Rethinking Risk Management

• Published date: 01 March 2022
• Author: René M. Stulz
• Date: 01 March 2022
• DOI: http://doi.org/10.1111/jacf.12486

IN THIS ISSUE:

Honoring

René Stulz

VOLUME 34

NUMBER 1

WINTER 2022

APPLIED

CORPORATE FINANCE

Journal of

8Globalization, Corporate Finance, and the Cost of Capital

René M. Stulz, The Ohio State University

24 e Limits of Financial Globalization

René M. Stulz, The Ohio State University

32 Rethinking Risk Management

René M. Stulz, The Ohio State University

47 Risk Management Failures: What Are ey and When Do ey Happen?

René M. Stulz, The Ohio State University

58 How Companies Can Use Hedging to Create Shareholder Value

René M. Stulz, The Ohio State University

67 Real Options and Hidden Leverage

Stewart C. Myers, MIT Sloan School of Management, and

James A. Read, Jr., The Brattle Group

81 Enterprise Risk Management: eory and Practice

Brian W. Nocco, Nationwide Insurance, and René M. Stulz, The Ohio State University

95 Risk-Taking and Risk Management by Banks

René M. Stulz, The Ohio State University

106 FinTech, BigTech, and the Future of Banks

René M. Stulz, The Ohio State University

118 Merton Miller’s Contribution to Modern Finance

René M. Stulz, The Ohio State University

32 Journal of Applied Corporate Finance • Volume 34 Number 1 Winter 2022

e actual corporate use of derivatives, however, does not

seem to correspond closely to the theory. For one thing, large

companies make far greater use of derivatives than small rms,

even though small rms have more volatile cash ows, more

restricted access to capital, and thus presumably more reason

to buy protection against nancial trouble. Perhaps more

puzzling, however, is that many companies appear to be using

risk management to pursue goals other than reducing variance.

Does this mean that the prevailing academic theory of

risk management is wrong, and that “variance-minimization”

is not a useful goal for companies using derivatives? Or, is

the current corporate practice of risk management misguided

and in urgent need of reform? In this paper, I answer “no” to

both questions while at the same time suggesting there may

be room for improvement in the theory as well as the practice

of risk management.

e paper begins by reviewing some evidence that has

accumulated about the current practice of corporate risk

management. Part of this evidence takes the form of recent

“anecdotes,” or cases, involving large derivatives losses. Most of

the evidence, however, consists of corporate responses to surveys.

What the stories suggest, and the surveys seem to conrm, is

the popularity of a practice known as “selective” as opposed to

“full-cover” hedging. at is, while few companies regularly use

derivatives to take a “naked” speculative position on FX rates

or commodity prices, most corporate derivatives users appear

to allow their views of future interest rates, exchange rates, and

commodity prices to inuence their hedge ratios.

Such a practice seems inconsistent with modern risk

management theory, or at least the theory that has been

presented thus far. But there is a plausible defense of selec-

tive hedging—one that would justify the practice without

violating the ecient markets tenet at the center of modern

nancial theory. In this paper, I attempt to explain more of the

corporate behavior we observe by pushing the theory of risk

management beyond the variance-minimization model that

prevails in most academic circles. Some companies, I argue

below, may have a comparative advantage in bearing certain

nancial risks (while other companies mistakenly think and

act as if they do). I accordingly propose a somewhat dierent

goal for corporate risk management—namely, the elimina-

tion of costly lower-tail outcomes—that is designed to reduce

the expected costs of nancial trouble while preserving a

company’s ability to exploit any comparative advantage in risk-

bearing it may have. (In the jargon of nance specialists, the

fundamental aim of corporate risk management can be viewed

as the purchase of “well-out-of-the-money put options” that

eliminate the downside while preserving as much of the upside

as can be justied by the principle of comparative advantage.)

Such a modied theory of risk management implies that

some companies should hedge all nancial risks, other rms

should worry about only certain kinds of risks, and still others

should not worry about risks at all. But, as I also argue below,

when making decisions whether or not to hedge, management

should keep in mind that risk management can be used to

change both a company’s capital structure and its ownership

structure. By reducing the probability of nancial trouble, risk

*I am grateful for extensive editorial assistance from Don Chew, and for comments by

Steve Figlewski, Andrew Karolyi, Robert Whaley, and participants at a seminar at McK-

insey, at the Annual Meeting of the International Association of Financial Engineers, and

at the French Finance Association. This article originally appeared in the Journal of Ap-

plied Corporate Finance, Vol. 9 No. 3 (Fall 1996), 8-24.

Rethinking Risk Management

his article explores an apparent conict between the theory and current practice of

corporate risk management. Academic theory suggests that some companies facing

large exposures to interest rates, exchange rates, or commodity prices can increase their

market values by using derivative securities to reduce their exposures. The primary empha-

sis of the theory is on the role of derivatives in reducing the variability of corporate cash ows

and, in so doing, reducing various costs associated with nancial distress.

by René M. Stulz, The Ohio State University*

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