Value and Risk: Beyond Betas

Abstract

Risk can be both a threat to a firm's financial health and an opportunity to get ahead of the competition. Most analysts, when they refer to risk management, focus on the threat posed by risk and emphasize protecting against that threat (i.e. risk hedging). In keeping with this narrow definition of risk management, the risk associated with an investment is almost always reflected in the discount rate in conventional discounted cash flow models. Since we also assume that only market risk affects discount rates, it follows that firms that expend time and resources in hedging firm-specific risk will lose value to the extent that risk management is expensive. Firms that reduce exposure to systematic risk will see no effect on value, if risk-hedging products are fairly priced. In this paper, we consider ways in which we can broaden both the definition of risk management to include ways of exploiting risk to gain a competitive advantage and the analysis of the effects on value. We argue that risk management can affect expected cash flows by altering investment policy and creating competitive advantages, which in turn can have consequences for expected growth rates and excess returns. This offers the potential for a payoff to risk management for many firms that may not benefit from risk hedging. In the closing part of this paper, we consider the steps involved in developing a comprehensive strategy for dealing with risk

Keywords: risk management, value

JEL Classification: G12, G39