René M. Stulz*
Revised, September 1996
*Bower Fellow, Harvard Business School; Reese Chair in Banking and Monetary Economics, The Ohio State University; Research Associate, National Burea of Economic Research. I am grateful for u
comments to Steve Figlewski, Andrew Karolyi, Robert Whaley, and participants at a seminar t a
McKinsey, at the Annual Meetingof the International Association of Financial Engineers, and at the French Finance Association.
Empirical evidence shows that the practice of risk management is limited and does not correspond to the prescriptions of the academic literature. In particular, the practice focuses on hedgin g
transactions exposures and a firm’s hedge ratios depend on the views of the managers of that firm. In this paper, we provide a new approach to risk management that is consistent both with the main results of the academic literature but takes into account the factthat firms can have a comparative advantage in bearing some kinds of risks. We examine the implications of this new approach for the management of risk management and for risk measures such as Var.
This article explores a paradox in the current practice of risk management. Academic research argues strongly that risk management creates value. Most of the academic research focuses on risk management that decreases variability of firm value or cash flows. Despite this academic literature, however, the practice of risk management is rather limited and it does not seem to correspond to the recommendations of academics. Does this mean that academic theories of risk management are not useful? Is there too little risk management? Is it the right kind of risk management?
In the first part of this article, I review some evidence we have about risk management practice. Part of this evidence has to do with the derivative losses of the past few years. What do these losses tell us about practice? Would these losses have occurred if firms had followed modern corporate finance theory? The rest of the evidence consists of survey data. All of the evidence shows that firms let their views about the rewards for bearing hedgeable risks affect their hedge ratios in a significant way. This raises the question of whether such a practice is consistent with modern risk management theory. I present the main elements of this theory. Whereas much of the literature interprets this theory as suggesting that firms should hedge risks to reduce the variance of cash flow, I show that the theory properly interpreted is consistent with some of current practice and can be used to improve current practice. The theory implies that some firms should hedge all risks, that other firms should not worry about risk at all, and finally, that some firms should worry only about some kinds of risks. Some firms have a comparative advantage in taking some types of risks; others do not. I argue that existing risk measures such as VAR or the variance of cash flows cannot be motivated from existing theory. I present a risk measure which has a foundation in modern finance theory and is easy to compute. Finally, I conclude with a discussion of the management of risk management. If risk management is not focused on variance reduction, then much more attention should be devoted to the control, management and evaluation of risk taking and we should develop a better understanding of the agency costs of risk taking.
The paper proceeds as follows. Section 2 discusses empirical evidence. Section 3 reviews existing
academic theories of risk management. Section 4 evaluates the empirical evidence in light of the academic theories. Section 5 makes the argument that firms have comparative advantages in taking some risks. Section 6 discusses why risk-taking differs across firms. Section 7 provides risk measures that are consistent with current practice and academic theories. Section 8 examines how risk...