Paper Sample: Corporate Risk Management Tools for Creating Shareholder Value

In the business environment, if an entity builds its corporations image, the value of its shareholder also improves. As a result, the price or cost allocated to the companys stock also rises. To achieve this objective, most companies adopt financial risk management techniques to protect themselves from risks that may result in the downfall of their shareholders value. One of the most effective methods of corporate risk management is corporate hedging. This essay is a discussion of why corporate hedging can be used as a tool for improving the shareholders value in a corporation by employing it as a corporate risk management strategy in a capital market characterized with imperfections.

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Corporate Hedging as a Tool for Creating the Shareholders Value

In a business setting, the term hedging refers to the creation of an investment as a strategy for reducing the risk great price fluctuations in an asset. It is a great tool for risk management that is employed by corporations to enhance shareholders value by reducing the costs associated with financial distress, agency conflicts, taxes as well as external financing (Bartram et al., 2011). In response to a publication authored by Aretz et al., (2010), it is true to state that corporate hedging enhances the shareholders value in a business. This phenomenon is developed on the premise that instead of spending substantial efforts in raising the prices of dividends, corporate managers should strive to enhance the corporations image. As such, as the value of the companys image improves, so does its value in its shares.

In a corporate setting, corporate hedging can improve and lessen asset substitution problem as well as under-investment (Aretz et al., 2010). This is through the reduction in the volatility of cash flows. Corporate hedging can also manage the aversion of risk caused by undiversified managers. It also enhances the effectiveness of managerial incentive structures via its potential to eradicate unsystematic risks (Campbell et al., 1990). In addition, it helps in lowering the volatility of cash flows as well as in lowering of bankruptcy cost (Disatnik, Duchin & Schmidt, 2014). In addition, it can also align the availability of internal financial resources in a corporation, and thus help a corporation to avoid expensive external financing. Ultimately, corporate hedging can help in the reduction of corporate tax burden when faced with convex tax schedules.

In the presence of various imperfections in the capital market, costs such as agency costs, direct and indirect costs of bankruptcy, financial distress costs, transaction costs, and taxes constitute ways of enhancing the shareholders value. However, to minimize the costs incurred in promoting the shareholders value in a corporation, hedging as a risk management strategy should be employed (Fatemi & Luft, 2002). In addition, in a corporation, hedging can be used as a way of reducing conflicts between shareholders and bondholders. Such conflicts may be caused by differences in investment decisions. In addition, hedging can also be used to manage the companys conflicts that may be caused by managers and shareholders due to various risk preferences.

In addition, corporate hedging can also increase the value of a company by minimizing the various forms of transaction costs. For example, corporate hedging can be used to minimize cash flows volatility. In most cases, companies face a minimal probability of having a default, and as such in most cases, they are forced to bear minimal expected cost of bankruptcy as well as financial distress. Consequently, a lower probability of default permits firms to be in a position to increase their leverage and as a result benefit from increased tax shields. Corporate hedging as a risk management measure in a company helps an organization to align its availability of internal cash flows as well as the need for finance meant for corporate investment.

Corporate Hedging Tools for Risk Management

Most companies use different tools of corporate hedging in their risk management policies. Nevertheless, the two primary classifications of hedging tools include forwards and options. The forms of forwards in corporate hedging include swaps, FRAs, futures as well as locks. On the other hand, the types of options as hedging tools include caps, puts, swaptions, floors as well as calls. Most corporations may use a combination of forwards and options to safeguard themselves from financial risks. One of such risks that are highly managed by using corporate hedging tools is the risk of foreign exchange fluctuations in interest rates.

Forms of Financial Risks That Can Be Managed Using Corporate Hedging

Financial risks are among the primary forms of risks that face numerous corporations. As such, they are considered to be among the core factors that may contribute to the reduction in the shareholders value in a business organization. Nevertheless, corporate managers can use corporate hedging as an effective way of protecting the shareholders value in a business organization. The use of corporate hedging can aid the corporation in alleviating the problems of underinvestment and in the reduction of the problems of asset substitution. In addition, corporate hedging can help a corporation in reducing its costs of bankruptcy as well as costs associated with financial distress. Ultimately, corporate hedging can also be effective in the reduction of corporate tax burdens.

Conclusion

In summary, in a capital market characterized by imperfections, the use of corporate hedging as a risk management measure can aid in enhancing the value of shareholders. This is via their impact on taxes, agency costs, as well as internal and external costs associated with bankruptcy. In addition, corporate hedging aids in alleviating underinvestment as well as problems of asset substitution through the reduction in the volatility of cash flows. In addition, corporate hedging increases the effectiveness of various incentive managerial structures through the elimination of unsystematic risk. Also, corporate hedging aids in the alignment of a companys internal resources, with the need to collect investment funds. As a result, it helps a corporation to avoid expensive external forms of financing. All these factors help in improving the companys shareholders value.

Reference List:

Aretz, Kevin; Bartram, Sohnke M.; (2010), Corporate Hedging and Shareholder Value, Journal of Financial Research, v. 33, iss. 4, pp. 317-71.

Bartram, Sohnke M.; Brown, Gregory W.; and Conrad, Jennifer. (2011), The Effects of Derivatives on Firm Risk and Value, Journal of Financial & Quantitative Analysis, Vol. 46, Issue 4, pp. 967-999.

Campbell, Tim S. and Kracaw, William A. (1990) Corporate Risk Management and the Incentive Effects of Debt, Journal of Finance, v. 45, iss. 5, pp. 1673-86.

Disatnik, D., Duchin, R., & Schmidt, B. (2014). Cash flow hedging and liquidity choices. Review of Finance, 18(2), 715-748.

Fama, Eugene F., 1998. Market efficiency, long-term returns, and behavioral finance. Journal of Financial Economics, 49(3), 283306.

Fatemi, A., and Luft, C. (2002), Corporate risk management; Costs and benefits,' Global Finance Journal, 13, pp. 2938