Finance Management-Risk Returns and Trade-offs
Risk Management is the process of assessing and modifying – on an ongoing basis – the many trade-offs between risk and reward that face a firm. These trade-offs can be evaluated based on whether they are done for the purpose of hedging, speculation and arbitrage. One of the first lessons that a finance student learns is that higher expected returns are accompanied by higher levels of risk. The corollary is that risk reduction typically entails some cost in the form of lower expected returns.
The classic risk-reward and trade-off introduces three key terms: Hedging, Speculation and Arbitrage. The initial position reflects the current status of the firm. Reward is some measure of an outcome whereby more is better than less. An economist might call the measure of reward, “utility” and a chief financial officer might call it “earnings per share”. Risk registers the degree of certainty about attaining the expected level of reward. More risk, moving to the right in the figure, spreads out the probability distribution for given outcomes. Moving to the left tightens the distribution, indicating greater certainty. The risk-free reward is the result when no uncertainty exists as to the outcome. Note that the initial position might be right where the firm wants to be in the terms of its potential risk and reward. Thus, sometimes effective risk management entails not taking any further action
Actions taken to reduce risk are known broadly as hedging. Such actions include diversification, buying options or insurance contracts and using forward and futures contracts to lock in a subsequent price or rate on a transaction. The common denominator is the intent to reduce risk and make the reward outcome more certain. Some people distinguish between hedging and insuring. Hedging, in the sense that it is limited to securing a future price, thereby eliminating potential gain as well as loss. Insuring against a loss provides protection from adverse price movement while retaining potential benefit.
Speculation is an action to increase expected reward, even though it raises the degree of uncertainty about achieving that outcome – a classic movement up and out in the reward – risk trade-off space. It is unlikely that a corporation would use the word “speculation” in describing its risk management strategy and it is certainly possible that the risk – taking activity is not only reasonable but also appropriate.
Arbitrage opportunities – circumstances in which a higher expected reward is not offset by higher risk – are the Holy Grail for financial managers. A reasonably efficient financial marketplace should preclude persistent arbitrage opportunities. The very presence of an opportunity should set off market forces that would lead to the elimination of the arbitrage gain. Nevertheless, a much touted application of interest rate swaps over the years has been to lower a firm’s cost of funds by issuing floating-rate debt and then converting it to a fixed rate.
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