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Can Risk Management Help Prevent Bankruptcy?

Can Risk Management Help Prevent Bankruptcy?. Monica Marin Ph.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).

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Can Risk Management Help Prevent Bankruptcy?

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  1. Can Risk Management Help Prevent Bankruptcy? Monica Marin Ph.D. Candidate, Finance

  2. Motivation • Warren Buffett: "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.“ (2002 Berkshire Hathaway Annual Report)

  3. 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.

  4. 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

  5. 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

  6. 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

  7. 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

  8. Approach II: Distance to Default (Contd.) • The value of the firm: • The market value of common equity: • Equity volatility & Asset volatility:

  9. Approach II: Distance to Default (Contd.) • Distance to Default: • Expected Default Probability:

  10. 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

  11. GMM Results (Duration Analysis)

  12. GMM Results (Distance to Default)

  13. GMM Results (Asset Volatility)

  14. GMM Results: Changes in DD

  15. GMM Results: Changes in AV

  16. 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

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