The Value of Real and Financial Risk Management
37 Pages Posted: 2 Jan 2006
Date Written: December 2005
We characterize a firm as a nexus of projects with their associated cash flows. Production and operations activities and real risk management activities distribute cash flows over states of nature and time periods, leading to a transformation possibility frontier similar to a production function. We show how changes in the price of risk affect the value maximizing levels of real activities. The typical separation between management activities concerning production and operations on one hand and real risk on the other is a source of efficiency gains but causes coordination problems. Financial risk management creates value by alleviating these coordination problems. It also allows a firm to meet cash flow-at-risk or value-at-risk constraints at no cost.
Keywords: Risk Management, Firm Value, Coordination, Value at Risk
JEL Classification: G22, G31, G34
Suggested Citation: Suggested Citation