According to (Michael, 1973), two parties could get around the crisis of asymmetric information by having one party send a signal that would make known some piece of applicable information to the other party. That party would then understand the signal and regulate their buying behavior in view of that usually by offering a higher price than if they had not received the signal. There are also many problems that both parties would instantaneously run into. For example estimating the time, energy, or money that should the agent spends on sending the signal. Presumptuous that, there is a signaling symmetry under which the agent signals frankly and the principal trusts that information, under what conditions will that symmetry smash? Potential employees look for to sell their services to employers for some remuneration, or price. In general, employers are enthusiastic to pay higher salary to employ better workers. Since employers are not for all time able to scrutinize potential employees’ abilities and output, they use education as a method to guess the skills of potential employees. The fundamental use of signalling is that when a firm modifies its capital structure, its market value might change which may be resulting in changes in the firms degree of systematic risk. The results point out that industry average debt ratio has a positive signalling consequence for the medium systematic risk firms only and that liquidity, profitability, timing of equity issuance and financial elasticity are the factors which have to be taken seriously when making debt financing decisions. So, signalling theory helps the firms create more profits financing from the stock market. Capital Market Theory: The Capital Market theory was offered by a Nobel Prize winner William Sharpe, there were two more economists, John Virgil Lintner and Jan Mossin, who arrived to related asset pricing models separately. Since the capital market theory prolongs effectively where the Markowitz portfolio theory left off. It is considered that competent investors will always have access to borrowed funds, or, at the very least, have the capability to lend funds at the risk-free rate of return. However, there might be concerns with borrowing funds at the risk-free rate. It is definitely likely to do so, but borrowing at the risk-free rate also supposes no turnover from the costs of borrowing for the lender. Obviously, there will have to be other methods to balance the lender, which may effect in limited ease of use of borrowed funds at the risk-free rate. The capital market theory also supposes that all investors have approximately the same opportunities of future rates of return, that they activate within similar investment periods, and that there are no tax or transaction costs included when calculating the required rates of return. As a final point, the capital market theory believes that capital markets are in stable state, which means that all the supply has met all the demand and that all assets on the capital market line have been appropriately priced on the base of their risk-adjusted. This also means that there is either no price rises or that effect of inflation have been entirely predictable. Contingency Theory: Contingency theory represents to any of a number of management theories. Behind the 1960s numerous contingency theories were developed parallel. These theories suggested that the previous theories such as Webers bureaucracy and Taylors scientific management had unsuccessful because they abandoned that management style and organizational arrangement were prejudiced by a variety of aspects of the situation the contingency aspects. There could not be one most excellent way for management or organization. In the past, contingency theory has required putting together wide generalizations about the formal structures that are classically connected with or best fit the use of different technologies. According to (Joan Woodward, 1958), who given argument that technologies openly determine differences in such organizational attributes as extent of control, centralization of right, and the formalization of rules and actions. According to (Lawrence and Lorsch, 1967), in a study of ten organizations in three different industrial situations plastics, food, and containers in the United States, that the degree of improbability in the three task sub-environments of the firms was strongly connected to their inner organizational arrangement. According to contingency theory, there is no one best way to manage and that to be effective, planning, organizing, leading, and controlling and these elements must be tailored to the fastidious situations faced by an organization. The contingency theory assumes that there is no general answer to such questions: for example, what is the right thing to do and what will be wrong? Should we use a mechanistic or an organic structure? Should we adopt functional or divisional structure? Should we adopt wide or narrow spans of management? Should we adopt tall or flat organizational structures? Should we be centralized? Should we make use of task or people oriented leadership styles? What motivational methods and incentive programs should we use? The Answers to these questions depends upon organizations, people, and situations differ and change over time. Thus, the right thing to do depends on a multifaceted range of critical environmental and internal contingencies. What technique and ways should be adopted in risk management depends upon the level of risk. Expected Utility Theory: The expected utility theory is the hypothesis in economics that outlines that the utility of an agent facing uncertainty is measured by bearing in mind utility in each possible state and constructing a weighted average. The weights are the agents guess of the chance of each state. The expected utility is thus a hope in terms of probability theory. To resolve utility according to this method, the decision maker must order their preferences according to the results of a variety of decision options. According to the theory, if someone like better A to B and B to C, then weights for the weighted average must be present such that she is unresponsive between receiving B absolute and gambling with the particular weights between A and C. According to (Daniel Bernoulli, 1738), expected utility hypothesis is a method to resolve the St. Petersburg Paradox. This was published by Von Neumann and Morgenstern in their Theory of Games and Economic Behavior in 1944. It is significant because it was developed soon after the Hicks-Allen ordinal revolution of the 1930s, and it invigorated the thought of cardinal utility in economic theory. Economics has not determined whether utility is cardinal or ordinal. This theory uses an idea of risk-aversion comes into play in many gambling circumstances, such as poker strategy. A risk-neutral posture is normally the best strategy in most circumstances, as it efforts to make the most of the expected value of each bet. However, there are circumstances where different strategies will be more advantageous. For example, many specialists support a risk-averse strategy in the early phases of a poker tournament, when there are still a lot of players left. As the tournament go forward, a more risk-neutral or even risk-acceptant strategy becomes the most favorable play. This change in approach is due to the difference between predictable value and likely utility in tournament poker. If a player has only a small number of chips left over, they should start to make larger and more recurrent bets, and consequently take on more risk, because this is the only method that offers them a possibility to rapidly amass a large number of chips, which will be essential in order to have achievement in the tournament. A risk-averse strategy may come into view to be a good method of protecting a players remaining chips, but due to the increasing blinds, this method usually decreases the players probability of finishing in the money for the tournament. We discuss an example to better understand risk management function: Suppose that an experimental subject discards the 50-50, lose $100, gain $110 gamble. Also suppose that this subject has exogenous risky income with a mean value of $10,000. If the subject does not put together the endogenous and exogenous risks then there is no insinuation of ludicrous large-stakes risk aversion. Thus we will here focus on the case where the subject is considered to put together the endogenous and exogenous risky incomes. If the risky incomes are incorporated by addition, does concavity essentially have an indefensible implication? Does small-stakes risk aversion that is endogenous to an experiment, collectively with exogenous large-stakes risky income; have calibration-theorem-like implications for large-stakes risk aversion? Let suppose random variables, X and Y represents the exogenous and endogenous risky incomes. The risky income that is considered to be endogenous to an experiment is the 50-50, lose $100, increase $110 gamble. The exogenous income is considered to have a log-normal allocation with mean of $10,000 and variance of $90,000. Suppose the von Neumann-Morgenstern function that values sums of amounts of income, y x + according to: “Source: James C. Cox. 2002. Risk Aversion and Expected Utility Theory: Coherence for Small- and Large-Stakes Gambles” It is uncomplicated to explain that above equation and the considered log-normal distribution of X implies that the agent will reject the 50-50, lose $100, gain $110 gamble. Does the agent have sensible large-stakes risk aversion? The answer is Yes, the smallest amount increase that would be essential to get a decision-maker with expected utility function including and the considered log-concave allocation of exogenous income to acknowledge a gamble with 0.5 probability of losing $20,000, and 0.5 probability of getting the gain, is a gain equal to $44,000. Portfolio Theory: Portfolio theory was offered by Harry Markowitz with his paper "Portfolio Selection," which came into view in the 1952 Journal of Finance. After Thirty-eight years, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a wide theory for portfolio selection. Investors paid attention on assessing the risks and rewards of individual securities in constructing their portfolios before the Markowitz offered his theory. Typical investment recommendation was to recognize those securities that offered the best opportunities for increase with the least risk and then construct a portfolio from these. Following this recommendations, an investor might terminate that railroad stocks all offered good risk-reward characteristics and compile a portfolio completely from these. Instinctively, this would be foolish. Markowitz dignified this instinct. For example, the average return on the risky asset is lower than the average return on safe asset. Putting more of the portfolio into bank deposits both increase the portfolio return and reduces the risk of variability of the return on the whole portfolio into the safe asset. Portfolio theory uses a market portfolio to represent a theoretical notion. Suppose a universe of risky investments available to an investor. The market portfolio has issues weighted proportionality to the whole market value of that subject outstanding in the market. For instance, if we suppose all the stocks that contain the S&P 500 stock index as our universe, then S&P 500 index fund would correspond to a market portfolio. A sensible deficiency of the concept of a market portfolio is the truth that it depends upon the universe of risky assets considered. In many circumstances, this is inadequate to domestic equities, but it could be included international equities, debt, real estate, etc. Beta is used to measure the systematic risk of a single instrument or a whole portfolio. The formula for this notion is given below: Ion the above equation, Cov (Zp,Zm) is the covariance between the portfolio return and the market return, while is the variance of the markets return. To consider buying the risky asset, the investor must believe the average return on the risky asset exceeds the average return on the safe asset. Suppose this is the case. How much of the portfolio will be put into the risky asset? It all depends how risky the risky asset is how big the differential is between the average return on the two assets. Generally, however the fraction of the portfolio held in the risky asset will be higher 1. The higher the average return on the risky asset compare with the safe asset. 2. The less risky is the risky asset. 3. The less risk averse I the investor. Financial and Assets Pricing Theory: Asset pricing theory grasps that the estimated return of a financial asset can be modeled as a linear function of a variety of macro-economic factors or theoretical market indices, where compassion to changes in each factor is symbolized by a factor-specific beta coefficient. The model-derived rate of return will then be used to price the asset properly, the asset price should equivalent the estimated end of period price discounted at the rate implied by model. If the price deviates, arbitrage should get it back into line. Risk can be developed by first considering a single asset held in isolation. Sensitively analysis and probability distributions can be used to assess the general level of risk embodied in a given asset. Financial theories are the basics for understanding the function of finance in markets. It is a mode of calculating investment value and risk and return on investment. Some of the theories comprise foreign currency transactions, value at risk and portfolio theory, which is the foundation of investment study. A best example of investment study is the CAPM model. it stands for Capital Asset Pricing Model. This is basis to all finance theory. The CAPM model tries to give details of relationship between risk and return on investment. This risk comprises both systematic and unsystematic risk. Below is the formula for CAPM: RE = RF + Beta (RM – RF) In the above formula, RF is the risk free rate. This is the rate that the investor gets for no risk. RM is the risk of the market as a total in general. RE is the expected return incorporating the risk free rate, market risk and beta value. The goal of risk management is to categorize, control and minimize the financial impact of events that cannot be guessed. By reducing potential risk, a company can reduce the potential loss related with that risk. References: Begg, David K. H. (1997). Economics. Fifth Ed. Berkshire. McGraw-Hill. Debreu, G. (1959). Theory of Value. New York: Wiley. Epstein, L. Zin, S. (2001). The Independence Axiom and Asset Returns. Journal of Empirical Finance 8. 537-572. Lawrence j. Gitman. (2000). Principles of Managerial Finance. Tenth Ed. San Diego State University. Robert, K. Wys. (2000). Effective Project Management. Robert, C. (1993). Operation and regulation in financial intermediation: A functional perspective, in Operation and Regulation of Financial Markets. Read More