RISK MANAGEMENT

Risk Management Impact on Shareholder Value

Risk Management Impact on Shareholder Value

Introduction

The ultimate goal of nay organization is to maximize shareholder's wealth. To achieve this purpose, management attempts to increase the valuation of its shares which can be achieved by increasing profitability. It has been found that increase in profitability is associated with increase in share prices. But the process of shareholder wealth maximization has to deal with a very crucial element in corporate management i.e. risk.

A business is surrounded by risk wherever it is engaged because of unfavorable consequences inherent in its activities. Moreover, organizations continuously enter new markets to generate maximum wealth for its stakeholders and hence creating new avenues of risk. It has been well established that risk and return are positively correlated. An organization cannot expect to generate excess return above risk free rate without taking ion risk. Unless an organization is extremely conservative and intending to earn just risk free rate, it cannot avoid the possibility of risk. Hence an organization must manage risk if it intends to earn positive risk adjusted excess return.

Both financial and nonfinancial firms engage in corporate risk management regularly, as is evidenced in their annual reports and their use of derivatives. There have been theories proposed in favor of the argument that capital structure does not affect the shareholder wealth in an efficient market. But the evidence suggest otherwise. Many firms regularly engage in risk management activities. For majority of US firms, the main objective of their risk management activities involves hedging against interest rate risk and foreign exchange risk. Many theories have suggested a positive relationship between risk management and shareholder wealth and the extensive use of derivatives supports the argument in presence of imperfect market conditions. Corporate hedging decreases the cost of financial distress and thus enhances shareholder value.

Failure of risk management strategies can lead to diminished market value and shareholder confidence. Shareholders and all the other stakeholders expect active risk management strategies from executive management. Many organizations are employing Enterprise Risk Management (ERM) as a tool to cater all the risks that can adversely affect shareholder value. Enterprise risk management is a new concept that is becoming part corporate agenda globally. The ERM approach has gained popularity because of the recent scandals due to lack of corporate governance. ERM is the process of detecting and analyzing risk from a companywide perspective. It is a structured approach aimed at aligning strategy, processes people for the purpose of evaluating risk faced by an enterprise.

The use of derivatives, mainly for hedging of foreign exchange and interest risk, have been predominantly used by firms as a part of their overall risk management strategy. The use of derivatives is a part of broad financial strategy that also incorporates level of financial risks, risk management tools and operating environment of the firm. The findings suggest that use of derivatives is associated with debt levels and maturity, dividend policy and degree of operating ...