Financial Risk Management Essay Example

shareholders find it optimal to implement a risk-management strategy ex-post, even without a pre-commitment to do so. The optimal investment risk in the model depends on firm leverage, the financial distress boundary, the project's time horizon, and the costs of financial distress. Similar to existing models (Smith and Stulz (1985)), firms with high leverage have a greater incentive to engage in hedging activities. However, my model explicitly demonstrates that firms with extremely high leverage lose their risk-management incentives.

Opler and Titman (1994) discovered that highly leveraged firms in industries with a higher prevalence of predatory behavior from competitors, such as those with a high concentration of players, are more motivated to hedge their positions. The study's model also shows that as project maturity increases, the incentives for hedging also increase. The model incorporates financial risk management strategies due to the costs associated with a firm being in a state of financial distress but remaining solvent until the maturity date. If these costs are absent, there would be no need for risk-management incentives. However, if the costs of financial distress are too high, distinguishing between financial distress and insolvency becomes less clear, resulting in reduced ex-post risk-management motivations.

Financial risk-management incentives are created within firms by the intermediate levels of deadweight losses. Price fluctuations give rise to risks for corporations, which directly or indirectly affect the company's value. The combination of factors such as greater deregulation, international competition, interest rates, and foreign exchange rate volatility, along with commodity price discontinuities starting in the late 1960s, has amplified corporate concerns. This heightened importance of financial risk management has persisted over time. Managing risks such as exchange rate changes for

multinational companies, fuel prices for transportation companies, or interest rate exposure for highly leveraged companies often determines whether a business succeeds or fails. Therefore, financial risk management is crucial in achieving a company's primary goal of maximizing stockholder wealth.

There are two primary ways to carry out financial risk management: diversifying the firm's portfolio and engaging in financial transactions. In the past, diversification was a frequently employed strategy for risk management. However, nowadays, firms tend to favor more direct approaches provided by the financial markets. This is because these markets offer methods of managing risk that don't necessitate direct investment in activities aimed at reducing volatility. One approach involves utilizing derivative instruments to transfer financial price risks to other parties. Prior to the development of derivative markets, there were limited choices available for addressing financial risks, most of which fell outside managerial control.

During the 1980s and 1990s, there were only a few exchange-traded derivatives available for corporate users to hedge financial risks. However, these options were limited in scope and duration (Santomero, 1995). To mitigate the risks associated with fluctuating exchange rates, companies often had to rely on alternative strategies such as establishing overseas plants. Another approach was natural hedging, which involved aligning currency structures of assets and liabilities (Santomero, 1995). Nevertheless, Allen and Santomero (1998) observed that commercial and investment banks, as well as derivatives exchanges, took proactive measures to introduce various new products aimed at helping corporate managers manage financial risks. Derivatives exchanges, having successfully introduced interest rate and currency derivatives in the 1970s, continued their innovation by continually adding new products, improving existing ones, and enhancing liquidity.

Since their inception, derivative instruments such as

forwards, futures, swaps, and options have seen significant market growth. The variety and quality of both exchange traded and over-the-counter derivatives have expanded, resulting in increased market depth. As a result of this growth, corporations are increasingly utilizing derivatives to hedge risks associated with interest rates, currency exchange rates, and commodity prices. This period can be considered the start of a revolution in derivatives. The modern and innovative derivative markets enable corporations to safeguard against financial risks or make necessary adjustments (Hu, 1995; 1996).

Companies are facing increasing pressure from shareholders and stakeholders to identify and manage financial risks in the current climate. Previously, it was believed that risk management had no impact on a firm's value, with support from the Capital Asset Pricing Model (Sharpe, 1964; Lintner, 1965; Mossin, 1966) and the Modigliani-Miller theorem (Modigliani and Miller, 1958). The CAPM suggests that diversified shareholders only need to be concerned about systematic risk. This may suggest that managers acting in the best interests of shareholders would not need to hedge non-systematic risks. The Modigliani-Miller proposition aligns with the findings of CAPM. Additionally, hedging decisions related to interest rate, exchange rate, and commodity price risks are considered irrelevant because stockholders are already protected through diversification.

Managers engage in hedging activities to reduce non-systematic risk. The clash between theory and practice is attributed to imperfections in the capital market, which justify the relevance of corporate risk management. Studies on derivatives as risk management tools generally support the expected relationships between risks and firm characteristics. Stulz (1984), Smith and Stulz (1985), and Froot, Scharfstein, and Stein (1993) developed models of financial risk management that predicted firms' attempts to reduce the

risks associated with potential bankruptcy costs or funding needs for future investment projects in the presence of asymmetric information. In many cases, derivatives can be used to achieve such risk reduction.

The empirical studies conducted by Campbell and Kracaw (1987), Bessembinder (1991), Nance, Smith and Smithson (1993), Dolde (1995), Mian (1996), Getzy, Minton and Schrand (1997), and Haushalter (2000) have all found evidence that firms with high levels of debt are more likely to use derivatives for hedging. The likelihood of a firm experiencing financial distress is directly tied to the proportion of its fixed claims compared to the value of its assets. Therefore, hedging becomes more valuable for highly indebted firms as financial distress can result in bankruptcy, restructuring, or liquidation, leading to direct costs. By reducing the volatility of a firm's cash flows or accounting profits, hedging decreases the probability and expected costs of financial distress (Mayers and Smith, 1982; Myers, 1984; Stulz, 1984; Smith and Stulz, 1985; Shapiro and Titman, 1998). This argument suggests that risk management's benefits should be greater when the fraction of fixed claims in a firm's capital structure is larger.

The use of derivatives and risk management practices aligns with the predictions made by the theoretical literature, which is based on maximizing value. Firms can decrease volatility in cash flow by hedging financial risks such as currency, interest rate, and commodity risk. This reduction in volatility leads to lower expected financial distress and agency costs, ultimately enhancing the present value of future cash flows. The financial economics approach to corporate financial risk management has been the most prolific in terms of theoretical model extensions and empirical research. This

approach builds upon the classic Modigliani-Miller paradigm, which states the conditions for the irrelevance of financial structure for corporate value (Miller and Modigliani, 1958).

This paradigm was later extended to the field of risk management. It also states that hedging reduces the volatility of cash flow and hence lowers the volatility of firm value. The reasons for corporate risk management were derived from the irrelevance conditions and encompassed higher debt capacity (Miller and Modigliani, 1963), progressive tax rates, lower expected costs of bankruptcy (Smith and Stulz, 1985), securing internal financing (Froot et al., 1993), and information asymmetries (Geczy et al.).

According to Stulz (1996), both diversification through hedging and having a comparative advantage in information can lead to higher value in a hedging premium. However, there is limited evidence supporting the predictions of financial economics theory approach to risk management. It is suggested that risk management does result in lower variability of corporate value. (e.g. 1997).

There is little evidence linking the main prerequisite for all other effects (as noted by Jin and Jorion, 2006) to the benefits specified by the theory. Tufano's (1996) widely cited paper finds no evidence supporting financial hypotheses and focuses instead on the influence of managerial preferences. Conversely, the higher debt capacity hypothesis is supported by Faff and Nguyen (2002), Graham and Rogers (2002), and Guay (1999). Guay (1999) and Geczy et al. positively verify the internal financing hypothesis.

In 1997, Faff and Guyen rejected the hypothesis, while Mian (1996) also rejected it. However, Judge (2006) found evidence supporting the financial distress hypothesis. The tax hypothesis was positively verified by Nance, Smith, and Smithson (1993), but other studies contradicted this finding (Mian, 1996; Graham

and Rogers, 2002). More recently, Jin and Jorion (2006) provided strong evidence indicating a lack of value relevance of hedging, although previous studies have shown a hedging premium (Allayannis and Weston, 2001; Carter et al., 2006). The tested hypotheses include all the rationales mentioned above, except for information asymmetries and comparative information advantage.

The text outlines three hypotheses about the effect of hedging on a company's value. The initial two hypotheses center around the connection between hedging and stock price volatility. Hypothesis 1a posits that there is an inverse relationship between hedging and stock price volatility, while Hypothesis 1b suggests an inverse correlation between hedging a specific risk and the vulnerability of stock prices to that particular risk factor. The third hypothesis examines whether there is a bonus associated with initiating hedging activities, using Guay's (1999) methodology.

Hypothesis 1c: Firms that initiate hedging experience an increase in their equity's market value.

According to the debt capacity and tax incentive rationales, firms have an interest in maximizing their gearing ratios, utilizing the tax shield fully, and reducing their tax charges. Hedging enables this by decreasing the risk of default and enabling higher debt capacity. Additionally, if the tax curve is concave, lower earnings volatility may result in lower average tax charges. However, in Poland, the corporate income tax is a flat rate, rendering this effect insignificant.

The following hypotheses are presented in relation to hedging and various financial ratios:

Hypothesis 1d states that there is a positive relationship between hedging and the debt/equity ratio.

Hypothesis 1e suggests that firms that begin hedging subsequently raise their debt equity ratio.

Hypothesis 1f proposes that firms with a low times interest earned ratio, but

above one, hedge more often compared to firms with a high ratio or lower than one.

Hypothesis 1g indicates that firms that hedge are able to pay their interest charges, as their times interest earned ratio is greater than one.

Hypothesis 2h states a negative relationship between hedging and income tax paid relative to sales.

Lastly, hypothesis 2i suggests that the average tax charge falls after firms start to hedge.

The final hypothesis of financial economics is related to obtaining internal financing for strategic projects and reducing costs of financial distress. These incentives are particularly important for companies with high development expenditure or other growth options. Hypothesis 2j states that there is a positive relationship between hedging and growth options, which can be seen through high R expenditure or a high market-to-book value ratio.

On the other hand, agency theory expands the analysis of the firm by considering the separation of ownership and control, as well as managerial motivation. within the field of corporate risk management, agency issues have been found to impact managerial attitudes towards risk-taking and hedging (Smith and Stulz, 1985). The theory also addresses potential conflicts of interest between shareholders, management, and debt holders due to asymmetries in earning distribution. These conflicts may lead to the firm taking excessive risks or neglecting beneficial projects that generate positive net value (Mayers and Smith, 1987).

Agency theory suggests that firm value can be significantly influenced by defined hedging policies (Fite and Pfleiderer, 1995). The hypotheses associated with financing structure also align with predictions from financial theory. Several studies have empirically examined the impact of managerial motivation factors on the implementation of corporate risk management, with some finding

a negative effect (Faff and Nguyen, 2002; MacCrimmon and Wehrung, 1990; Geczy et al., 1997). However, Tufano (1996) did find positive evidence in his analysis of the gold mining industry in the US.

Studies of financial theory have tested hypotheses regarding financial policy. The results have shown that agency theory and financial theory have similar predictions in this area. However, the majority of empirical evidence does not support the hypotheses of agency theory. Nevertheless, agency theory does offer significant support for hedging as a response to the misalignment of managerial incentives and shareholder interests. The following hypotheses aim to examine the fundamental implications of this theory.

The first hypothesis examines if firms hedge to reduce risk for block shareholders. The following three hypotheses investigate whether hedging serves as a means to protect debtholder interests and enhance debt capacity. Hypothesis 2a suggests a positive correlation between hedging and individual block ownership. Hypothesis 2b states that companies with high debt/equity ratios tend to use hedging more frequently. Hypothesis 2c posits that firms are prone to initiate hedging when they possess low equity/assets ratios and intend to raise debt or obtain a bank loan. Hypothesis 2d proposes that firms are inclined to initiate hedging when they have high debt/equity ratios and wish to issue debt or take out a bank loan.

New Institutional Economics provides a different perspective on financial risk management, focusing on governance processes and socio-economic institutions. According to Williamson (1998), these institutions guide risk management practices. While empirical studies on this approach have not been conducted yet, the theory suggests that corporate behavior in risk management may be influenced by institutions and accepted market practices. Additionally, the theory

suggests that security is linked to specific asset purchases (Williamson, 1987), indicating the importance of risk management in contracts that involve two parties without diversification options, such as large financing contracts or close cooperation within a supply chain. If institutional factors do significantly impact hedging, this should be reflected in the available data.

In Poland, there may be a variation between sectors regarding hedging popularity. It is possible to speculate that hedging will gain more popularity over the years. Another implication is that shareholders might be interested in reducing company risk to attract block ownership. This prediction aligns with agency theory, where NIE shares similar views. Additionally, this theory suggests that ownership structure in general can influence firm practices.

The implications are tested through the following hypotheses:

Hypothesis 3a states that there are variations in hedging popularity across industries.

Hypothesis 3b suggests that the frequency of hedging fluctuates over time.

Hypothesis 3c proposes a positive correlation between hedging and individual block ownership.

Hypothesis 3d suggests that the ownership structure influences hedging behavior, specifically with regards to government, institutional investors, and foreign investors. Stakeholder theory, initially developed by Freeman (1984) as a managerial tool, has evolved into a theory of the firm that provides in-depth understanding. This theory emphasizes the importance of balancing stakeholder interests to determine corporate policy. An extension of implicit contracts theory from employment to other contracts, such as sales and financing, has shown potential in financial risk management (Cornell and Shapiro, 1987). In industries like high-tech and services, consumer trust in a company's ability to continue providing its services can significantly impact its value.

The implicit claims of the value in financial risk management are influenced by the

expected costs of financial distress and bankruptcy. When companies implement risk management practices, it reduces these costs and increases the value of the company (Klimczak, 2005). This perspective from stakeholder theory offers a novel perspective on the reasoning behind financial risk management, although it has not been directly tested. The investigations into the financial distress hypothesis (Smith and Stulz, 1995) provide only indirect evidence to support this claim (Judge, 2006).

According to Charles (2004), Finance Theory states that a company should only undertake a project if it increases the value of its shareholders. The theory also highlights that company managers cannot generate shareholder value by taking on projects that shareholders can do on their own at the same cost. Applied to financial risk management, this suggests that company managers should not hedge risks that shareholders can hedge themselves at the same cost. This concept is known as the hedging irrelevance proposition. In an ideal market, a company cannot add value by hedging a risk if the cost of bearing that risk internally is the same as bearing it externally. However, in reality, financial markets are unlikely to be perfect.

The text suggests that firm managers have numerous opportunities to create value for shareholders through financial risk management. The key is to identify which risks are more cost-effective for the firm to manage compared to the shareholders. Generally, market risks that lead to unique risks for the firm are ideal for financial risk management. However, in the international context, the concept of financial risk management undergoes significant changes. Multinational corporations face several challenges in addressing these obstacles. Research has explored the risks that firms must consider in operating

across multiple countries, including three types of foreign exchange exposure for different future time periods: transactions exposure, accounting exposure, and economic exposure (Conti & Mauri, 2008).

Chapter Two Empirical Evidence

Both managers and researchers consider financial risk management to be essential. Managers must control financial risk for the long-term growth of companies, while researchers are interested in both the theoretical and practical aspects of this issue. Over the past few decades, numerous scholars have focused on researching enterprise financial risks from various perspectives. Barbro and Bagajewicz (2004) proposed a new twostage random management pattern to reduce financial risk from a managerial standpoint. This pattern has been used in studies on financial risk in small and medium-sized enterprises.

Hu (2005) conducted a survey to analyze small and medium-sized enterprises in central Taiwan. The study used multivariable analysis and Logit regression to build a financial planning model. Four conclusions were drawn to decrease financial risk. Firstly, company leaders should possess multiple professional knowledge. Secondly, the company must focus on significant environmental changes that may lead to poor management of small and medium-sized enterprises, such as changes in government policies. Thirdly, a sound financial system is necessary. Lastly, the company should establish a good monitoring system. By effectively addressing these four aspects, the probability of a company experiencing a financial crisis can be significantly reduced. Cao and Zeng (2005) studied the empirical financial risk management of large enterprises by using financial leverage as the dependent variable.

According to the authors, the financial risk of enterprises is positively correlated with the scale and structure of liabilities, negatively correlated with profitability and operational ability, and has

no obvious linear correlation with interest rate and solvency. Previous studies have primarily focused on the concept of financial risk for SMEs, early warning models, strategies, and management of financial risk. However, few scholars have conducted empirical studies on financial risk management, especially for SMEs. The global financial crisis that started in 2008 has affected numerous enterprises, both large and small. In a previous empirical study, Zhou and Zhao (2006) found that the average level of financial risk for private listed companies was significantly higher than that of state-owned listed companies. Another study by Liao (2006) used small and medium-sized enterprise data provided by a financial institution to analyze the characteristics of these types of enterprises using logistic regression and factor analysis, with variables including both financial and non-financial factors.

The conclusions are as follows: when the model considers both financial and non-financial variables, its predictive ability is superior compared to the model that only uses financial variables. It is also more challenging to predict the financial risk of young small and medium-sized companies (less than 7 years old) compared to older companies. Wang and Chen (2010) conducted research on financial risk under financing restricted conditions using unbalanced panel data. They found that the financial risk of constrained companies is higher than that of unconstrained companies.

Chapter Three Summary of Research Methodology

Data Analysis will be conducted on a panel of Kenyan non-financial companies listed at the Nairobi Securities Exchange. The panel will include data from approximately 150 companies (with slight variations in numbers for specific years) for the period spanning from 2006 to 2011. The last two years of

the series will be used to verify the results, and data for this period will be collected from 30 randomly selected companies.

The choice of Kenyan listed companies for theory verification may raise concerns about possible idiosyncratic factors influencing financial risk management in Kenya. However, all companies included in the study will be based in Kenya, regardless of their ownership structure. It is argued that verifying financial risk management theory using data from a developing country can yield reliable results, just like studies based on data from wealthier countries. Firstly, Kenyan companies have been rapidly learning new business models and techniques, including financial risk management, over the past 17 years. Secondly, due to the ongoing economic transition, there are fewer historical and institutional factors influencing the current state of financial risk management in Kenya compared to countries like the USA, UK, or Germany. Lastly, there is sufficient financial market infrastructure in Kenya for companies to engage in risk management.

Therefore, Kenyan companies can incorporate financial risk management processes if they find them beneficial. The study will focus solely on non-financial corporations, specifically companies in sectors unrelated to financial services. This approach, utilized by Nance et al. (1993), Faff and Nguyen (2002), and Berkman and Bradbury (1996), is based on the belief that banks, insurance companies, and other financial sector firms obtain and issue derivative instruments not just for hedging but also for trading purposes. The data will be gathered from two sources: annual reports and financial statement notes for the fiscal year 2006, as well as through a survey.

A questionnaire will be sent to managers in Kenya who are responsible for making financial risk management decisions in

selected companies. The survey data will be analyzed using both univariate and multivariate analysis. Descriptive statistics have been used to provide insights into the risk management practices of firms in both samples. Furthermore, the differences in means between Kenyan users and nonusers have been examined using independent sample t-tests. By using this test, unresolved issues in the area can be statistically calculated. Unfortunately, there have been few research studies on effective financial risk management by organizations in Kenya. Therefore, it is necessary to further explore this area through research.

This study aims to address the existing knowledge gap.

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