Why Bother with Risk Management when Idiosyncratic Risk Doesn't Matter?
22 Pages Posted: 11 Dec 2019
Date Written: November 23, 2019
Firms seem to care a lot about "risk management": the practice of hedging risks whether they are correlated with market risk or not. The standard reasons why widely held corporations might be averse to idiosyncratic risk are based on the principal-agent problem, bankruptcy costs, external finance, and tax convexity. This paper offers a different reason: idiosyncratic risk makes business decisions more difficult. Risk can increase the value of investment projects because of option value. We must distinguish, however, between risk over the expected value of profits ("value risk") and risk over the volatility of cash flows ("cash-flow noise"). Value risk is good because an unprofitable policy can be abandoned. Cash-flow noise is bad because it makes learning when to abandon more difficult. This distinction is unrelated to Knightian risk or ambiguity aversion, and it matters even if the firm's agents are risk neutral.
Keywords: idiosyncratic risk, risk aversion, business risk, real options, learning, capital budgeting, risk management, value risk, cash-flow noise
JEL Classification: D21, D25, D81, G32, L21
Suggested Citation: Suggested Citation