21.1Risk Management and the Modigliani-MillerTheorem

Many of the major financial innovations of the 1980s were associated with the markets

for derivative securities, such as options, forward contracts, swap contracts, and futures.

These contracts provide relatively inexpensive and efficient ways for corporations and

investors to bundle and unbundle various aspects of risk, allowing those who are least

able to bear the risks to pass them off to others who can bear them more efficiently.

To understand this, return to the factor model introduced in Chapter 6 to reexamine

the stock returns of firm i. We will express those returns as

˜ F˜F˜. . . F˜˜	(21.1)
r
ABCii11i22iKKi

where

˜represent macroeconomic factors like interest rate movements, currency

Fs

changes, oil price changes, and changes in the aggregate economy

srepresent the stock’s sensitivity to those factors, or factor betas

˜is firm-specific risk

Astock’s sensitivity to factor risk as well as firm-specific risk is determined by the

firm’s capital expenditure and operating decisions (for example, whether to locate a

plant in North Carolina or Malaysia) and its financial decisions (for example, whether

to borrow in U.S. dollars or Japanese yen).

1

See, for example, Bodnar, Hayt, and Marston (1998).

²Interest rate volatility increased substantially in October 1979 when Federal Reserve Chairman Paul

Volcker announced that the Federal Reserve Board would no longer attempt to control interest rates.

Similarly, the volatility of foreign currency rates increased dramatically after 1973 when foreign

exchange rates began to float.

Grinblatt1493Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1493Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

Chapter 21

Risk Management and Corporate Strategy

741

Factor riskis generally not diversifiable, but often it can be hedged by taking off-

setting positions in financial derivatives. Firm-specific riskis just the opposite; it is

generally diversifiable but cannot be hedged with derivative contracts. It is possible,

however, to hedge many sources of firm-specific risk with insurance contracts. For

example, a fire insurance contract provides a good hedge against the losses incurred as

a result of a fire.

The Investor’s Hedging Choice

Before analyzing the hedging choice of firms, it is instructive to first consider the

possibility that individual investors hedge on their own. Assume that an investor

observes the factor sensitivities of the different investments available to him and con-

structs a relatively balanced portfolio which diversifies away firm-specific risk and is

weighted to give the investor his or her preferred exposure to the various sources of

factor risk, as represented by a particular configuration of factor betas.

Recall that the betas or factor sensitivities of the portfolio are the weighted aver-

ages of the sensitivities of the different securities held in the portfolio. In addition to

buying and selling stocks and bonds with the appropriate risk profiles, the investor may

use derivatives to more directly alter the portfolio’s exposure to particular sources of

systematic risk. For example, if F˜in equation (21.1) represents uncertain movements

2

in oil prices, investors can directly change the exposures of their portfolios to oil price

movements by buying or selling oil price futures or forward contracts.

Derivatives like forwards and futures are indeed used by many investors in exactly

this manner. However, the most important users of derivative instruments are corpora-

tions and financial institutions, like banks, that want to alter the risk profiles of their firms.