Corporate risk management: an overview

Corporate risk management and hedging are important activities within financial as well as non-financial corporations. Under the assumptions of Modigliani and Miller [1958], corporate risk management is a redundant activity. However, the existence of market imperfections can explain the corporate use of derivatives. Hedging can increase firm value when 1) firms face a progressive tax rate, 2) there are expected costs from financial distress, and 3) hedging can reduce agency costs of debt. Furthermore, derivatives’ use can be explained by the risk attitude of managers. This paper provides a review of, and some critical notes on the theoretical and empirical literature on corporate risk management strategies. It will be stated that the empirical results for the theoretical hypotheses are mixed, even though corporate risk management can substantially increase firm value. The major determinant of derivatives’ use is firm size. The mixed results indicate that corporate risk managers, willingly or unwillingly, do not behave in an optimal way. Therefore, this study may motivate corporate risk managers to use derivative instruments in order to create shareholder value, since it shows the benefits of corporate risk management and the sources of these benefits.