Can Risk Management Help Prevent Bankruptcy?
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Transcript of Can Risk Management Help Prevent Bankruptcy?
Can Risk Management Help Prevent Bankruptcy?
Monica MarinPh.D. Candidate, Finance
Motivation
Warren Buffett:
"Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.“
(2002 Berkshire Hathaway Annual Report)
Question and Hypothesis
QUESTION: Are risk management instruments used for risk
reduction or for speculation purposes?
HYPOTHESIS: The use of risk management instruments reduces
the probability of default.
Related Literature
Arguments for the use of risk management instruments to: REDUCE RISK
Smith and Stulz,1985
Limited empirical evidence on the relationship between risk management and bankruptcy:
· no relationship (Nance, Smith Jr., Smithson(1993),Mian(1996))
· weak relationship (Fok, Carroll, and Chiou, 1997)· strong relationship (Judge, 2006)
SPECULATE Faulkender, 2005: interest rate risk management is driven by
speculation
Approach I: Duration Model
A discrete time duration model (complementary log-log regression)
Takes account of: the sequential nature of the data censoring time-varying covariates
Approach II: Distance to Default Structural model (the Black-Scholes-Merton option
pricing model) Advantages:
extracts information from market prices computes the probability of default / distance to default
independently for any firm
Disadvantages: assumes:
market efficiency perfect liquidity lack of arbitrage conditions
does not incorporate financial restructuring
Approach II: Distance to Default (Contd.) Firm equity ~ a call option on the assets of the firm
strike price equals the value of zero coupon debt with maturity at time T
If at time T, then exercise; else let option expire and default
The value of the call option is equal to
DVA
)0,max( , ttA DV
Approach II: Distance to Default (Contd.) The value of the firm:
The market value of common equity:
Equity volatility & Asset volatility:
tAtA
tA dWrdtV
dV
,
,
ATrT
TT
AE VedNeDdNeVV )1()2()1(
T
E
AAE edNV
V )1(
Approach II: Distance to Default (Contd.) Distance to Default:
Expected Default Probability:
T
TDV
DDA
ATA
)2
(ln2
))
2()ln(
(
2
T
TDV
NEDPA
ATA
Data
344 firms: 172 pairs (bankrupt and non-bankrupt)
Time period: bankruptcies occurring between 1998 and 2005, followed between 1994 and 2004
Matching criteria: asset size and industry in the fiscal year before bankruptcy
GMM Results (Duration Analysis)
GMM Results (Distance to Default)
GMM Results (Asset Volatility)
GMM Results: Changes in DD
GMM Results: Changes in AV
Conclusion
Risk management is associated with: lower probability of bankruptcy higher distance to default lower asset volatility
The benefit of using risk management instruments is greater when: interest rate hedging needs are high foreign currency hedging needs are high commodity price hedging needs are low